Moral Hazard

A term that is often heard, although probably not heard often enough, in connection with the debate involving the ongoing "bailouts" of certain sectors of the American financial and industrial communities is moral hazard.

Although the term moral hazard was first used in the early days of the insurance industry, for the purpose of this brief essay a moral hazard will be defined in terms of two "actors:" a principal and an agent. A moral hazard occurs when the agent knows that the principle will indemnify, or bear the ultimate responsibility for, actions by the agent. Since it is known in advance that principal is obligated to protect the agent, the agent may then behave in a more reckless manner than if there was no indemnity provided by the principal.

To demonstrate this concept, let's assume that you are a professional poker player and you want to make sure that you don't lose a bundle of money during a string of bad luck. I'm in the business of financing poker players. You (the agent) and I (the principal) agree that I'll protect you against any losses for a fee of $100. You're happy because you don't have to worry about losing everything and I'm happy because I get $100.

After a few days my business of protecting gamblers is so successful (because they're winning and I haven't had to make up any losses) that I now have 1000 gamblers paying me to cover their losses. Then I start to worry about the consequences of more than a few dozen gamblers having a bad day at the tables because I know it won't take long for me to be wiped out. Fortunately (for me), there is an organization known as Gambler's Galaxy that will buy my obligations to protect gamblers for 95% of my fee. I jump at the opportunity and sell my $100,000 worth of fees that I've collected from the gamblers to Gamblers Galaxy for $95,000. I still have my money and, as a bonus, now someone else is responsible if the gamblers get careless, such as playing bad hands that they should have folded, and start losing.

Gamblers Galaxy also wants to make money. It takes my obligations, combines them with others that they have purchased, and then sells them to the casinos as an investment that pays a few percentage points more than the money market rate. Now everyone is happy because we're all making money and more people than ever are gambling, which means even more money will wind up in our collective pockets. Well, we were happy until the unthinkable happens: the gamblers start making dumb bets (the consequence of moral hazard) and are losing a lot of money!

I could care less if all the gamblers start playing sloppy and making bad bets because I've sold my obligations to cover their losses to another Gamblers Galaxy. That group, in turn, converted all those obligations into "investments' that were sold back to the casinos, which now stand to lose a bundle.

Gamblers Galaxy is now in big-time financial trouble because the gamblers are in financial trouble and, since it doesn't want to deal with angry casino owners (and their employees such as "Tony the Frog" and "44 Magnum Joey"), they appeal directly to the Gambler in Chief. After deciding that if Gamblers Galaxy crashes it will "have a serious negative effect" on the national economy and that it's "too big to fail," the Treasury Department and the Federal Reserve take over Gambler's Galaxy and make the taxpayers pay for the debts of incompetent gamblers.

If all this has a ring of familiarity, it should.

A few months ago, I posted an essay (How the Financial Crisis Happened) in which I described the underlying causes of current financial equivalent of the La Brea Tar Pits. At that time I only indirectly mentioned moral hazard because I thought the concept should be obvious. I was wrong.

In my opinion the federal regulatory agencies that were supposedly monitoring the financial industry were either unaware of the concept of moral hazard and its potential effects (unlikely) or deliberately ignored it due to political expediency (very likely). Sadly, the hands of both political parties were soiled in the actions that led us into this mess. This, in turn, leads to one simple question.

Is there anyone, either elected or appointed, with enough common sense to extricate the economy from this mess and then to lessen the chances of it happening again?