Moral Hazard

Moral hazard is when they take your money and then are not responsible for what they do with it.
~ Gordon Gekko

1. Relevance of Moral Hazard

THE unemployment rate in the United States is now around 9%. Over 13% of all US mortgages are either delinquent or in foreclosure (Mortgage Bankers Association). Total loses resulting from the sub-prime mortgage crisis are expected to run into the trillions of dollars.

At the heart of this global financial meltdown is a concept known as “moral hazard”.

2. What is Moral Hazard?

Moral Hazard is a concept that is often misunderstood, or at least badly explained, by people who should know what they are talking about; business writers, politicians, most online business dictionaries and sometimes even economists … And so we turn to Hollywood for clarity.

Gordon Gekko captured the nature of Moral Hazard very concisely when he explained that “moral hazard is when they take your money and then are not responsible for what they do with it.”

Gekko may well have borrowed his definition from Paul Krugman; Professor of Economics at Princeton University, 2008 Nobel Prize winner, and New York Times columnist. Krugman describes 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.”

To summarise these two iconic figures, we might simply think of Moral Hazard as any situation where a person or organisation is not fully responsible for the consequences of its actions. As a result, the person or organisation may take greater risks than it otherwise would because it is not responsible for paying the full cost if things go badly.

It is worth noting that “Moral Hazard” is an economic concept and does not necessarily imply that there is any immorality or unscrupulous dealing involved, not necessarily.

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One Reply to “Moral Hazard”

  1. Great article Tom!

    The term “moral hazard” conjures up the quintessential image of “wall street taking advantage of main street” which resulted in the sub-prime mortgage crisis as mentioned in your post. This is moral hazard at its most apparent.

    However, a subtler form of moral hazard should also be considered – that of the dichotomy between board executives and shareholders. Take for instance, the board’s supposed alignment of interest with the shareholders under general US Corporate Governance Law. Under this theory, what benefits the board should also benefit the equity holders – but this isn’t necessarily true. Board members may take risks in a variety of cases where the potential loss outweighs the benefits for many different reasons. For example, an executive may make an investment with an unjustified risk on behalf of the corporation because a positive return on the investment would result in an exponential increase in executive pay while a negative return on the investment would have little to no impact on executive pay. In this situation, most of the risk is born by the shareholders leaving the executive free to act with little consequences. This is where moral hazard sets in.

    Let’s also not forget that often times board executives are also bond holders of the corporation as well. Given the naturally opposing interest of bond holders and shareholders, executive bond holders would act (even though he/she shouldn’t) in a manner inconsistent with the shareholders’ best interest.

    So much of TARP is centered around this in the form of executive compensation issues. Do you think it is safe to say then that our society is operating under a de facto moral hazard inducing model? Would love to hear your thoughts.

    Stella

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