The Moral Hazard

Risk is an inherent feature of all investment. Many people thought they could make a fast buck by buying a house they couldn’t otherwise afford and either selling it in a year or two for a profit, or refinancing for a lower rate when their appraised value jumped. There were many, many onlookers to the growing housing bubble who knew that at some point the bubble would have to burst. For some, however, the promises of easy profits, coupled with the the temptation of convenient (and questionable) lending policies drew many into real estate purchases beyond their ability to pay or in some cases, even understand.

Of course, there were cases of unfair, even fraudulent lending practices leading unsuspecting lenders into disaster, and these should be vigorously prosecuted, and as a community we should investigate ways to help those unfairly treated. However, I suspect these cases do not make up a majority of the mortgages in default, which increasingly includes even more credit-worthy and ostensibly financially savvy borrowers.

It’s not just individuals, however. As we’ve seen, investment houses and banks were caught up in the bubble too. Institutions like the now-failed Bear Stearns (and investment house, not a bank), continuously overvalued their mortgage-backed assets. Bear Stearns bailed out some of its own hedge funds which faced financial collapse by loaning them over $3 billion. These hedge funds were suffering from holding onto too many mortgage-backed securities which, if finally liquidated, would be worth far less what their owners claimed. Finally, Bear Stearns couldn’t hold their own house of cards up, and faced a run on their assets from creditors. Instead of allowing their failure to take its course, the Federal Reserve stepped in to help bail them, and have made available emergency loans to other institutions in order to bail them out as well.

Hedge funds were originally intended for, as their name suggests, hedging against downturns and volatility in various markets. They are for the most part unregulated (relative to mutual funds, for instance), and therefore are limited to accredited and institutional investors who presumably are supposed to know what they’re getting themselves into. Yet those hedge funds which have collapsed under the weight of the mortgage crisis, like those from previous years that collapsed from extremely risky trades in derivatives, clearly did not have acceptable risk management polices in place. Why not? Because being risk-averse by necessity reduces chance of profit.

Here we find the heart of the dilemma. If we allow our government to bail out these institutions, then we are basically sending the message that these institutions are free to pursue highly risky policies because their downside risk is covered by the taxpayer. You can bet, however, that the taxpayer did not share in many of the obscene profits that fueled the bubble (and the vast majority of taxpayers are not even eligible to invest directly into these funds). This is what’s caused the moral hazard, where a party that is insulated from risk behaves less responsibly than if that party were made to face the full risk of their actions.

On the other hand, if we allow these institutions to take their lumps, perhaps even collapsing into bankruptcy, then we are laying the groundwork for a more stable and responsible market in the future. The cost for this growth is, perhaps, a temporary general economic contraction as the dominoes of bad investing come down throughout the financial network. Far from disastrous, however, this contraction is perfectly natural and healthy… and necessary for a vibrant economy in the future.

For those most vulnerable in such downturns, we can debate public policy about how to help them out. But let us not reward rampant speculation through taxpayer bailouts, and let’s not go running to the government and cede to them more power to wield over our economy; especially considering how incompetent our government has already proven itself with the inordinate economic power it already has.

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