Tuesday, March 18, 2008

Moral Hazard

One point of discussion coming out of the Bear-Stearns collapse is moral hazard. For teachers of economics or personal finance, this is a topic that can provide good discussion and get the students thinking about personal and systemic behavior under certain circumstances. As we see in the definition, moral hazard is a kind of market failure that arises when economic behaviors are protected from loss. The idea is that rational players in the marketplace, if they know that they are protected from loss to some extent, will take on greater risk than they would otherwise. In this post, I will relate the concept to personal finance and decision-making, to larger economic decision-making, and finally to what is coming out of the Bear Stearns situation.

In the personal finance and decision-making area, moral hazard has a couple of applications. Many teachers find this a natural fit when talking about insurance. Generally, insurance is designed to limit or even eliminate losses to certain types of risk. Auto insurance can reduce or replace losses in an accident where the car is damaged. Health insurance can help pay medical bills in times of illness. Homeowners insurance can mitigate losses in case of fire, theft, or other calamities. And life insurance, while it can't replace the insured, can reduce the lost earnings and offset final costs in the event of death. The fact that these losses are reduced by insurance essentially reduces the negative incentive for people in certain circumstances, which causes them to assess the risk of certain activities differently. A person in a stressful situation may drive a bit more aggressively because, in the back of their mind, they know that they're insured. Home repairs may be left undone a bit longer because insurance could cover a loss. Parents may even unknowingly enhance moral hazard by constantly helping their child out of trouble. The child, knowing that mom and dad can back me up, may engage in behavior that they would not otherwise undertake if they knew they would suffer the full cost. Of course, that presumes they understand the full cost. But if experience says there's no apparent downside, why not take the risk? And finally, when it comes to banking, most people pay no attention to the condition of the bank where they have accounts. This is largely due to the moral hazard that comes with deposit insurance. If the bank is insured and the depositor will recover all or most of their deposits, there is no incentive to follow the bank's business -- until it's too late.

This brings us to the larger economic application of the concept. By providing guarantees against losses, an incentive is in place to undertake riskier behavior than might have otherwise taken place. Deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC) is the classic example. But other examples are available. Implied Federal guarantees underlie some types of lending (Fannie Mae, Sallie Mae, etc.). The implication is because these organizations were created by act of Congress. The understanding is that the Federal government stands behind the loans if they go bad. Would this provide an incentive to make riskier loans? Or in the case of bundled loans that are then sold to investors, would investors perceive less risk of default if there is an implication of a Federal guarantee? It would certainly seem logical. Other examples would be the Federal rescue of Continental Illinois in the 1980s. The Chicago-based financial institution made loans to the energy sector that went bad. As Continental was faced with mounting losses, other banks withdrew support and Continental found itself illiquid. The Federal Reserve and other Federal agencies rescued the firm, giving birth to the phrase "too big to fail" in the process. While Continental eventually righted itself and was eventually deemed attractive enough to be bought out by another firm; the precedent was set - and underlying question rose to the surface. Will riskier activity by some firms be subsidized?

In the case of Bear Stearns, by extending access to the discount window to an investment bank, has the Federal Reserve developed a new level of moral hazard? At this point, that's hard to assess. I would expect we will see a number of papers come out on this topic. Bear Stearns was, by some accounts, a firm that engaged in risky behavior, being one of the first to suffer significant losses as sub-prime mortgages began to unravel. Some would say that Bear Stearns was not given any particularly preferential treatment, especially in light of its bargain basement sale to J.P. Morgan. Other people, and I would agree with this group, point out that what made Bear Stearns a candidate for rescue was the fact that it was counter-party to many contracts with other financial institutions. If Bear went down, it would certainly weaken other candidates. This action provided a fire-break to contain the damage.

One can certainly make a case that moral hazard affects behavior. And moral hazard appeared to be working at a number of levels in the sub-prime mortgage market that ultimately unwound Bear Stearns. In closing, I would encourage you to read the posts by Gary Becker and Richard Posner on their blog. I think you will find both posts, as I did, interesting and relevant; and a base for some discussion with your students on behavior in the marketplace.

I look forward to your comments.


juliechismar said...

The conversation regarding moral hazard needs to be put on the back burner and addressed after the risks to the financial system abate. I am certain there will be studies, and proposals made to prevent the current environment in the future. But not yet, confidence and trust are what is needed.

Tim Schilling said...

I beg to differ. This is the perfect time. I say this because a "guarantee" or "insurance" or whatever else you want to call it that would induce confidence and trust can contribute to moral hazard. If you can achieve a sense of confidence and trust that causes you to assess risk incorrectly. That's moral hazard. And that's the downside to taking action. We're hoping for a "one-armed economist", but that's not possible, even though it may be desireable.

Meds said...

I absolutely agree. The application of moral hazard was the first thing that came to mind when I discussed the Bear Stearns mess with my AP Econ students last week. In fact, my classes have been using the moral hazard application since the Fall to discuss what was taking shape with the economy. I find that the students really enjoy the application of this principle.