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Some effects of moral hazard

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As the world’s financial markets continue to limp along, affecting as they do small island economies as our own, many governments are focusing on how to jump start their economies out of recession. At the same time the concept of “Moral Hazard” has been brought into sharp focus and is being seen as a key factor contributing to this extraordinary crisis.{{more}}

Moral hazard is a term commonly used to describe those situations where a person or institution is effectively insulated from the possible negative consequences of their choices. This makes them more likely to take risks that they would not otherwise take, most notably with assets and capital entrusted to them by others. It is really a state of mind created by the belief that government is going to bail us out if something goes wrong in our lives or in our economy. There are situations, however, in which moral hazard concerns can be relaxed as in a case where the credit system is close to collapse. The fact that persons are inclined to take more risks when they are insured may suggest that moral hazard could have played a big part in explaining the current financial crisis.

In march 2008 when the U.S. authorities saw it fit to bail out the bond holders of investment bank Bear Stearns to the tune of $ 29 billion, it seems to have had a moral hazard effect, in that it encouraged Lehman Brothers and other investment banks to delay their raising of more capital, because they might have been expecting the government to come to their rescue if times get much worse. Indeed times did get worse and the chairman of Lehman Brothers in his congressional testimony noted that his firm did not get the same bailout as others did. In other words, if only the government had stepped in, Lehman Brothers would not have collapsed and he would not have been addressing congress on the matter.

Implicit in the lending policies of Fannie Mae and Freddy Mac was the assumption that as government sponsored enterprises with lower capital requirements than private institutions, they could always look to the Federal Government for assistance if an unusually high number of their clients defaulted. The whole idea of personal and public bailouts is what has been behind the problem in the first place. As long as institutions believe that government stands behind them, no matter what level of risk is taken, the level of risk will rise to the point where failure could be imminent. But if the risk pays off, the company is rewarded with increased profits, while if it loses, the government covers the losses. Such a philosophy makes for bad decisions and has led millions to take on mortgages they could not afford.

So the road to the big bailout in 2008 had its genesis in an idea- the idea that we don’t have to be 100% responsible for our lives or our institutions because a great cushion or safety net lies below us. Since the quasi government entities Fanny Mae and Freddy Mac operated under an implicit guarantee that tax payers would bail them out if needed, this allowed banks to package their loans and sell them to these government backed entities in the knowledge that tax payers will bear the final risk. If it were made clear that lenders would not be bailed out, the free market would have been unlikely to offer home -ownership promoting loans in the manner they did.

When meeting bank representatives in the Vatican in December 2008, Pope Benedict XVI said that “one of the prime duties for the banking and lending institutions is showing solidarity with the more vulnerable members of society as well as support for the creation of wealth”, a mild hint in support of the concept of the moral hazard idea. Policy makers do have a duty to protect the interest of the more vulnerable members of society, but they would need to strike a balance in the application of their policies to avoid the harmful effects associated with the moral hazard philosophy.