From the desktop of Brad DeLong, a very good synthesis of the evolving state of Federal Reserve policy:
We now have two precedents. If the Federal Reserve judges that a major financial institution:
- is too big to fail in that its failure will generate systemic risk
- has followed portfolio strategies that have produced inappropriate and excessive leverage
- requires immediate action
then the Federal Reserve will intervene to structure and support a deal that leaves principals and investors in the offending systemic risk-creating institution with effectively zero entity. Counterparties will be rescued. Principals and investors will not--even if normal more lengthy legal and bargaining processes would give principals and investors a share of the equity value on the table.
This is not the arms-length equal-treatment impersonal-rule-of-law ideal to which a government should aspire. This does, however, seem to get the incentives about right.
Charlie Kindleberger once wrote, in Manias, Panics, and Crashes, that the key to avoiding both depression and moral hazard was for the lender-of-last-resort to always show up in a crisis but for its appearance to always be doubted until the very last moment. These two precedents suggest that the Federal Reserve is evolving a case-law-of-twenty-first-financial-crisis that is somewhat different: in a crisis the lender-of-last-resort will always show up, but investors and principals in individual institutions that need to be specially rescued will discover that the lender of last resort is not their friend.
It is the "too big to fail" characterization of an institution that precludes the ideal arms-length equal-treatment impersonal-rule-of-law conduct of monetary policy. Given that characterization, however, the Fed's evolving policy goes directly after moral hazard in two places. First, by (very nearly) wiping out the value of the equity, the Fed sends the strongest message it can to these institutions that you don't want the Fed to have to get involved. Second, by moving control of the financial decisions away from the insiders who now hold little equity, the Fed sets up reasonable conditions for more prudent behavior after it leaves the scene.