Learning moral hazards

Rob Price

We have been living in the land of moral hazard.

"Moral hazard" is a term I heard Henry Paulson, secretary of the U.S. Treasury, use in a recent press conference. Secretary Paulson was explaining the federal government's decision not to bail out Lehman Brothers — a private investment bank. That decision had something to do with "moral hazard," Paulson declared.

According to my research, the term "moral hazard" was coined in the 17th century and used frequently in the business of insurance. It describes the situation in which someone, having purchased insurance, is now prone to taking unnecessary risks. The sale of the insurance policy creates the "moral hazard" of the insured party being willing to abandon prudent caution.

Similarly,in the world of finance, the term "moral hazard" describes a situation in which a lending institution is willing to make risky loans, or investments, under the assumption it will not bear the full brunt of the penalty in the event the loan turns sour.

"Moral hazard" is a term that explains a lot about the frightening meltdown in the national and international finance markets, the sort of meltdown that led to the 158-year-old Lehman Brothers investment house going broke over a weekend. And the Dow Jones Industrial Average losing a thousand points in a few days.

Understood properly, it's a term best used in the context of adults. Children constitute a natural moral hazard because they don't understand the concept of risk. But children are too young to think about risk properly, so they are not held to a moral standard when they behave foolishly. Growing up, however, involves the sometimes painful recognition that foolish actions carry the risk of painful consequences.

Of course, surveying the current wreckage on Wall Street — Lehman Brothers broke; Merrill Lynch bought out by Bank of America; AIG taken over by the federal government — it's possible to conclude some of the country's financial geniuses remain, emotionally speaking,walking 10-year-olds.

For years, moral hazards have been sprouting throughout the financial sector like weeds, beginning with the creation of sub-prime mortgages. As long as the value of real estate continued to climb, there was no problem with these loans: the borrower could sell the property at a profit after a year or two, before the interest on the loan exceeded his ability to make monthly payments. Once the housing bubble burst, though, the property couldn't be sold at a profit, and the owner was left with property he couldn't afford, nor sell without taking a loss.

Moral hazard #1: Housing investors figured there was no way to lose money, because the price of real estate seemed destined to keep on rising. That is not investing; it's speculation.

And it got worse: Banks were willing to write the mortgages because they knew they could turn around and sell them to gigantic corporations like Fannie Mae and Freddie Mac. Those two companies were willing to buy risky mortgages because they knew, as government sponsored enterprises, they could fall back on the largess of the federal government in the event of a downturn in the housing market.

Moral hazard #2: Fannie Mae and Freddie Mac were prone to inappropriate risk because they felt, in a sense, insured by the purse of the federal government.

Enter the global financial market. Sub-prime mortgages were bundled into securities and sold as bonds to investment firms like Merrill Lynch and Lehman Brothers, whose chief executive officers were willing to make the risky investment because they were: (a) walking 10-yearolds; (b) greedy, or (c) both. Children are naturally greedy, and they often don't understand how a bad choice can carry unpleasant consequences. But that's a particularly dangerous combination for adults. Too many risky investments in search of instant wealth is a one-way ticket to being broke.

Moral hazard #3: Pushing financial risks down the road through a complex network of investment houses doesn't eliminate the risks. It just spreads them out.

I wish I could say I feel better, now that Secretary Paulson has introduced me to the term "moral hazard." I don't. What's happening in the financial markets has me scared and knowing what Henry Paulson means by "moral hazard" doesn't improve things.

And actually, I had a pretty good sense all along of what constitutes "moral hazard." That's because I'm an adult, and adults understand that life carries risks. And so we tend to behave a little more conservatively than children, or, it turns out, many of the geniuses who ran our best financial institutions.