If you’ve taken any Economic Theory classes in College (or University for you Canadians), you’re certainly familiar with the term “Moral Hazard.” If you haven’t, I’ll quickly define it and give you 3 recent examples in less than 500 words. I know most of you are busy this holiday season.
Definition
A Moral Hazard is created when one person makes a decision about risk, while another person bears the cost if things go badly.
Examples of Moral Hazard
- Mortgage Securitization
I’ve already explained to you Why Banks Sell Mortgages so I won’t dive into the details. While there are certain benefits to this practice, it creates a huge moral hazard. If the bank that originates and underwrites a mortgage immediately sells it to investors, the investors bear the risk. If the mortgage is then insured (or “backed”) by a government agency, this hazard grows greater.
This leads me to…
- Too Big To Fail
One of the biggest complaints I still hear is that “taxpayers shouldn’t have bailed out the big bad banks.” This is an extremely valid complaint, but the argument is usually ill-informed. The reason the bailout was problematic is because it creates a moral hazard.
During the financial crisis, many major banks found themselves in horrible positions. At the same time, there were many smaller banks that were financially sound. When the government bailed out the bigger banks, depositors around the country withdrew their money from the smaller banks and moved to the bigger banks. For example, Bank of America’s deposits increased from 805 Billion in 2007 to 1 Trillion in 2010.
The exact opposite should have occurred, but depositors felt “safer” because they knew big banks would be protected.
Last but not least…
- Unemployment Insurance
Before you flood my inbox with hate-mail, hear me out. I have had A LOT of conversations with friends, clients and former co-workers that have been (or are currently) unemployed. They all say the same thing. “Why would I go out and work for $x/hour when I can do nothing and get paid $y/hour? In this example, the difference between ‘x’ and ‘y’ is minimal. This government-provided safety net, thus, creates a moral hazard.
Readers: Can you think of any other (recent) examples of Moral Hazard? Do you disagree with any of the above examples?
