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September 12, 2008

Moral Hazard

By Wade Rousse

I’m hearing the TV pundits use the term moral hazard a lot recently in discussions about the government intervention with Freddie and Fannie.

In economics class, moral hazard is usually introduced during discussions about insurance. Hal Varian offers a good example in his textbook. It involves bicycle-theft insurance. If a person buys an insurance policy that completely reimburses him or her if the bicycle is stolen, that person might start leaving the bike unlocked. The lack of incentive to protect the bike is called moral hazard. The point is that people with some form of insurance might take greater risks because they know they are protected. This can result in more claims for the insurance companies. Too much of that and the companies could go bankrupt.

The TV pundits are screaming that the government intervention to rescue Freddie and Fannie is creating an enormous moral hazard problem. They argue that the managers of these institutions, realizing they do not carry the full burden of potential losses because of the government intervention, might continue to engage in risky lending practices that could offer higher returns (or again, result in tremendous loses) . The managers might be especially motivated by the hefty bonuses that can accompany these potential higher returns.

What do you think?

Posted by Wade at September 12, 2008 8:00 PM

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I think the fed bailout is a moral hazard, but the steps taken to protect banks were necessary. I'm willing to bet that many banks made interest only loans and approved risky borrowers because times were good. Many banks rode the bubble because if they didn't and their rivals did, they would lose market share.

Posted by: Mike Fladlien at September 13, 2008 10:50 PM

I would disagree that a government bail out creates materially greater moral hazard than already exists in most financial firms. Many executives and top managers are already compensated based on short term performance based metrics. These performance based compensation packages create an incentive for management to take short term risks which may sacrifice long term profitability. Will a manager take higher risks if they know they will get bailed out? I would argue no. If a risky strategy fails, management does not get paid, and may lose their jobs. Their bonus does not increase if the government bails them out and they may still lose their jobs. There does not seem to be any marginal profit incentive for management to take greater risks in the face of government intervention. They already have all the incentives needed to take on copious amounts of risk.

The argument could even be made that managers will take less risk in the face of government bail outs. The government does not usually intervene without establishing more regulation and oversight. If a company knows the government will bail them out, they are also probably expecting the government to take a closer look at their business practices. With greater government oversight, the regulating authorities may have a tendency to intervene before things get really bad. When a company expects the government will take back the keys, there is an incentive for less risk, not more.

Posted by: David Rodziewicz at September 14, 2008 7:00 AM

Both Mike and David bring up some interesting points. David pointed out that "when a company expects the government will take back the keys, there is an incentive for less risk, not more." This is could very well be true. However, in the past the Federal Reserve has bailed out Bank of America and Citibank in the past. It seems that with these bailouts there weren't any attached regulations for problems such as this in the future. If more regulations were instituted after Citibank and Bank of America would the problems with Fannie and Freddie be in the state they are now. Should the U.S. Federal reserve attach an agreement to bailouts in which whoever is being bailed out must submit to more regulation. Maybe this logic is tenuous but I would like to hear any thoughts on this.

Posted by: Michelle at September 28, 2008 3:00 AM

great post, very informative. I wonder why the other specialists of this sector don't notice this. You should continue your writing. I am sure, you have a huge readers' base already!

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