Moral Hazard

“Moral Hazard” (for a longer discussion) was one of the most important – and necessary – factors that allowed the Great Recession of 2008 to occur.  Indeed, it may have compelled it to happen sooner or later.  So, maybe a sufficient factor, too.  For the mathematicians out there, moral hazard may have been a “necessary and sufficient” factor for the Great Recession of 2008, the Recession that was nearly the Second Great Depression.

So, what IS this thing called “moral hazard”?

Moral hazard is a condition or set of conditions that present a person or a business with the opportunity to make a bet where “heads I win, tails you lose.”  We all look for bets like this but few present themselves to us because we have laws that try to make life … more fair.  And a moral hazard bet is inherently unfair.

The kind of moral hazard that presented itself so often to the banks in the early 2000’s was being able to write a mortgage for a family, take a fee for the transaction, and then sell the mortgage to another bank or financial institution.  If the mortgage holder were to default on his monthly payments, the mortgage writer and his bank would be off the hook; the bank that bought the mortgage would take the loss.  Another example is making high-risk high-reward trades for a bank where if the trades work out the bank profits enormously and so does the trader; if the trades fail, the trader still has his salary and his bonuses and his bank will be rescued by the government (heads you win, tails the government – the taxpayer – loses) because it is “too big to fail,” too important to the health of the financial sector of the economy (finance is the new tail that wags our economy).

Moral hazard was the pre-condition that finally led to the government having to bail out the banks in 2008 and 2009.  The government HAD to bail out the banks for fear of the credit system drying up and crashing.  But what allowed that condition to exist in the first place was the rolling back of some Depression era banking regulations, specifically the repeal of the Glass-Steagall Act of 1933 which separated commercial banks (with ordinary depositors, like you and me) from investment banks (with fat cat investors who want a high return on their deposits).  Allowing these two kinds of banks to operate under one roof put ordinary peoples’ deposits at risk when an investment banker took a risk that failed.

The condition of moral hazard is insidious because traders are forced to make high-risk high-reward bets because they are “heads we win, tails someone else loses” kinds of bets, they are winning gambles, they are “sure things.”  Not to take advantage of the moral hazard conditions would put the trader’s business at risk with clients who want high rewards; not to take advantage of the moral hazard conditions would be to accept being at a competitive disadvantage with his peers, his competitors and his clients.

Moral hazard was dangerous because it led – inevitably – to the federal government having to bail out banks to the tune of trillions of dollars.  Without regulations in place to prevent moral hazard conditions, a crash is inevitable, sooner or later.

But here’s a funny thing.  Had you, dear reader, been a trader at one of those banks, you would have made those high-risk trades, or you would have been less successful than your peers at the bank and you’d have taken a huge risk of being fired.  The young man who chooses not to pay for health insurance who then falls sick and uses the local hospital’s Emergency Room – at the public’s expense – is another example of moral hazard.  But here is something else even funnier: you, dear reader and most every American, routinely demands moral hazard of your government.  How so?  Because you demand government services but you don’t want to be responsible for paying for them.  How many of you want a strong defense, want good schools for your kids and mine, safe roads and bridges, unemployment insurance just in case, a sound Social Safety Net, and most if not all the rest – how many of you want these things, but then give your vote to the guy who promises to cut your taxes?

Moral hazard?  It’s sort of American, isn’t it?  How much longer can we afford it?  As things are today, the banks are larger than they ever were and they still play under conditions of moral hazard; we WILL experience another Great Recession, sooner or later, because the conditions demand it.  Maybe a Second Great Depression.  And because your Congressman (the same one you elected to cut your taxes) has not heard YOU demand that Moral Hazard in Finance is unacceptable!