Where the moral hazard comes from

I have a sneaking suspicion that the term moral hazard is getting a bit abused at the moment.  Let’s use the Wikipedia definition:

A moral hazard is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk

Cool, and in the case of the bank bailouts that have occurred around the world, who were the people who knew that the cost of their “risky behaviour” would fall on someone else … bondholders.  This is from Garett Jones:

So by their estimate over 90% of the benefit to banks’ balance sheets went to bondholders …

If most political battles need a villain to succeed, it’s easy to see why bondholders have largely escaped the wrath of voters: Bondholders make poor villains.  The bank promised to repay, and now the bank can’t.  The bondholder wasn’t out there making the loans; the bondholder didn’t vote for the directors who led the company to the brink of destruction; the bondholder just handed some cash to the bank and hoped for the best.

Bondholders have had good luck getting government guarantees, and I suspect their luck will continue.  That means rational investors will dump more cash into the megabanks with minimal scrutiny: The megabanks are the new Fannie and Freddie.
The fact is, if we wanted to “get rid of moral hazard” we’d have to accept the inherent riskiness of our lending – we don’t get paid an interest rate for kicks, it covers inflation and a rate of return stemming from lending that has some inherent risk.
The reason economists have generally shown no sympathy for people when the finance companies collapsed here isn’t because we are heartless, it is because people wanted to act as if their lending was riskless.
Remember, if you are complaining about “moral hazard” you are attacking bondholders – not so much the banks (who are easy to demonise because they wear suits), but the people who leant money without considering risk and those who advised them.
4 replies
  1. Danyl
    Danyl says:

    For a lot of investors the lending was risk-less. Both the initial investment AND the high rate of return were guaranteed by the taxpayer.

  2. Danyl
    Danyl says:

    And for another large class of investors – mostly elderly people in retirement homes – the high risk was totally disproportionate to the low returns, even before they lost everything they had. You can argue that the very elderly got what they deserved for not being ‘informationally efficient’, or whatever, but it’s hard to make an ethical case for such an outcome.

    • Matt Nolan
      Matt Nolan says:

      The failure here was also with the advice they were given – which was immoral, which is why I conclude:

      “Remember, if you are complaining about “moral hazard” you are attacking
      bondholders – not so much the banks (who are easy to demonise because
      they wear suits), but the people who leant money without considering
      risk and those who advised them.”

      Also, I’m sorry but I can’t be particularly sympathic to anyone who went and rolled all their money into a single finance company to earn a half percentage point more because they assumed things would never fail. It is no different to me than if they’d done the same thing with lottery tickets.

      I had family who did that as well, no matter how much I’d try to say it was a bad idea the extra 0.5% was just too tempting.

      Investors have the right to better information, and they aren’t going to go around “actively managing their portfolio” – few people should do such a thing. But not putting your eggs in one-basket is a principle we were taught in primary school, and no matter how old the person is they should be doing that – I don’t see why anyone else should be responsible for someone not doing this.

      Banks already provide a “risk-free” place to put your funds due to the govt guarantee … so if these funds were so important to people why were they throwing them into risky investments for little return? Part of it is that financial advisers were dodgey – and that needs to be fixed. Part of it is that people were just being greedy, and if you take on that risk you should accept when you get burnt.

      The crisis showed that people need to recognise that there is risk with return – and hopefully we come out of this with financial advisers that actually serve people instead of taking advantage of them. But none of this changes the fact that when we bemoan “moral hazard” publically, the culprit is the bondholder, the saver who expects a government guarentee to socialise their potential loses.

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