Punchinello’s Chronicles

January 16, 2010

What is Moral Hazard?

The news pundits, New York intelligentsia and people in the lah-de-dah crowd love to come up with new words and expressions. “Moral hazard” is one such term, and I’ve been hearing it more and more lately. It’s kind of funny, given that morality has been under attack for decades, so what’s this alleged hazard they’re discussing? Turns out that we have two perfectly good words already: temptation and incentive.

Maybe you’ve heard about how moral hazard somehow connects with Big Banks, otherwise known as Too Big To Fail (TBTF) banks. Or perhaps you’ve heard the term applied to Wall Street brokers and investment companies. Whatever you’ve heard, you likely let it slide right on by and figured it had something to do with…something. But just think about temptation.

There’s a great expression I ran across the other day, a sort of old saying:

Capitalism without bankruptcy is like religion without Hell.

What’s Hell got to do with it? Well, it’s the punishment you get if you don’t do the right thing. If you don’t follow the moral principles and rules set forth by God (or someone), then you get punished. A religion tells you that you’ll end up in Hell after you die. Capitalism tells you that you’ll go bankrupt if you don’t do the right thing in business. Of course you could go bankrupt anyway, even if you’re morally right. Sometimes a business just doesn’t attract customers for other reasons.

Let’s suppose you’re having a nice snack in a mall, watching people go by. There’s this guy walking along and he drops his wallet, doesn’t notice, and keeps walking. What’s the right thing to do? Wouldn’t it be to pick up the wallet, run after him and tell him you’d found it? Of course. That’s a moral code. It instructs you on things like honesty, empathy, justice, and what’s right and wrong.

But now let’s suppose you look in the wallet and see $1,000 in cash. A temptation is where you’d like to do something for self-gain but you know it’s wrong. Granted; if you just found a $100 bill lying on the floor of the mall, kicked off to the side, then you’d probably just keep the money. How would you know what else to do with it? Would there be a way to make sure the right owner got the money? No, probably not.

An incentive isn’t the same as a temptation. An incentive is a reward for doing some sort of action or behavior. If you open the wallet, see the money and then see a note: “I will give a $20 reward for anyone who returns my wallet if I lose it,” that’s an incentive. Of course you still have to resist the temptation to just take all the money for yourself. But if you DO choose the right thing, there’s an added incentive in the reward.

Whenever you encounter a set of events that tests your morality, that’s now called a moral hazard. I suppose it means that you’re in danger of being corrupted or something. Why they can’t just stick with temptation and incentive is beyond me, but then, for me, life is full of mysteries!

Suppose you want to buy a house. Let’s say it’s a $150,000 house. You don’t have any money saved, you’re maybe working (maybe not), and you struggle each month to pay your bills. But by golly, you sure do wish you had a house of your own! Then you see an ad from a bank that promises you that you can buy a house. Even in your financial situation.

You know you can’t afford the house. You can barely afford rent, but you sure do want your own house! You’re tempted. And that’s a form of moral hazard. The bank, on the other hand, is just trying to sell loans. Where’s the moral hazard in that? Ah…but that’s not what happened.

The federal government in the form of Fannie Mae and Freddie Mac, not to mention the Department of Agriculture and Sally Mae (for student loans) offered an incentive to the bank. They basically told the bank that if that bank gave you a loan, the bank then could hand off the entire responsibility for the loan to the federal agency. In other words, the bank was acting as a storefront, only for the purpose of getting you in the door and writing the loan. Beyond that, they were done.

If the bank had to worry about actually getting paid back for the money they lent you, then they’d also have to pay attention to whether you’d be good for the money. But since the bank no longer had any worries, why should they care? They could write as many loans as they wanted to, regardless of ability to make payments by the customer. What the heck…the government would take care of it.

Is that right? Is that an honorable thing to do? Is that the way a business is supposed to work? Is that capitalism? No, it’s not the way things are supposed to go! In fact, by taking away ALL risk to the bank, the federal government created both the temptation for banks to write bad loans, AND an incentive for banks to write bad loans!

Hmm…isn’t it also the federal government, together with our fine institutions of higher learning who have told us that there’s no such thing as morality?

What about visiting the emergency room when you feel a cold coming on, or you have a fever, or you break out in a mysterious rash? Is that the right thing to do? Should you even bother to see if maybe you’re just getting a cold? Should you bother to wait a minute or two to see if the rash gets worse? Isn’t an ER supposed to handle things like car crashes, shootings, projectile bleeding from the eyes? Of course it is!

The federal government stepped in and said that if you want to visit the ER that’s fine. They’ll pick up the extraordinary tab. Not only that, but they’ll force the hospital running the ER to take less money than they normally charge. In fact, many people today have a “co-pay” of only a tiny fraction of any kind of medical costs. That creates a temptation to just wander into any old hospital for any reason at all. Is it an emergency? Well…no, not really…it just feels different from normal health.

I think that we’re hearing about moral hazards because that confuses the issues. Anyone can understand that the federal government set up incentives and rewards to banks to make rotten loans. Anyone can understand that banks were tempted by free money to spend it for themselves and increase their profits. If congress had passed a law that said the government was going to give out these rewards, do you think people may have noticed?

Yes, most people would have noticed. Which is why nobody mentioned such things as NINJA loans. That stands for people who have No Income, No Job, No Assets. In other words, all you had to do was walk into a bank and point to a picture of a house. Ten minutes later you’d walk out owning the house. Sign papers? Nope. Prove you have money? Nope. Come up with a down payment? Nope. The government would handle it all for you. For free. Sort of.

We live in a world of situational ethics, amorality, and a strong anti-religious movement (the secular movement). Nobody is wrong, nobody is right. There’s no particular good thing, nor is there any particular bad thing. Everything is just fine, dude, as long as it feels good. For you. Forget how anything feels for anyone else, it’s all about our own feelings. If your feelings are hurt, sue someone. You’re definitely right, even if there’s no such thing as right.

The moral hazard is living in a world without any morality whatsoever. The only “hazard” is to those few people who actually do have a morality. For most people, most bankers, most corporate management and almost every politician, there’s no hazard at all. That’s probably why we’re hearing the term so much in the news. It’s only when something doesn’t exist that the news media spends time saying that it’s “out there, somewhere.”

The folks who create “South Park” call it shenanigans. When someone at a carnival sets things up so that you can’t win, you have the right to call shenanigans and the local crowd will listen to your case and render a judgment. In Washington, along with most other hallowed halls of government, people call it moral hazard. Then a peer group of other politicians sit around and discuss whether to have committee meetings to decide if anything may have happened. Not if whatever may have been right or wrong, just whether something happened.

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