Moral Hazard

You may have single-handedly dissuaded me from pursuing being an educator as a part-time encore career. Reading that your macro-economic instructor doesn’t tie current market conditions to current subject matter startled me. We’re living in very interesting times. While it was common in my college years to learn most things from textbooks (we barely had computers at the time) and take multiple choice tests, I had hoped there would have been more focus in your education to expand beyond dated case studies towards using the current world examples happening around us to illustrate important schools of thought.

Things are not always as they seem.

I have in my possession a Finance textbook that contains a case study showing Enron in a positive light. Yes, you read that correctly, before Enron became the unequivocal pariah example of corporate evil, it was so well respected that it was used as a model company for study at a graduate level finance course. All the while, below the surface fraud, greed, and corruption flourished, at the company and at the auditor level as well.

The people at the top are not infallible.

If the tools I’m taught in class cannot be used to accurately depict the behavior in the world’s large markets like oil or commercial real estate, where’s the value in learning these models? If these markets are too complex and the supply and demand curves I learn are only relevant for lemonade stand math, why do I need to know them? If the models only work in hindsight or in paper derivative markets, I have more cause to worry.

To that end, I will put my money where my mouth is attempting to explain the somewhat arcane economic term “moral hazard” we touched on last week in a fun yet profane manner.

Moral Hazard as commonly defined in the top couple google links (a whole other issue) is something like:

• lack of incentive to guard against risk where one is protected from its consequences, e.g. by insurance.
• is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk

Accurate yes, but such dry, stale, and sterile writing. I’m going to attempt to liven it up by articulating how I understand the phrase.

My personal viewpoint of the term is that it is the exact polar opposite of the currently popular, ((but vulgar (sorry mom & mom like people)) phrase:

Fuck around and find out.

“Fuck around and find out” to me has an implied “will” or “must” meaning. It’s fundamentally a simple “if/then” statement, a conditional argument. “If you fuck around, you will find out.” This implies a sense of risk on the side of the,…..hmm how do I phrase this….”the fucker” indicating they know they are at risk, and if things go wrong, there will likely be negative consequences. This is a true an accurate view of each and every decision we make. There are always opportunity costs and consequences.

The problem of moral hazard is that it removes the whole “find out” part of the equation. It tells whomever to just take the risk (or borrow the money) and they’ll never see negative unintended consequences. It just instructs the party to just fuck around haphazardly. Without the corrective measures of “find out”, people, companies, and governments take on entirely too much risk because “why not?”

An example of this was demonstrated vividly in the 2008 housing crisis. Banks, builders, and developers (egged on by the Fed’s super low interest rate policies) allowed tremendous risk in the housing market including my favorite, the “Ninja loan”, defined as: no income, job, or assets.

When you subsidize demand, price increases.

This led to a very large bubble in the housing market and the destiny of all bubbles is to “pop”, which it did spectacularly.

When it popped, for the most part the “little people” were not spared, they lost homes, dollars, and credit ratings. The counterparties, namely banks and entities acting like banks, were deemed “too big too fail” by the government so they were bailed out at taxpayer expense. It was sad that the people that lost their ass in the crash, then had their taxes used to pay off the risky bets of others who escaped the same gambles untouched. But the true problem with moral hazard is that if the player doesn’t feel the pain of the consequences, they repeat the behavior. Even more so, players that watched the companies get bailed out were disappointed that they missed out on a chance to risk with no downside. It’s like offering someone a spot at a slot machine you never need to put any money into, it just pays out.

What helped the rebound after the 2008 crises to be so strong is that we knew for the most part who was fucking around, so the government surgically inserted dollars into specific markets to shore them up. Some would argue they merely kicked the can down the road, but that’s a story for another day.

Which brings us close to where we are today, which in my opinion is getting very close to 2008 with the exception that this time…everyone is fucking around.

They don’t call economics “the dismal science” for nothing!