Moral Hazard - Finance

Finance

Economist Paul Krugman described moral hazard as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly." Financial bailouts of lending institutions by governments, central banks or other institutions can encourage risky lending in the future if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. So-called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well but be bailed out by the taxpayer if the investment turns out badly.

Taxpayers, depositors, and other creditors often have to shoulder at least part of the burden of risky financial decisions made by lending institutions. According to the World Bank, of the nearly 100 banking crises that have occurred internationally during the last 20 years, all were resolved by bailouts at taxpayer expense.

Many have argued that certain types of mortgage securitization contribute to moral hazard. Mortgage securitization enables mortgage originators to pass on the risk that the mortgages they originate might default and not hold the mortgages on their balance sheets and assume the risk. In one kind of mortgage securitization, known as "agency securitizations", default risk is retained by the securitizing agency that buys the mortgages from originators. These agencies thus have an incentive to monitor originators and check loan quality. "Agency Securitizations" refer to securitizations by either Ginnie Mae, a government agency, or by Fannie Mae and Freddie Mac, for-profit government sponsored enterprises ("GSEs"). They are similar to the "covered bonds" that are commonly used in Western Europe in that the securitizing agency retains default risk. Under both models, investors take on only interest rate risk, not default risk.

In another type of securitization, known as "private label" securitization, default risk is generally not retained by the securitizing entity. Instead, the securitizing entity passes on default risk to investors. The securitizing entity, therefore, has relatively little incentive to monitor originators and maintain loan quality. "Private label" securitization refers to securitizations structured by financial institutions such as investment banks, commercial banks, and non-bank mortgage lenders.

During the years leading up to the subprime mortgage financial crisis, private label securitizations grew as a share of overall mortgage securitization by purchasing and securitizing low quality, high risk mortgages. Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private label securitizations, and performed far better in terms of default rates.

Economist Mark Zandi of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis. He wrote that "the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote, "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up, only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."

Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend with their cards because without such limits borrowers may spend borrowed funds recklessly, leading to default.

Securitization of mortgages in America started in 1983 at Salomon Brothers and was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the mortgage securitization system in the United States, many different debts of many different borrowers are piled together into a large pool of debt, and then shares in the pool are sold to lots of creditors.

Thus, there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language that the papers that he/she signed were written in, or even that the paperwork exists and is in good order. It has been suggested that this may have caused subprime mortgage crisis.

Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the subprime crisis, however, national credit authorities (the Federal Reserve in the US) assumed the ultimate risk on behalf of the citizenry at large.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout would prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and the burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis.