The Cost of Keeping Risk Cheap, and the Next Bubble

The American public was rightly outraged at the bailouts of Wall Street, particularly Citigroup , AIG , and Bank of America , which each took (and needed) tens of billions of dollars in taxpayer money to stay afloat.

In each case, the public fuming centered on shareholders getting bailed out. But that was a slightly misrepresented view. Shares of the heavily bailed-out banks fell more than 90%, and because of heavy share dilution from bailout funds, most of those losses will never be recouped. Far from walking away scot-free, shareholders lost nearly everything.

The real outrage should have been targeted at bondholders. They are the group that financed a bank's outrageous risk-taking during the bubble, and walked away with 100 cents on the dollar after the bailouts. That story didn't make many headlines because the world of debt markets is so foreign to most Americans, whereas the stock market is familiar. But the debt markets are where the real bailouts took place. And if you want to look for where there is moral hazard -- where investors feel they can take risk without facing any downside -- that's where you need to look.

Last week I sat down with Ron Suskind, a former Wall Street Journal reporter and Pulitzer Prize-winning author of five books. We got to talking about public policy, which led into a conversation about the cost of risk. Here's what he had to say (transcript follows):

Ron Suskind: "The fact of the matter is, a fundamental structural issue that hasn't changed, is guiding events. And if you read Ken Rogoff or Carmen Reinhardt, their book This Time is Different, the single sentence, if you want to save yourself a 700-page read, is basically that risk is artificially underpriced in the current U.S. and largely global economy by edict and effort -- often right-minded and well-intentioned -- of governments. They say we're going to keep debt and largely risk cheap.

"When you do that, you create bubbles. It's like a law of physics! It's like the sun rising in the east! And it's no different than it has been since the 1980s in the United States -- every bubble bigger, every burst a little harder to recover from. And literally the question is not whether there is now a bubble, but where; where it will express itself, where it will inflate. And that's because we have not dealt with the underlying structural issues of getting risk properly priced. And the way you do that is for there to be a bite in terms of the debt markets. People to take real haircuts. Like, 'Wow, we're ruined. Now we know better, in terms of the due diligence necessary to buy this thing called debt,' and to deal with these issues of downside risk. That's what gets risk properly priced, and we're not doing that now."

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The article The Cost of Keeping Risk Cheap, and the Next Bubble originally appeared on Fool.com.

Fool contributor Morgan Housel has no position in any stocks mentioned. The Motley Fool recommends American International Group. The Motley Fool owns shares of American International Group, Bank of America, and Citigroup and has the following options: Long Jan 2014 $25 Calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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