GSE Bailout and Moral Hazard: Hank Paulson Aims at the Wrong Target

Debt buyers were clearly taking risk with the high expectation of a government guarantee. This is seen in the level of credit spreads. The agents of the equity owners observed this and took advantage of the cheap debt. We can't tell that an equity cram down in these circumstances was unexpected, so Paulson's bailout plan may be growing the moral hazard problem since we may observe an actual bailout instead of an implicit guarantee. When presented with cheap debt, the agents of the equity, even knowing they won't be bailed out, may repeat exactly the same behavior. That the equity has control doesn't mean that not bailing them out has any effect if the cheap debt led to this.