Between Scylla and Charybdis: moral hazard or systemic risk: bailout Odyssey poses tough choices.

• Author: Adams, Tucker Hart
• Position: [the] ECONOMIST

It was only seven months ago that Standard & Poor's assured us that the majority of the losses in mortgage-backed securities had been disclosed, topping out at $285 billion. It certainly didn't turn out that way!

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The situation worsened through the summer. In October, despite hundreds of billions of dollars in emergency lending to an unprecedented range of financial institutions, the nationalization of Freddie Mac and Fannie Mae and forced mergers of failing banks, the international financial system teetered on the verge of collapse. What should a responsible government do? There's not an easy answer.

Think back to high school or college, when you first read Homer's "Odyssey." Scylla was a horrible creature with six heads and 12 feet who dwelt on a rock and ate sailors who passed by too closely. Charybdis had a single gaping mouth, which sucked in huge quantities of water and belched them forth three times a day, creating enormous whirlpools.

Odysseus was forced to choose which monster to confront when passing through the narrow Straits of Messia. He opted to pass close to Scylla and risk losing a few sailors, rather than chance the loss of his entire fleet to the whirlpool.

A moral hazard-the Scylla of financial markets--occurs when an individual or business is protected from downside risk and hence takes bigger chances than he otherwise would do. In recent decades, as financial institutions moved from holding loans on their books to packaging and selling them to the investing public, a moral hazard was created. The financial institutions benefited from the fees paid when the loans were made, but believed themselves protected if the loans weren't repaid, since they no longer owned them.

Hence, mortgage loans requiring little or no down payment were offered to borrowers with poor credit histories and/or unverified income streams. This was the root of the recent credit crisis that began in July 2007.

This led to speculation that some financial institutions are just too big to be allowed to fail. If so, their incentive to make prudent lending and investment decisions has been diminished. They can continue to benefit from the upside profits that accompany risky decisions, but will be protected from the downside losses if those decisions...