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What is a Moral Hazard?
A moral hazard refers to the concept that parties at least partially protected from risk will act differently (often more recklessly or carelessly) than if they didn’t have those safeguards.
Many come across moral hazards on a daily basis. For example, some tenured professors put little effort into their lectures and focus on their research. Or if a homeowner has their house fully insured, they might be less inclined to secure every single room or might smoke in bed.
What’s important is that another party pays in some shape or form for the actor’s decision. So while the students will not take any responsibility if the university decides to fire the professor, they will not have received the quality education for which they paid—at least in this particular professor’s class. Or in the case of the homeowner, their insurance company will have to take full financial responsibility for paying them back in the case of a robbery.
Often, when the term is used, an individual, group, or corporation facing a moral hazard knows that all or a significant share of the risk and consequences will go to another party. This can become a considerable problem when the acting entity can recklessly capitalize on a situation without the consequences of failure as others, in the event of failure, will shoulder the responsibility often without any option.
It’s as they say: nothing comes free.
The failure of the hedge fund Long Term Capital Management (LTCM) reportedly cost $3.6 billion to save. Should the company have been left to fail?
The Origins of the Moral Hazard
The concept of the ‘moral hazard’ actually has its origins in insurance.
An eternal, or at least long-standing, conflict exists between insured and insurer. On one side, the insured wants to get protections to mitigate damages of all sorts for the least premium/cost as possible. But on the other, the insurer hopes these damages do not occur so they do not have to actually cover incurred costs.
But in situations involving moral hazard, the insured may feel emboldened to take more risks because they know that they have those financial safeguards in place. The thing is, they don’t want the insurer to discover that risks out of the norm were taken, otherwise, they might have to pay all or more of the costs to cover the damage.
This is known as ‘asymmetric information,’ where two sides do not have the same amount of knowledge about an issue.
For example, take the case of a car accident. Insurance companies generally assume that drivers do not want to get into accidents. In order to reduce their potential risk, insurance companies will conduct a comprehensive investigation into your driving record, driving statistics for your area and demographics, etc. The more risky your case, the more you have to pay for coverage (or you might even get rejected). That’s how they protect themselves, especially considering that they obviously cannot know what’s going on in the minds of each of their clients during the moments leading up to auto accidents.
Corporations and the Moral Hazard
The concept of the moral hazard has also come up in relation to historic financial crises caused by big corporations taking on too much risk. Think about the collapse of Bear Stearns or the near-collapse of AIG during the 2007-2008 subprime mortgage crisis.
While your local businesses don’t get saved from failure, multinational corporations are often called ‘too big to fail.’ Essentially, that phrase refers to corporations being so big that the economic consequences of their failure would be (or believed to be) catastrophic. Thus, when such a corporation nearly collapses, there’s a high chance that the government will intervene and act as the lender of last resort.
These safety nets create moral hazards that can lead to more risk-taking. As the diagram above indicates, it can become a vicious cycle.
But who pays for these bailouts?
Taxpayers. They get used as unwilling market insurers. But unlike insurance companies who make a profit off of selling insurance by choice, taxpayers gain nothing for paying the bill, like that one friend who wasn’t told the group was going to dine and dash.
Financial Crises, Moral Hazard Minefields
Savings and loan associations refer to financial institutions that, while similar to banks, focus on assisting individuals to acquire residential mortgages. Due to ‘The Great Inflation’ of the late 70s and early 80s, when interest and inflation rates ballooned, S&Ls experienced considerable troubles.
In 1982, then-President Ronald Reagan signed the Garn-St. Germain Depository Institutions Act into law. This legislation not only removed the loan-to-value ratios and interest rate caps for S&Ls but also enabled them to hold 30% of their assets in consumer loans and 40% in commercial loans.
Out of the Garn-St. Germain Act, ‘zombie thrifts/banks’ emerged. S&Ls started investing in high-reward, supposedly high-risk commercial real estate and junk bonds. These high-reward investments did not come with the high risk because taxpayers, not the S&Ls or its officials, would have to take responsibility for any losses under the Federal Savings and Loan Insurance Corporation (FSLIC).
That was the moral hazard for the S&L crisis.
According to a study conducted by economists John B. Shoven, Scott B. Smart, and Joel Waldfogel, S&Ls had all the incentives they needed to take on as much risk as possible. They write, “this legislation, in combination with the deteriorating financial condition of firms in the industry, gave S&Ls the means and the incentive to compete aggressively for funds…There is a moral hazard problem in a troubled thrift…Thrift institutions that are down, but not out, have every reason to take extra risks. The bigger the risk and the higher the stakes, the greater the chance that the firm might be saved.”
The Savings and Loan Crisis in the 70s resulted in the failure of nearly a third of 3,234 S&Ls and reportedly cost taxpayers $132 billion. Was economic foul play involved?
Subprime Mortgage Crisis
To give you an extremely abridged explanation of the 2008 financial crisis, investment banks had been aggressively buying up collateralized debt obligations (CDOs) through the shadow banking system. CDOs are financial packages comprised of different kinds of debt, including subprime mortgages. Turns out, credit rating agencies had incorrectly rated the risk of these CDOs much lower than they actually were.
To protect themselves from defaults on the debt they’d purchased, investment banks acquired debt insurance (a.k.a. credit default swaps). They were buying high-risk, speculative investments at such a high volume to a point that insurance agencies could not begin to pay it back in the event of default. Both the insurers and insured were profiting immensely.
Until they weren’t.
Unsurprisingly, many defaulted on their subprime mortgages, and the debt insurance kicked in. Boatloads of money needed to be paid back, but corporations were not liquid enough to handle such a demand. Investors started selling back securities en masse, creating a ‘run on the bank.’
The government swooped in before the economy completely collapsed. 987 companies received close to $500 billion in aid, under the Troubled Asset Relief Program (TARP).
Thus, we have the moral hazard play out. Where we, the taxpayers, had no choice in deciding whether the government ended up bailing out these massive corporations who had essentially caused their dogged quest for dollars.
Alternatives and Solutions to Moral Hazards
Because of the ubiquity of moral hazards, they can appear inevitable. That does not mean alternatives and solutions exist to counteract situations involving them.
- No company is too big to fail
Instead of the government intervening when corporations fail, stronger businesses can compete to buy up the ruins at fire-sale prices. Companies would generally be more cautious, as they would not have the government safety nets in place. That shift in behavior across industries would theoretically minimize the chances of a total collapse.
- Incentivize safe(r) behavior
Perhaps more applicable to insurance rather than government bailouts, incentivizing safe(r) behavior has long been a common part of insurance contracts. Insurance companies design a contract that often gives you partial coverage only, sharing the risks and potential costs in the event of an accident.
Insurance firms can also make the process of getting money arduous, deterring the insured from putting themselves or their property at risk.
- Punish bad behavior
The government could bail out reckless corporations, but still, take strong punitive actions against them. Setting a high-interest rate or other stipulations could disincentive companies from even using the safety net in the first place. Perhaps a better deal could come from another business.
- Separate banks
A potential issue of fractional reserve banking, banks can become insolvent because most of their depositors’ capital is tied up in risky investments. The savings and the investment divisions could be split into two completely separate entities, preventing wide-scale bailouts. This idea was central to the Glass-Steagall Act of 1933.
- Performance-related pay
On an individual level, salaried employees could take longer breaks or work shorter hours because they feel a sense of professional security. Employers can prevent this moral hazard by designing contracts that, perhaps, pay more for high performance. Sales jobs often have this incentive built into their pay structure.
Billions of government revenue could be held in tax havens. Don’t believe us? See what your fellow citizens are saying on the Zero Theft Movement platform…
- Proper oversight/stringent auditing
To help prevent crisis, regulatory authorities need to properly oversee corporations and make sure they are not taking on excessive risk. This can help nip the problem in the bud before it explodes into a full-blown catastrophe.
For PBS, the Chair of the Financial Crisis Inquiry Commission Phil Angelides argues that we would have avoided the subprime mortgage crisis if regulators had not gotten so lax.
He asserts, “…when you look at the facts, what you will see is you will see a building over 30 years of a deregulatory mindset in which the belief became embedded in intellectual circles and the financial circles that the financial masters on Wall Street had learned to control risk….in the early 2000s you see the emergence of lots of warning signs, red flags, flashing red and yellow lights along the way: the unsustainable rise in housing prices; the reports of egregious and predatory lending practices that were cropping up all over this country, starting in places like Cleveland and then spreading to the “sand states” [Arizona, California, Florida and Nevada].”
Addressing Moral Hazards on a Large Scale
The moral hazards between insurance companies and individual customers will likely remain a difficult dance. But when it comes to the potential vicious cycle of high-risk corporate activity and government bailouts, perhaps we need to make a big change.
Should the government let corporations fail, as they would in a genuine free market? Or should they get bailed out but with severe consequences? Maybe you have a better idea?
We at the Zero Theft Movement are working to calculate the best estimate for the monetary costs of corruption in the U.S. Corporate, political, and everything in between. Our community isn’t trying to simplify corruption to a single score, nor are they using the definition of a few experts or business professionals. Each holon, or interpretive group, decides what they consider is ‘theft.’
The Zero Theft Movement provides a safe and independent platform where you and your fellow citizens work together to investigate and debate potentially rigged areas across the economy. Through blockchain voting, the way to make all your work permanent, public, and unchangeable, you decide whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.