Bailouts and Moral Hazard

Hazardous Morals

As Daniel Henninger noted in the Journal today, moral hazard is hot right now. This is the stick that commentators of all political affiliations use to beat the Fannie/Freddie bailout, the Paulson rescue plan, any proposal to restructure mortgages, or any other government action that has the effect of protecting someone from his bad decisions.

The concept of moral hazard originated in the insurance industry, and describes the problem that people who are well insured are more likely to take unwise risks. (For example, if you have comprehensive insurance on your car with no deductible, you may not bother locking the doors.) In the current context, the argument is that if the government bails out financial institutions by taking troubled assets off their hands, they will not have an incentive to be more careful in the future. In this usage, moral hazard becomes suspiciously similar to moral indignation pure and simple: many people feel instinctively that banks that took excessive risks deserve to go bankrupt, and the bankers who made lots of money on the way up should lose their jobs. (These people often also believe that homeowners who can’t pay their mortgages should lose their houses).

The problem of moral hazard is real. And moral hazard should be taken into account when designing any rescue packages and, more importantly, when the time comes to rewrite the regulation of the financial sector. But there are several reasons why it should not be allowed to simply veto any government action.

  1. Moral hazard is most important in a repeated or continuous context. When you buy an insurance policy at the beginning of the year, you know if you are fully covered, or if you will be responsible for some proportion of the losses you incur, and you behave accordingly. It applies less clearly to retrospective bailouts like the current plan, where it is not clear that a similar situation will ever arise again. For example, perhaps one of the behaviors we want to discourage is leverage ratios of 30 to 1, like those at Bear Stearns and Lehman. Well, there are no more investment banks, and commercial banks have much lower leverage limits. Besides, there is another way to discourage undesirable behavior: regulation.
  2. As Martin Wolf argued in the FT in the long-gone days of the Fannie/Freddie bailout, the moral-hazard argument to punish the shareholders has the perverse effect of discouraging private capital. Given widespread fears that many banks are undercapitalized, it would be a good thing if they could raise capital in the private markets rather than from the government, like Goldman Sachs did with Warren Buffett. But if the government is planning to take the moral high ground and let banks collapse, then no one will step up with the capital.
  3. Most importantly, there is something fundamentally illogical about the moral hazard argument. If we bail out the banks now, it goes, then they will behave in harmful ways in the future. But right now we are facing the greatest danger to the financial system since the Great Depression. What future harm are we worried about that is more serious than the potential harm we are facing right now?

“While I find helping these banks highly distasteful, moral hazard concerns should be put aside temporarily when the whole short term credit system is close to a complete collapse.” Those words were written by no less a free-market advocate than Nobel Laureate Gary Becker.

3 responses to “Bailouts and Moral Hazard

  1. I think you conflate two very different types of Moral Hazards, that interestingly are each the very different thoughts brought to mind depending on the listener’s Right or Left viewpoint, and quite opposite in effect.

    One is a hazard of leadership, that a leader without accountability to have no concern for others. So a sharpie who works up a new derivative scheme will not consider a down side as they would be personally much richer and long gone before such things occur.

    Such a person will be the first to argue for deregulation, that if such a ponzi scheme was wrong the market would take care of it. But as it reached it’s zenith unless the government buys in at the top the whole thing would come crashing down.

    The other hazard is personal hazard. That a person protected from pain will be more careless than one who is not.

    This is often framed as “buyer beware”, or as it might be better put “jogger beware” as people expect to be able to jog where they wish without being mugged or something is very wrong with the neighborhood, but do not have the same expectation of shopping, though they should.

    The Insurance argument itself is pure smoke as any personal damage cannot be fully covered, but small damages are more numerous than large ones, and a threshold will cause many fewer claims.

    Specifically applied to the “sudden” need for a bailout. There are indeed many victims of the ponzi scheme both wealthy and not so much, and some of their damage may need to be made whole, but it is very much a crime scene, and those who have conspired to the damage of others should at the very least cover those losses, to the extant of their own bolstered means, and where grevious face jail time as well.

    Where laws do not exist or have been rescinded, there is still the desire for bailout and such claw backs can be part of the process.

    My biggest fear is that Paulson will be another “Brownie” or “Alberto” and when the real cops show up all the evidence will be buried in whitewash or destroyed.

  2. Please I am rather slow. Are they (business and the world leaders) asking for help? Maybe these people that contributed to this mess are now saying they have all the answers as to how to get out of this mess. In any case, maybe now it is known what does not work. Instances of what does not work:
    Robbing Peter to pay Paul. (So now Paul is broke because of this practice?)
    Honesty is the best collateral a person can have.
    Be good to the people on your way up because you may meet them on your way down.
    Money is only worth what it will buy.
    The value of anything is only what we place on it.
    There are no free rides.
    Stealing from other people, being dishonest with other people is also doing the same to one self.
    Cast your bread on the waters. (Seed money) It will surely return to you.
    Remember to have good old fashion wholesome fun.
    When you give advice be ready to fill the shoes of the ones to whom you are giving advice.
    Want to know how to succeed at something? (Ask someone who has been there and done that.)
    Keep from reinventing the wheel. Someone has already done that.
    Ask for help. The worst to happen is the answer of no.
    Remember when helping someone you are helping yourself.
    No one is an island. What happens to one can easily spread to all.
    Of course you know all of this, better than I. So again I ask has a request for

  3. Moral hazzards can be resisted by first: Doing onto others as you would have them do onto you.