Moral Hazard, Continued

If you keep bailing your kid out of trouble, will he ever learn to stand on his own? And will he engage in ever-riskier behavior, knowing that you will ride to the rescue?

Moral hazard is easy to understand on a personal level.

Moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected. (WSJ – 8/13/07)

The more people who behave recklessly, the more likely it is that government will relieve them from the consequences of their folly. And once the precedent is set, it becomes exceedingly difficult to reverse course. One familiar example is the Federal flood insurance program, which has resulted in enormous expenditures because homeowners repeatedly rebuild in flood zones and know that the government will step in where private insurers refuse to tread.

That’s why I feel like a sap for buying earthquake insurance, which costs us over $1,000 per year for limited coverage. If the Big One ever hits the Bay Area, the Federal spigot will open wide to feed what will be the mother of all disaster relief efforts. Insured or not, I’ll be able to rebuild.

But what gets my dander up is the pleas for help from the Wall Street gazillionaires who are feeling some pain now that sub-prime loan defaults are wiping out the net worth of some highly leveraged entities and severely damaging that of others.

"You don't want to see the Fed bail out these guys who have made a lot of money. They have made their bed and you want to see them lie in it," says a veteran trader at a New York brokerage house. "Then again, you don't want to see the economy go into recession."

In retrospect low interest rates and lax credit standards, aka “easy money”, fueled this echo boom of leveraged buyouts two decades after the concept was introduced in a big way by Drexel, Burnham, Lambert and Kohlberg, Kravis, Roberts. Easy money, combined with derivative instruments that didn’t behave as they were supposed to when markets underwent stress and “advances” in the equally arcane worlds of international tax, accounting, and financial structuring, led to the creation of this decade’s masters of the universe, the hedge fund and private equity players. They’re feeling pain (and so are small investors---my portfolio’s down more than 10% from its highs) but the real economy is still going strong.

I hope that governments can resist the howls for help. Letting the markets work through the lessons of this fender-bender will reduce the chances of a big crash later. © 2007 Stephen Yuen

[For a previous posting on moral hazard, see here.]

[Update - 8/17: Allen Sloan of Fortune casts a jaundiced eye at the iniquities of central banks' rescue efforts.]