Moral Hazard

bailout by Christopher Weyant

In economic theory, a moral hazard is a situation where the costs that could incur from a decision will not be felt by the party taking the risk. Knowing that the potential costs and/or burdens of taking such risk will be borne, in whole or in part, by others creates a moral hazard and invites high risk behavior.

For example, with respect to the originators of subprime loans, many may have suspected that the borrowers would not be able to maintain payments and that, for this reason, the loans were not, in the long run, going to be worth much. Still, because there were many buyers of these loans (or of pools of these loans) willing to take on that risk, the originators did not concern themselves with the potential long-term consequences of making these loans.

After selling the loans, the originators bore none of the risk so there was no incentive to investigate the long-term value. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party isolated from risk behaves differently from how it would if it were fully exposed to the risk. Another, more complex, example would be the euro debt crisis, in which the troika of relief funds (ECB, IMF, EC) for heavily indebted nations like Greece are waiting as long as possible to act. The risks of a money run, and the consequential market crash in Europe is by far not as detrimental to these institutions as to the indebted nations themselves.

Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned. According to research by Dembe and Boden, the term dates back to the 17th century and was widely used by English insurance companies by the late 19th century. Early usage of the term carried negative connotations, implying fraud or immoral behavior (usually on the part of an insured party). Dembe and Boden point out, however, that prominent mathematicians studying decision making in the 18th century used ‘moral’ to mean ‘subjective,’ which may cloud the true ethical significance in the term.

Economist Paul Krugman described moral hazard as ‘any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.’ Financial bailouts of lending institutions by governments, central banks or other institutions can encourage risky lending in the future if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So-called ‘too big to fail’ lending institutions can make risky loans that will pay handsomely if the investment turns out well but be bailed out by the taxpayer if the investment turns out badly. Taxpayers, depositors, and other creditors often have to shoulder at least part of the burden of risky financial decisions made by lending institutions. According to the World Bank, of the nearly 100 banking crises that have occurred internationally during the last 20 years, all were resolved by bailouts at taxpayer expense.

Many have argued that certain types of mortgage securitization contribute to moral hazard because it enables originators to pass on the risk that the mortgages they originate might default and not hold the mortgages on their balance sheets and assume the risk. In one kind of mortgage securitization, known as ‘agency securitizations,’ default risk is retained by the securitizing agency that buys the mortgages from originators. These agencies thus have an incentive to monitor originators and check loan quality. ‘Agency Securitizations’ refer to securitizations by either Ginnie Mae, a government agency, or by Fannie Mae and Freddie Mac, for-profit government sponsored enterprises (‘GSEs’). They are similar to the ‘covered bonds’ that are commonly used in Western Europe in that the securitizing agency retains default risk. Under both models, investors take on only interest rate risk, not default risk. In another type of securitization, known as ‘private label’ securitization, default risk is generally not retained by the securitizing entity. Instead, the securitizing entity passes on default risk to investors. The securitizing entity, therefore, has relatively little incentive to monitor originators and maintain loan quality. ‘Private label’ securitization refers to securitizations structured by financial institutions such as investment banks, commercial banks, and non-bank mortgage lenders. During the years leading up to the subprime mortgage financial crisis, private label securitizations grew as a share of overall mortgage securitization by purchasing and securitizing low quality, high risk mortgages. Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private label securitizations, and performed far better in terms of default rates.

Economist Mark Zandi of Moody’s described moral hazard as a root cause of the subprime mortgage crisis. He wrote that ‘the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined.’ He also wrote, ‘Finance companies weren’t subject to the same regulatory oversight as banks. Taxpayers weren’t on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards.’

Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend with their cards because without such limits borrowers may spend borrowed funds recklessly, leading to default. Securitization of mortgages in America started in 1983 at Salomon Brothers and was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the mortgage securitization system in the United States, many different debts of many different borrowers are piled together into a large pool of debt, and then shares in the pool are sold to lots of creditors. Thus, there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language that the papers that he/she signed were written in, or even that the paperwork exists and is in good order. It has been suggested that this may have caused subprime mortgage crisis.

Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the subprime crisis, however, national credit authorities (the Federal Reserve in the US) assumed the ultimate risk on behalf of the citizenry at large. Others believe that financial bailouts of lending institutions do not encourage risky lending behavior since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout would prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and the burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis.

The term ‘moral hazard’ comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as the clients would like to be protected. This inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. However, since insurance companies cannot perfectly observe their clients’ actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information.

Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information rather than by hidden actions. Adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece. It is this asymmetry of information prior to the transaction that prevents the transaction from occurring. If both the seller and the buyer were uncertain of the quality, they would be willing to trade the good based on expected values. Similarly, if both the seller and the buyer were certain of the quality, they would be willing to trade the good based on its actual value. By contrast, moral hazard is seen after the deal is done; one of the parties to the deal (in this case, the person purchasing the insurance or warranty) may be more careless because he/she has the insurance, and thus does not need to pay the full cost of a damage. Here, it is not the prior information that either party has, but the inability of the insurance provider to control and monitor increased risk-taking behavior that creates the potential for market failure. Also, while in adverse selection, the seller is usually the one possessing more information, moral hazard usually has the buyer (of the insurance service) having too much control.

Two types of behavior can change as a result of a moral hazard. One type is the risky behavior itself, resulting in a before the event moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms). A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post (after the event) moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise. Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim.

Economist John Nyman suggests that two types of moral hazard exist: efficient and inefficient. Efficient moral hazard is the viewpoint that the over consumption of medical care brought forth by insurance does not always produce a welfare loss to society. Rather, individuals attain better health through the increased consumption of medical care, making them more productive and netting an overall benefit to societal welfare. Also, Nyman suggests that individuals purchase insurance to obtain an income transfer when they become ill, as opposed to the traditionalist stance that individuals diversify risk via insurance.

Moral hazard can occur in workplaces when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations: When a manager has a secure position and cannot be readily removed. When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects. When funding and/or managerial status for a project is independent of the project’s success. When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division. When a manager may readily lay blame on an innocent subordinate. When there is no clear means of determining who is accountable for a given project. When senior management has its own remuneration as its primary motivation for decision making (hitting short-term quarterly earnings targets or creating high medium term earnings, without due regard for the medium term effects on, or risks for the business so that large bonuses can be justified in the current periods). The shielding occurs because any eventual hit to earnings can most likely be explained away, and in the worst case, if an executive is terminated, usually the executive keeps the high salary and bonuses from years past.

When a numbered company is used for construction projects as a subsidiary of a larger enterprise. An example is a numbered company is incorporated to construct a condominium in Vancouver. It is built to meet the minimum building code requirements, but is not designed for Vancouver’s typical weather patterns (mild temperatures, lots of moisture). A few years later, the exterior cladding of the building is disintegrating with mold and rot. The numbered company that built it has no assets, so the condominium owners must suffer a large expense to rebuild it. In this scenario, the senior officers of the numbered company, and its shareholders used the protection of a numbered limited liability company to take higher risks in the design and construction. Unless the law and the regulators have some effective means to hold those responsible to account, moral hazard would be expected to continue to future building projects. In extreme cases, moral hazard can lead to or permit control fraud to occur, where actual illegal activities take place.

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