Moral Hazard: I dunno... I can imagine quite a bit

In reading my post from Monday on mortgage bailouts, one commenter mentioned moral hazard. I feel like this is becoming an over-used term, and I'd like to state Accrued Interest's official position on the subject.

According to the most authoritative source I could find (Wikipedia)...

"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."

Any time risk has shifted in any way from one party to another there is potential for moral hazard. Someone who has health insurance that pays for all prescriptions probably winds up using more prescription drugs. That's one example of moral hazard.

In the case of a bailout, it is usually not the bailout itself, but the implication of the bailout. Its the precedent set that is problematic. So for example, when a rich kid crashes Daddy's car into the neighbor's tree, and Daddy just buys another one, the kid makes an assumption about the future. He assumes that Daddy will keep bailing him out of jams.

So let's look at two simplified examples of a housing-related bailout. In one corner, let's say that banks are forced to write down all upside down mortgages by 20% and in exchange, the government agrees to take all subsequent losses on the loans. The banks who made bad loans suffer a good deal from this, but perhaps not as much as they would have otherwise. This isn't exactly Daddy buying them a new car. More like Daddy paying for the damage the kid did, but making him ride the bus to school from then on. We can debate whether those are adequate consequences or not, but certainly the banks didn't expect to take a 20% loss on those loans when they first made them.

The same goes for bond holders. They suffer losses much greater than they anticipated when they bought the bond. Maybe not as large as might have otherwise been, but still large.

The borrowers who took out loans they knew they couldn't afford get completely bailed out here. Maybe they don't get a new car, but Daddy's repairs the old one and things continue as they had before. The borrower gets something for nothing.

Now compare that with some program that encourages people to buy foreclosed homes in a big way. What you've done is alter the demand curve for homes by making them both more affordable for end buyers and making a buy to rent investment more attractive.

In this case, the borrower is probably no better off. S/he was already foreclosed upon. He really doesn't care what happens to his house after that. The bank is clearly better off, because they get a better price on their REO portfolio. Investors too. Both have their loss severity reduced.

But all the guilty parties wind up suffering a fair amount under such a plan. In other words, every one involved regrets their actions.

Now let's take a step back. We know that the government is going to interfere in the housing market. No matter what is done, there will be moral hazard involved. I'd like to see moral hazard limited by making sure that all involved in the mortgage lending process suffer to a significant degree. We want everyone involved to be saying (sarcastically) to themselves "This is some rescue!"

What we don't want is for either the lender or the lendee to say, "That wasn't such a chore now was it?" We don't want one party to bear all the risk, nor to have the government take away all the pain from any one group of participants.

You can reduce the supply of foreclosed properties either by preventing the foreclosure or by having someone buy the foreclosed properties. Any program which prevents foreclosures is benefiting the lendee at either the lender or the tax payer's expense. By encouraging investors to buy foreclosed properties, you are giving the primary benefits to an uninvolved third party.

I think that translates to less moral hazard.