Moral Hazard

Today, the Federal Reserve and President of the United States offered a life raft to the mortgage market.

It sounds like this will come in the form of additional liquidity for lenders from the Federal Reserve, and loan guarantees and loan restructuring for borrowers through various government departments.

Although this may seem like much needed help for "victims" of the market, to me it looks like a dangerous incentive to take more risk--also known as moral hazard.

You see, borrowers who shouldn't have gotten money were lent money. Many were speculators hoping home prices would keep going up. Others were ignorant of the loans they signed because they didn't bother to read the paperwork.

Should borrowers be bailed out who shouldn't have borrowed? Suppose I go out and buy a large screen TV with my credit card. Suppose I can't make the payments because I didn't realize the interest rate I would pay. Should taxpayers bail me out because I'm ignorant of the contract I signed? If they do, what would I learn? Not to take the risk?

Even worse, lenders knew about their borrower's credit histories and ability to pay. Lenders also knew they would pass such loans off to Wall Street investment banks who would sell such bad loans to ignorant investors.

Should the mortgage originators, Wall Street banks and lazy investors be bailed out for making bad loans? Suppose I lend someone money at a 20% rate because they can't get a loan elsewhere. Suppose they can't make payments at some point. Should the taxpayer bail me out for making a bad loan? What would I learn? Not to make loans to people who can't pay?

The Fed and President are offering to bail out borrowers and lenders with other people's money. Those other people are U.S. taxpayers. You will pay in the form of inflation due to the Fed printing money and higher tax rates or higher government debt due to the executive branch bailing out "victims" of bad lending.

The real problem with this scheme, as any study of history will tell you, is moral hazard. If someone learns they can take risk at another's expense, then they're incentivized to take that risk over and over again.

If you let a teenager borrow your car and they get in an accident, what do they learn if you prevent them from living with the consequences? Why would that be any different with adult borrowers and lenders in the U.S. economy?

Just look at the people rebuilding their huge houses in Alabama that were wiped out by hurricane Katrina. They know they don't have to pay for insurance because the government will bail them out, so they are quite happy to rebuild because they know they won't bear the expense of the risk they're taking.

So, when you see spiking inflation over the next several years and higher tax rates or increased federal debt to pay for all the bailouts the government is offering, keep in mind that you're getting to bail out speculators in real estate, people with bad credit histories, banks who pass their loans off to Wall Street, Wall Street investment banks that don't need the help, and investors who don't bother researching what exactly they are buying.

And, when such teenagers take this risk over and over again, and you get to bail them out each time, remember that there is a name for this phenomenon--moral hazard.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.