Too Much Moral Hazard…

Much of the financial mess we’re experiencing has been attributed to financial derivatives (like credit default swaps), or as Warren Buffet describes them – financial weapons of mass destruction.

But why are derivatives such a problem? Is it that they’re opaque and hard to value? Is it that they’re kept “off-the-books”? Is it that they’re a vehicle  for speculation? Well, maybe… But I think the bigger problem is that they led to moral hazard in the financial industry.

What is moral hazard? Moral hazard is essentially the premise that:

“An individual or institution insulated from risk may behave differently from the way it would if it were fully exposed to the risk.”

Would you buy the same expensive car if you didn’t have insurance? Would you speed if you knew there was a cop on every corner? Would you steal a million dollars if you knew the worst that would happen would be a week in jail? Balancing risk and reward plays a big part in our decision making process.

Why were all those banks giving away subprime mortgages to unqualified borrowers? Because they could… Derivatives can be used as a form of insurance. The banks got to reap all the rewards and the record profits coming from issuing those mortgages, and got to delegate all the risk to someone else through the use of credit default swaps. With such a system in place, it’s no wonder they indulged…

Now that the worst case scenario has come to pass, are all these institutions going to suffer the consequences? No, because they’re “too big to fail”. The government is taking billions of bad decisions off their hands – reinforcing moral hazard even further.

What’s the solution to this mess? Both U.S. presidential candidates are talking about more government regulation. But does that really stop moral hazard? Probably not… Bureaucracy and regulation don’t get rid of moral hazard – only full exposure to risk does.

Would the upper management of these financial institutions have been so reckless if they were personally responsible and accountable for the outcomes? No way. All the CEOs got paid their millions regardless of whether they drove their companies into the ground or not. What was their incentive to limit risk?

Why did our grandparents pay off their houses as quickly as possible, and save every penny they could? The prospect of literally being out on the streets with absolutely nothing was a scary proposition.

These days, we have unemployment benefits, homeless shelters, bankruptcy protection, and insurance on just about everything, leading to moral hazard that’s rampant not just in our financial industry, but throughout our society in general. I’m not suggesting we necessarily get rid of these things, but we need to understand the costs.

If we want to avoid future financial calamities, we need to take a hard look at the type of behavior we’re encouraging. Free markets can lead to a positive, self-reinforcing cycle, but only when there is full exposure to risk.

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