Bank Bailouts and other Moral Hazards

In the previous post on Moral Hazard, we learnt that Moral Hazard refers to any situation where a person is not fully responsible for the consequences of their actions. As a result, they may take greater risks than they would have otherwise.

Here are 6 examples of situations where Moral Hazards arise in practice.

1. Insurance

The provision of insurance is the most common example of Moral Hazard.

For example, if you have comprehensive private health insurance you’ll be more likely to visit the doctor. You may also engage in more risk taking activities because you are not responsible for paying the medical costs if things go badly e.g. you go bungy jumping and throw your back out.

Malcolm Gladwell provides the amusing example of Universal Pepsi Insurance:

“Moral hazard” is the term economists use to describe the fact that insurance can change the behavior of the person being insured. If your office gives you and your co-workers all the free Pepsi you want—if your employer, in effect, offers universal Pepsi insurance—you’ll drink more Pepsi than you would have otherwise.

2. Mortgage Securitisation

Mortgage securitisation is an insidious and often misunderstood example of Moral Hazard.

The US government, motivated by a desire to expand home ownership, has for many years actively encouraged bankers to make loans to people with poor credit ratings. Fannie Mae and Freddie Mac, two large government sponsored enterprises, have carried out this policy through a process known as “mortgage securitisation”. Mortgage securitisation involves:

  1. purchasing mortgages from banks and mortgage brokers;
  2. grouping these mortgages together into large pools; and then
  3. selling “shares” in these mortgage pools to investors.

Moral Hazard exists because the banks and mortgage brokers who originate the loans do not pay the cost if lenders default. As a result, they have an incentive to make as many loans as possible, even to people with extremely poor credit ratings. These loans are often referred to as NINJA loans because they are made to people with No Income, No Job and No Assets.

3. The Greenspan Put

The Greenspan Put is another example of Moral Hazard.

Since the late 1980’s the Federal Reserve has followed a policy of significantly lowering interest rates in the wake each financial crisis (this policy is often referred to as the Greenspan Put). Lowering interest rates has the effect of increasing the amount of money available to the economy which prevents the economy from deteriorating further and stops asset prices from falling. As a result, this policy encourages investors to take excessive risks because they know that the Fed will lower interest rates if things go badly.

4. Bank Bailouts

Following on from mortgage securitisation and the Greenspan Put, we arrive at bank bailouts.

The provision of bank bailouts by government is perhaps the most topical example of Moral Hazard. In 2008, in the wake of the sub-prime mortgage crisis, the US government created a US$700 billion Troubled Asset Relief Program (known as TARP) to buy financial assets from banks and other financial institutions. The bailout was intended to stabilise financial markets, make sure that credit markets remained liquid and to prevent a repeat of the great depression. A worthy goal, however one small problem with TARP is that it creates a big Moral Hazard. If banks know that government will bail them out, then they will continue to engage in excessive risk taking.

Bailouts are now even being provided to sovereign states. In May 2010, the EU and IMF agreed to provide Greece with bailout money to the tune of €110 billion.

We can expect more financial instability to come.

5. Private Equity

Private equity vehicles, popular until around mid-2007, are another example of Moral Hazard.

Let’s assume that investors give a private equity firm $100 million to invest. If the private equity fund makes a profit of $20 million after one year then the fund managers might take 20%, or $4 million. If the fund loses $20 million after one year then the investors lose $20 million and the fund managers pay nothing. Since the managers are not fully responsible for the consequences of their investment decisions they have an incentive to take excessive risk.

6. The Limited Liability Company

The limited liability company presents an often overlooked form of Moral Hazard (props to Stella Szeto for pointing this out).

A company will often link the amount that its executives get paid with the company’s performance on the stock market. The reason for doing this is to align the interests of the executives with the interests of shareholders, which makes sense on one level (see Principal-Agent problem).

If the company performs well and its stock price rises strongly then shareholders are happy and executives will get a bonus in the form of cash, shares and/or options. However, if the company performs poorly then shareholders lose, while executives still receive their base salary and are not required to compensate shareholders. As a result, executives have an incentive to take excessive risks in an attempt to inflate the company’s short term stock price.

Consultants – highly paid scapegoats?

Consultants charge huge sums for superficial but well “powerpointed” presentations in return for the company executives’ right to take full credit for any successful outcomes

MANAGEMENT consultants are often loudly criticised. Why is this so?

A large part of the reason is that consultants are paid a lot of money to provide recommendations which may or may not be implemented, and may or may not work.  They get paid regardless of the outcome, and this rubs a lot of honest, hard working people the wrong way.

A consulting joke one of my good friends told me recently provides some insight into the negative sentiment that sometimes surrounds the profession:

A man drives up to a farmer who is herding his sheep and says “if I tell you how many sheep you have, can I have one of your sheep?” Intrigued, the farmer agrees. The man sits down, pulls out his laptop, does some calculations, makes some phone calls, takes some satellite photos and finally announces, “you have exactly 413 sheep.” The farmer is impressed, “that’s exactly right, you can have the sheep of your choice.” The man picks one of the animals and the farmer says “now can you do something for me? If I can tell you what you do for a living, will you give me back my sheep?” The man agrees and the farmer immediately replies, “you’re a consultant!” The man is amazed, “yes, how could you know that?” “Well”, says the farmer, “you came without being asked, you told me something I already know, and you don’t know anything about my business … Now give me back my dog.”

Hat tip to Nick Cocco for the joke.

This joke, apart from being pretty funny, conveys the idea that consultants don’t add value. Could this be true?

“NO!”, I hear myself say (shout, scream), “if consultants don’t add value then they wouldn’t be highly paid and smart managers would stop using them. But consultants are highly paid and smart managers do use them. Therefore, consultants must add value!”

Mustn’t they?

This argument is certainly sound. Or at least, I like the sound of this argument.

The question is, why would smart managers employ expensive consultants if they don’t add value to the company?  Why indeed!  To quote Peter Spencer:

… it all started when executives at large companies decided that they needed some external scape-goats to blame if and when costly new business ventures failed.

Over the years this symbiotic relationship has developed enabling the consultants to charge huge sums for sometimes superficial but well “powerpointed” presentations in return for the Company Executives’ right to take full credit for any successful outcomes while shifting the spotlight of blame comfortably away from themselves in case of failure. “Failure is a bastard but success has many executive fathers”.

What do you think, are consultants just highly paid scapegoats?