Social Security Fix

Moral HAZARD

   I felt like I just had to weigh in on one of the most popular subjects of the day.  It has been five years since the Housing Industry and its cohorts in Insurance, Banking, Credit Bureaus, Realtors, and Speculators ruined our economy. It has been said that not one of the principals in the evils has been brought to trial, convicted and sentenced.  Which is probably not true, but almost.

   As a third grader in a one-room country school, I was introduced to Aesop’s Fables.  I can’t recall a single one, or the moral it taught, but some research could pull one out to look at.

   Hopefully, others have had the joy of reading one, get called to the recitation bench, asked if I found the moral, and could I explain it.  As I recall, I was pretty good at it because I had had three or four years listening to my school mates sweat through similar examinations and knew what most of the tricks were.

    My, how I wish they could teach like that today. I am going to expose the Preface to a recent addition to my internet knowledge and below that present a fable translated by Ambrose Bierce from the original Greek, wherein our hero gets on a bridge and meets an adversary named Material Interest. Another story was the Fox and the Grapes. Perhaps you remember that one.

  Below is the Preface to the Aesop’s Fable Website

PREFACE 

  THE TALE, the Parable, and the Fable are all common and popular modes of conveying instruction.  Each is distinguished by its own special characteristics.  The Tale consists simply in the narration of a story either founded on facts, or created solely by the imagination, and not necessarily associated with the

teaching of any moral lesson.  The Parable is the designed use of language purposely intended to convey a hidden and secret meaning other than that contained in the words themselves; and which may or may not bear a special reference to the hearer, or reader.  The Fable partly agrees with, and partly differs from

both of these.  It will contain, like the Tale, a short but real narrative; it will seek, like the Parable, to convey a hidden meaning, and that not so much by the use of language, as by the skilful introduction of fictitious characters; and yet unlike to either Tale or Parable, it will ever keep in view, as its high prerogative, and inseparable attribute, the great purpose of instruction, and will necessarily seek to inculcate some moral maxim, social duty, or political truth.  The true Fable, if it rise to its high requirements, ever aims at one great end and purpose representation of human motive, and the improvement of human conduct, and yet it so conceals its design under the disguise of fictitious characters, by clothing with speech the animals of the field, the birds of the air, the trees of the wood, or the beasts of the forest, that the reader shall receive advice without perceiving the presence of the adviser.Thus the superiority of the counselor, which often renders counsel unpalatable, is kept out of view, and the lesson comes with the greater acceptance when the reader is led, unconsciously to

himself, to have his sympathies enlisted in behalf of what is pure, honorable, and praiseworthy, and to have his indignation excited against what is low, ignoble, and unworthy.  The true fabulist, therefore, discharges a most important function.  He is neither a narrator, nor an allegorist. He is a great teacher, a corrector of morals, a censor of vice, and a commender of virtue. 

  In this consists the superiority of the Fable over the Tale or the Parable.  The fabulist is to create a laugh, but yet, under a merry guise, to convey instruction.  Phaedrus, the great imitator of Aesop, plainly indicates this double purpose to be the true

office of the writer of fables.  

I wish to introduce one of Ambrose Bierce’s (Aesop’s) fables.

The Moral Principle and the Material Interest

  A MORAL Principle met a Material Interest on a bridge wide enough 

for but one.

  "Down, you base thing!" thundered the Moral Principle, "and let me 

pass over you!"

  The Material Interest merely looked in the other's eyes without 

saying anything.

  "Ah," said the Moral Principle, hesitatingly, "let us draw lots to 

see which shall retire till the other has crossed."

  The Material Interest maintained an unbroken silence and an 

unwavering stare.

  "In order to avoid a conflict," the Moral Principle resumed, 

somewhat uneasily, "I shall myself lie down and let you walk over 

me."

  Then the Material Interest found a tongue, and by a strange 

coincidence it was its own tongue.  "I don't think you are very 

good walking," it said.  "I am a little particular about what I have underfoot.  Suppose you get off into the water."

  It occurred that way.

   Ohh! Let’s go over this one more time! Where is Ev Dirksen? OK

" I am a man of principle, and one of my basic principles is flexibility. " I thought I had It remembered as Unbending Principle. 

   But either way it’s OK. This seems not what we read in the Preface. To get us back on the right track – Moral means Truth, Certainty and the American WAY! (or is it truth, justice and the pursuit of happiness?) Where is Jefferson and the Louisiana Purchase, or Lincoln and the end of Slavery, or Roosevelt, the Trustbuster, who gave us those schools, Aesop’s Fables and the quintessential American Way?  Oh! Yes, the Material Interest is alive and well, Thank YOU!

   First a personal disclosure. My nephew, Casey worked in the World Savings SF Office, where he might have known Paul Bishop. He appraised property. His older brother worked at Golden West Financial before it merged with World Savings, and was transferred from the Denver Office to San Antonio and was an executive, and is now retired.

   But not to be left out is our whistle blower, Paul Bishop. Did he give us an earful back in 2006, Listen to Scott Pelley “

August 19, 2010 11:41 AM

World Of Trouble

By

CBSNews

How did the mortgage industry destroy itself and set off an economic collapse that ruined the finances of millions of Americans? Executives tend to hold themselves blameless, saying that no one could have seen the disaster coming. 

Well, judge for yourself after you hear the story of Paul Bishop (update: Paul Bishop loses arbitration hearing), who worked at the nation's second largest savings and loan. World Savings Bank was among the industry's most admired mortgage lenders. But Bishop says the kind of lending practices he saw were leading to a world of trouble that would ultimately result in billions in losses and a federal investigation. 

What does Paul Bishop say he told executives at World Savings, three years before the crash?

"We're breaking the law, okay? We're breaking the law. You know we're breaking the law. I know we're breaking the law. What the hell do you think is going on here? You know, you're granting too many people loans who simply can't qualify," Bishop told 60 Minutes correspondent Scott Pelley.

Bishop's story is a rare inside look at forces that tore the economy apart, as seen by a plain-spoken loan salesman who is now suing World Savings, claiming that he was fired for telling executives what they didn't want to hear.

"I definitely talked to him about Enron. I said, 'We're sitting on an Enron.' This is…bigger than Enron. I mean, we're doing four billion a month in loans. If housing drops, housing value drops, people start to default, you know? This is a nightmare. These people will not survive it," Bishop told Pelley.

Bishop was a mortgage salesman at World Savings San Francisco Loan Origination Center. He'd been a top salesman at IBM and spent years as a stock broker. Most everywhere he went, he had a reputation for speaking his mind and ruffling feathers. He joined World in 2002, in part, because of its history.

Bishop says the owners were Herb and Marion Sandler.

"And their reputation at the time was what?" Pelley asked.

"It was flawless, near as I could tell," Bishop said.

In fact, Herb and Marion Sandler were legendary. In 1963, they started Golden West Financial and grew to 285 branches under the name World Savings. The Sandlers' were known for careful, conservative lending. They've given away millions of dollars to charity and started an advocacy group for low income borrowers called the Center for Responsible Lending. 

---

To read Herb Sandler's response to the story, click here

---

In 2006, just before the housing crash, the Sandlers sold their bank to Wachovia and pocketed $2.3 billion.

Trouble is, some of their money came from people like Betty Townes, who is financially ruined after being sold a series of World Savings mortgages she couldn't afford. 

Asked how many times she refinanced, Townes said, "Well we refinanced practically every year."

World salesmen convinced Betty to refinance her mortgage four times in four years. She got about $20,000 each time. "Well, all I know that they told me this loan was best for me," she told Pelley.

But how could it be best when Betty's pension couldn't qualify her for the loans?

"They told me that they would go by my husband's payroll," she said.

"Even though he'd been laid off from the shipyard?" Pelley asked.

"No, he'd passed away," Townes replied.

Her husband, Ronnie Townes, was dead. World Savings noted that in her papers. But his former income was used to qualify Betty. 

Maeve-Elyse Brown, a lawyer for a non-profit group working to save homeowners from foreclosure, says Betty Townes' actual income was about $1,875, but that the income written on her loan application was over $4,000.

Asked who did that, Brown told Pelley, "The interviewer that's listed is a staff person for World, for World Savings, according to the loan documents."

"What does that tell you?" Pelley asked.

"Looks like whoever typed up this document put in the number that they thought was the right number to get the loan approved," Brown said.

"The term was 'packaged.' It had to be packaged correctly when it got to the underwriter," Bishop told Pelley.

Bishop says a story like Betty's was common at his former office. 

He says facts were manipulated on some loan documents to get past company underwriters who approved the loans. "You know, let's not say this. Let's delete these items that they're probably not gonna check on. Let's add this. Let's just move it around."

"Packaging the loan meant modifying [the loan]…to make sure it would pass the underwriters' inspection?" Pelley asked.

"Correct. It was one grand wink-wink, nod-nod," Bishop said.

One person you won't see in this story is Herb Sandler. For months, 60 Minutes invited him to sit down for an interview. But instead, he sent these letters. 

---

Read Herb Sandler's first letter and his second letter to 60 Minutes.

---

He says it is "categorically false to suggest that we trained or permitted employees to falsify a borrower's income." Sander called it "totally unacceptable in our culture."

But Paul Bishop says he watched the bank famous for quality begin to emphasize quantity. World relied on outside mortgage brokers to bring in 60 percent of its customers. The more loans that were approved, the more the brokers, and World Savings, made in fees.

"We would have these instant underwriting events in an office where we would assemble five underwriters right there," Bishop told Pelley.

Asked how many loans would be covered in a single day, Bishop said, "80, 90, we would keep track of it. 80, 90, 100 would be reviewed, yeah. Oh, yeah."

By 2005, 38% of World's clients had subprime credit scores. And customers were shown fliers that told them their income would not be checked by the bank.

"So I don't really need to know what you make. I don't need proof. You tell me you make $200,000 a year? You make $200,000 a year," Bishop said.

"No verification?" Pelley asked.

"Not gonna check," Bishop replied.

Herb Sandler told 60 Minutes if there was no income verification, the bank still checked credit reports and appraisals. But 60 Minutes spoke to two former World salesmen and a former executive who made similar allegations to Bishop's. One said, "It was all about volume, quantity over quality."

To understand what was happening in the mortgage industry, 60 Minutes went to Bob Simpson, whose company, IMARC, investigates failed mortgages. 

"When one lender dropped standards, another lender felt that they had to do the same," Simpson told Pelley.

Simpson says World and other lenders were in a ruinous competition for customers. "There are people inside of every institution that have been screaming for years about these terrible loans. Don't fund these. These are horrible loans. And they were routinely ignored inside of their own institutions."

Asked why they were ignored, Simpson said, "Because there's no money in common sense. There's no money in stopping a loan. There's only a payday when that loan closes."

The loan World was selling was potentially risky. It's called an option ARM, but at World it went by the cheerful name "Pick-A-Payment." The monthly statement offered four different payment amounts that the homeowner could actually choose from. But, the lowest payment didn't even cover the interest on the loan. Deferred interest would add up month after month, leaving the homeowner farther and farther behind. 

That's what happened to Betty Townes. World sold her four Pick-A-Payment loans, racking up $40,000 in fees and deferred interest for the bank. Now her full payment is larger than her monthly income.

"Hard to think of Betty without a home," Pelley noted.

"It's horrifying to think of her without a home. It's just unacceptable," Maeve-Elyse Brown said.

And she's not alone. Between 2003 and 2006, the total amount of deferred interest from World borrowers, choosing that lowest payment, jumped from $21 million to $1.2 billion.

"That's the borrower saying to you 'I can't make my payment' or 'I'm not making my payment.' Now that was increasing at $100-million a month," Bishop said.

And that, he says, is when he began complaining to his bosses. "And basically it was characterized as, 'Look, you're a malcontent. I mean, you're not happy here. You don't like it here. You don't like the way we do business here.' I said, 'You know, it's all true. You know, it's all true. But, you know, you can't continue to do this.'"

Then in the summer of 2005, Bishop saw an article in the Wall Street Journal which Herb Sandler boasted about the soundness of the bank's loans. 

Bishop told Pelley he complained, saying to a senior manager: "I think we have crossed the line. And there's no question in my mind that the chairman of the board, the founder of this bank, has no clue what's going on. Or he's indicating that in the press."

"Did you use the term 'predatory lending' with him?" Pelley asked.

"I'm sure I did. 'Fraud' for sure I used," Bishop said.

"And he said what?" Pelley asked.

"He said, 'Well, you know, I'm not aware of that,'" Bishop replied.

After that, Bishop got into a heated argument with a fellow employee and the bank threatened to fire him. He says it was retaliation for his complaints. So he talked to Tim Wilson, the corporate head of sales. 

Bishop says he told Wilson: "'This is somebody's home. This is a home they can't afford. Okay? We are complicit in this, okay? You're granting too many people loans who simply can't qualify.' He said, 'I don't have any instance of that.' I said, 'Come down to Vicente Street. Pull 100 loans, any 100…down at my office.' I said, 'I don't have the ability to do that or I'd do it. Come down to the office. Pull 100 loans. You're gonna be stunned at what you see.'"

Asked if Wilson did that, Bishop said "No."

Wilson did write a memo about their conversation, saying Bishop could not point to "any specific examples of employees or loans that do not conform to company policy" and he noted that "random audits are done weekly all over the country."

In his letter to 60 Minutes, former bank owner Herb Sandler said there are hundreds of former World employees who would "dispute Mr. Bishop's claims and speak to the company's focus on quality lending." He makes a point of saying his bank kept its loans on its own books rather than selling the risk to Wall Street, which "created a strong incentive to ensure that our loans were based on sound underwriting." Still, since the market collapsed, World's portfolio has lost billions.

Bob Simpson asks, "What, in a managerial sense, failed? Your leaders either knew those loans were terrible, or they didn't know. And either answer is bad for World Savings." 

"And when the Sandlers say 'We didn't know?'" Pelley asked.

"Shame on them. They should have," Simpson replied. 

"What went wrong?" Pelley asked Bishop.

"Well we ran out of borrowers," he replied. "Everybody that could qualify, anybody that could fog a mirror, anybody that could just breathe, you know, and qualify at any level had basically been refinanced once, twice, three, sometimes four times."

Herb Sandler told 60 Minutes World approved only about 60% of its applications. He says his "high quality loans" wouldn't have failed "had the economic crisis not caused…housing prices to drop by 50%."

In May 2006, before the housing crash, Sandler announced he was selling World to Wachovia for $25 billion. 

For Bishop it was the last straw. He says he told a manager he planned to warn Wachovia and days later, he was fired. Bishop says a lawyer told him to think twice before getting in the way of the merger.

"Did anyone at World ever specify why you were fired?" Pelley asked.

"To this day they have not," Bishop said.

Asked why he thinks he was fired, Bishop said, "I think I was right in the middle of $25 and a half billion dollars."

"Did you call Wachovia?" Pelley asked.

"I did not," Bishop said.

Asked if he regrets not making that call, Bishop said, "I'll always regret it. I'll always regret it."

The losses from the Pick-A-Payment portfolio are now estimated at $36 billion. Wachovia was so badly wounded, it was acquired by Wells Fargo with the help of a taxpayer bailout. 

"We have talked to some former executives of the bank who tell us that they listened to your complaints, they investigated your complaints, and they found that there was nothing to them," Pelley told Bishop.

"Are they employed today?" Bishop asked.

"No," Pelley said.

"Surprise. They lost their job. The bank went bust. They took down the fourth largest bank in the country with them. But there was no problem," Bishop replied.

Produced by Graham Messick

Copyright 2010 CBS. All rights reserved.

   The news today is a 2 billion loss to J.P.Morgan Chase, with 3 growing. They say it was their own money, but who knows? Bank regulations seem to have withered after the demise(Bill Clinton/Phil Graham) of the Glass-Steagell Act which separated them from Investment Banks, which carry larger risks, not having depositor’s money to play around with. My daughter, Connie, worked several years at Chase before the merger, and rose to a VP in the ID Division. They played a game called Liar’s Poker, which has since become the name of a book by Michael Lewis. I have a sketch of his experience at Solomon Bros. before the merger with CitiBank. After reading this, compare Moral Principle of Wall Street occupiers and the Material Interest of CitiBank et.al.”

Liar's Poker is a non-fiction, semi-autobiographical book by Michael Lewis describing the author's experiences as a bond salesman on Wall Street during the late 1980s.^[1] First published in 1989, it is considered one of the books that defined Wall Street during the 1980s, along with Bryan Burrough and John Helyar's Barbarians at the Gate: The Fall of RJR Nabisco, and the fictional The Bonfire of the Vanities by Tom Wolfe. The book captures an important period in the history of Wall Street. Two important figures in that history feature prominently in the text, the head of Salomon Brothers' mortgage department Lewis Ranieri and the firm's CEO John Gutfreund.

·                                 The book's name is taken from liar's poker, a high-stakes gambling game popular with the bond traders in the book.

[edit]Overview

Liar's Poker follows two different story threads, though not necessarily in chronological order.

The first thread is autobiographical, and follows Lewis through his college education and his hiring by Salomon Brothers (now a subsidiary of Citigroup) in 1984. This part of the book gives a first-person account of how bond traders and salesmen truly work, their personalities, and their culture. The book captures well an important period in the history of Wall Street. Important figures in that history feature prominently in the text: John Meriwether, mortgage department head Lewis Ranieri, and firm CEO John Gutfreund.

The second thread is a history of Salomon Brothers and an overview of Wall Street in general, especially how the firm single-handedly created a market for mortgage bonds that made the firm wealthy, only to be outdone by Michael Milken and his junk bonds. This thread is less dependent on Lewis' personal experience and features quotes apparently drawn from interviews with various relevant figures.

Lewis jumps back and forth between these two threads in the book.

   I’m not done, there’s more! Listen to Wendell Potter take on the Insurance ‘Material Interest.’

Praise for DEADLY SPIN

“A gripping indictment.”—Kate Pickert, Time

“You’re the Daniel Ellsberg of corporate America. I mean, what that man did during Vietnam helped to end that war…. People should read this book. The whole book lays it right out there about how the health insurance companies had bamboozled this country and lied, just outright lied about things.”—Michael Moore to Wendell Potter on Countdown with Keith Olbermann

“To get the country back on track, Potter exhorts consumers to adopt a healthy dose of skepticism toward corporate doublespeak. That’s a sound prescription, one which no American can afford not to have filled.”—Joshua Kendall, The Boston Globe

“An illuminating, up-to-the-minute testimonial sure to garner widespread attention and controversy.”—Kirkus Reviews

“Potter engagingly weaves together industry secrets with his own moral struggle and transformation into a whistleblower who tried to beat back the spin that nearly killed Obamacare.”—Emily Loftis, Mother Jones

“This book is more than just one PR man’s tell-all book about the insurance industry. It’s a wake-up call.”— Gary Weiss, Portfolio

“[Potter] trenchantly critiques the failure of America’s for-profit health-insurance system…. [and his] street cred and deep knowledge of the industry make his indictment unusually vivid and compelling.”—Publishers Weekly

“Deadly Spin is a must-read for all who want to learn more about what [the health reform law] is and what it is not. It is a handbook for social change, and the backstory is how effective messaging can result in social change.”—John Presta, New York Journal of Books

“[Potter] ridicules the notion that America’s free-market system can provide actual health care within a for-profit structure… This whistle-blower perspective will heighten discussion and debate on the vital topic of health care in America.”—Booklist

“Wendell Potter is a straight shooter—and he hits the bulls-eye here with an expose of corporate power that reveals why real health care reform didn’t happen, can’t happen, and won’t happen until that power is contained.”—Bill Moyers

“The recently passed health care bill did many good things, including make health insurance available to more Americans and restrain some of the most egregious practices of the health insurance industry. It also forced more people to become customers of that industry. What the bill did not do is reform the health care system. Wendell Potter explains why not, and what went wrong.”—Howard Dean

“Wendell Potter transformed the national debate over health care when he stood up and told the truth about the health insurance industry. By breaking the insurance industry’s code of silence and explaining to his fellow Americans how health insurance companies put profits ahead of patient care, Wendell showed extraordinary courage. The compelling story of Wendell’s conversion from a health care executive to an outspoken reform advocate is essential reading for anyone trying to understand the American health care system.”—Senator Jay Rockefeller of West Virginia

“Deadly Spin makes clear what reporters were—and are—up against as they try, and often fail, to make the complex pros and cons of health care reform clear to citizens, as big-money players misdirect and obfuscate. More important, it illuminates what citizens are up against as they try to figure it out.”—Mike Hoyt, Executive Editor, Columbia Journalism Review

   I also wish to disclose, after leaving Chase, and several other executive jobs, my daughter, Connie happened to work at MVP Healthcare (an insurance co.) not too distant from Potter’s experiences. She told me the good news that the American Psychiatric Association is publishing a new edition of DSM: DSM V, which includes Gambling as No. 37 in their list of addictive disorders. I would like to refer readers to an earlier blog of mine, The Silly Mind, about a book on the therapy of cures for this type of mental health problem. It seems to me rather than trying greedy executives for malfeasance in their official duties, it would be well to bring in counselors, to first fix the problem in the financial industry.

Substance Use and Addictive Disorders 

Please find below a list of disorders that are currently proposed for the diagnostic category, Substance Use and Addictive Disorders. This category contains diagnoses that were listed in DSM-IV under the chapter of Substance-Related Disorders. The Substance-Related Disorders Work Group has been responsible for addressing these revisions. Among the work group’s previous proposals was the recommendation that the diagnostic category include both substance use disorders and non-substance addictions. Gambling Disorder has been moved into this category, which was listed in DSM-IV under the chapter, Impulse-Control Disorders Not Elsewhere Classified. As noted above, the diagnostic category name itself has been changed in response to both the expansion of the category and to international recommendations of participants involved with diagnostic revisions

(DSM V 1913)

   We have little use for oxymorons like Moral Majority, which is neither moral nor a majority, I can’t help thinking that Moral Hazard is a worthwhile subject if you are a worshipper of Dualism, like I am. I found a couple of articles which both have lofty goals, and also cover the netherworld which gets a lot of attention but little praise. The first (Moral Hazard) has Kevin Dowd in the Cato JouenL as its author, while the second is from Wiki, and deals with the Principle Agent Problem. Paul Krugman an Economics writer at the New York Times has also sounded off on the hazard of Moral Hazard. He used a New Yorker cartoon with the caption “Rescue be damned; our conservative principles will see us through!” Two stragglers on hands and knees in a desert.

Moral Hazard and the Financial Crisis

Kevin Dowd

There is no denying that the current financial crisis has delivered

a major seismic shock to the policy landscape. In country after country,

we see governments panicked into knee-jerk responses and

throwing their policy manuals overboard: bailouts and nationalizations

on an unprecedented scale, fiscal prudence thrown to the

winds, and the return of no-holds-barred Keynesianism. Lurid stories

of the excesses of “free” competition—of greedy bankers walking

away with hundreds of millions whilst taxpayers bail their

institutions out, of competitive pressure to pay stratospheric bonuses

and the like—are grist to the mill of those who tell us that “free

markets have failed” and that what we need now is bigger government.

To quote just one writer out of many others saying much the

same, “the pendulum will swing—and should swing—towards an

enhanced role for government in saving the market system from its

excesses and inadequacies” (Summers 2008). Free markets have

been tried and failed, so the argument goes, now we need more regulation

and more active macroeconomic management.1

Cato Journal, Vol. 29, No. 1 (Winter 2009). Copyright © Cato Institute. All rights

reserved.

Kevin Dowd is Professor of Financial Risk Management at the Centre for Risk

and Insurance Studies, Nottingham University Business School. He thanks Dave

Campbell, Carlos Blanco, Jim Dorn, Jimi Hinchliffe, Mahjabeen Khaliq, Duncan

Kitchin, Dave Morris, Cynthia Ngo, and Basil Zafiriou for helpful comments.

1This argument is of course nonsense because we haven’t had free markets. Instead,

markets have operated within a framework of extensive state intervention that goes

back a very long time, and our priority should be to investigate the impact of the

state-mandated parameters within which markets have been “free” to operate.

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Associated with such arguments is the claim that the problem of

moral hazard is overrated. A prominent case in point is Lawrence H.

Summers himself. In a widely cited column, he exhorted his readers to

beware of a “moral hazard fundamentalism” which, he argued, was “as

dangerous as moral hazard itself ” (Summers 2007). His use of the disparaging

term “fundamentalism” suggests that he did not intend it as a

compliment. But whatever his intent, the issue identified by Summers—

the role of moral hazard—is central to the controversy over the causes

of the present crisis and the lessons that should be drawn from it. Unlike

him, however, I believe that moral hazard is a (much) underrated problem:

moral hazard played a central role in the events leading up to the

crisis, and we need to appreciate this role if future reforms are to be well

designed and prevent further disasters down the line. Understanding

moral hazard is fundamental to understanding how the economy

works—and if this is “moral hazard fundamentalism,” so be it.

The Nature of Moral Hazard

A moral hazard is where one party is responsible for the interests

of another, but has an incentive to put his or her own interests first:

the standard example is a worker with an incentive to shirk on the

job. Financial examples include the following:

• I might sell you a financial product (e.g., a mortgage) knowing

that it is not in your interests to buy it.

• I might pay myself excessive bonuses out of funds that I am

managing on your behalf; or

• I might take risks that you then have to bear.

Moral hazards such as these are a pervasive and inevitable feature of

the financial system and of the economy more generally. Dealing

with them—by which I mean, keeping them under reasonable control—

is one of the principal tasks of institutional design. In fact, it is

no exaggeration to say that the fundamental institutional structure of

the economy—the types of contracts we use, and the ways that firms

and markets are organized—has developed to be the way it is in no

small part in response to these pervasive moral hazards.

Subsidized Risk-Taking: Heads I Win, Tails You Lose

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Moral Hazard and the Financial Crisis

  Many of these moral hazards involve increased risk-taking: if I can

take risks that you have to bear, then I may as well take them; but if

I have to bear the consequences of my own risky actions, I will act

more responsibly. Thus, inadequate control of moral hazards often

leads to socially excessive risk-taking—and excessive risk-taking is

certainly a recurring theme in the current financial crisis.

A topical example is the subprime scandal. In the old days, a bank

would grant a mortgage with a view to holding it to maturity. If the

mortgage holder defaulted, then the bank would usually make a loss.

  It therefore had an incentive to be careful who it lent to and prospective

borrowers would be screened carefully: a subprime would-be

borrower didn’t have much chance of getting a mortgage. However,

if a bank originates a mortgage with a view to selling it on (i.e., securitizing

it), this incentive is seriously weakened. In fact, if it sells on

the mortgage to another party it has no interest in whether the mortgage

defaults or not, and is only concerned with the payment it gets

for originating the loan. The originating bank is now happy to lend to

almost anyone, and we end up in the patently unsound situation

where mortgages are being granted with little or no concern about

the risks involved. On this basis, even the doziest mortgage broker can originate subprime mortgages for even the least creditworthy borrowers. The

fact that the borrowers are incapable of making payments on

the mortgage will magically be priced into the mortgage by

the securitization process, which will bundle the mortgage

with other mortgages originated by a similarly lax process and

sell the lot to an unsuspecting German Landesbank attracted

by the high initial yield. Everyone will make fees on the deal,

everyone will be happy [Hutchinson 2008a].

Unfortunately, this giant Ponzi scheme could keep going for only as

long as house prices continued to rise and new entrants continued to

come into the market. Once interest rates started to rise and house

prices started to fall, then the supply of suckers inevitably dried up

and the whole edifice began to fall in on itself.

A second example is what the BBC’s Robert Peston christens the

“greed game.” The partners of private equity and hedge funds would

invest their backers’ funds on a compensation arrangement that typically

gave them 20 percent of gains made (plus a 2 percent annual

management charge); any losses, however, were shouldered by the

backers alone. Investments were then leveraged by enormous borrowing.

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As Peston (2008) explains,

  ‘Thus, if a private-equity firm or hedge fund generates a capital

gain of £1bn—and in the boom conditions of the past few

years, that wasn’t unusual—the partners in the relevant fund

would trouser 20 percent, or £200m. But if there was a loss

of £1bn, well only the backers would lose.’

  Backers were willing to go along with these generous terms because

the funds had generated good returns for many years. These remuneration

packages prompted an exodus of (real or imaginary) talent

from the banks into the funds, and the banks responded by adopting

similar practices themselves. Fund managers and bankers then took

much greater risks than they would had their own money been at

stake. “But with none of their own money on the line and the potential

to generate colossal bonuses. Peston goes on to explain, “Many

were seemingly seduced by their own propaganda: they apparently

believed that structured finance was revolutionary financial

technology for transforming poor quality loans into high quality

investments. There was an epidemic of Nelsonian Eye

Syndrome on Wall Street and London. And bankers, private equity

partners and hedge-fund partners acknowledge—or at

least some do—that the cause was good, old-fashioned greed

induced by a turbocharged remuneration system that promised

riches in return for minimal personal risk.’ [Peston 2008].

Note too that, once paid, bonuses are typically not recoverable later.

This absence of any deferred compensation gives fund managers an

incentive to focus only on the period to their next bonus. If the fund

makes losses later, then that is not their concern (or, of course, their

fault). The absence of deferred remuneration thus institutionalizes

short-termism and undermines the incentive to take a more responsible

longer-term view.

  Yet the subprime scandal and the greed game are merely illustrative

of a much broader and deeper problem—namely, that moral

hazard in the financial sector has simply been out of control. As

Martin Wolf (2008a) aptly put it, no other industry but finance “has

a comparable talent for privatising gains and socialising losses.”

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  Instead of “creating value,” as we were repeatedly assured, the prac-

tices of financial engineering (including structured finance and alternative

risk transfer), huge leverage, aggressive accounting2 and dodgy

credit ratings3  have enabled their practitioners to extract value on a

massive scale—to walk away with the loot, not to put too fine a point

on it— while being unconstrained by risk management, corporate

governance, and financial regulation, all of which have proven to be

virtually useless. We therefore need to ask why the various “control

systems” failed so dismally.

The Failure of Financial Risk Management

The first question is what went wrong with financial risk management.

  The answer is a complex and multi-layered one. At the most

superficial level, practitioners of modern quantitative risk management

all too often make a range of inadequate assumptions: they

assume that financial risks follow Gaussian distributions (and so

ignore the “fat tails” which really matter); they assume that correlations

are constant (and ignore the fact that correlations tend to radicalize

in crises and so destroy the portfolio diversification on which a

risk management strategy might be predicated); and they make assumptions

about market liquidity that break down when they are most

needed. Many risk models and risk management strategies also

ignore strategic or systemic interaction: this is comparable to a cinema-

goer who thinks he can easily get to the exit in the event of a fire,

ignoring the likelihood that everyone else will be running for it as

well. These and other common modelling errors lead to risk models

that are focused far toomuch on the “normal”market conditions that

do not matter at the expense of ignoring the abnormal market

2     (There have also been problems with “fair value” accounting. The new accounting

standard FAS157 codifies recent trends in accounting standards and gives rise to all

manner of chicanery in which models can be used to create imaginary increases in

value and so boost bonuses without having to realize the profits first. Going in the

other direction, FAS157 also allows an institution to ignore prices received in distress

sales even though those are the market prices actually obtained. For more on

these and related problems, see Hutchinson (2008b).

3The rating agencies had routinely issued investment-grade rating to securitizations

based on subprime mortgage loans. These were often justified by credit-enhancement

practices (such as overcollateralization and credit default insurance), which, in

theory, could suffice to make them investment-grade. However, there is also evidence

that some insiders knew that the rating process was unsound. For example,

there was an interesting e-mail exchange in 2006, subsequently leaked to Congress,

in which a Standard & Poors’s analyst opined wistfully: “Let’s hope we are all wealthy

and retired by the time this house of cards falters.”)

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conditions that do. This leads to the somewhat worrying conclusion

that the practice of what passes for risk management might actually

be counterproductive and leave the financial system more rather

than less exposed in a crisis.4

Then there are the problems with the valuation models and the ways

they are used. “Marking-to-market” is not feasible in the absence of liquid

markets; in such cases, valuation will often involve “marking-to

model” instead. Marking-to-model depends on assumptions, however,

and these are open to question and possible abuse.5 Model-based valuations

do not reflect true market prices and, as we have seen again and

again recently, a marked-to-model position can suddenly be revealed to

have a market value that is only a fraction of its model-based valuation.

  Some highly appropriate examples are to be found in two of the

most popular villains of the financial crisis: Collateralized DebtObligations (CDOs)  

(Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand.)

and Credit Default Swaps (CDSs). A CDO is a

tranched claim on an underlying pool of bonds or assets such as

mortgages, and a CDS is a swap contract in which the payoff is

dependent on a default event. The sizes of the markets for these

instruments are truly enormous: the size of the CDO market in 2007

was around $500 billion, and the notional principal of the CDS market

by the end of 2007 was around $60 trillion.6 The valuation of

these instruments is however highly problematic: this is partly

because of the need to use complex financial models but also, more

4  (The most commonly used risk measure, the Value-at-Risk (VaR), has major problems

of its own stemming from the fact that it tells how much we stand to lose on

the best 99 days (or whatever) out of 100, but does not tell us anything about what

we stand to lose on the remaining 1 day that really matters. This results in VaRbased

risk management systems being especially susceptible to “gaming” by traders.

Indeed, it is no exaggeration to say that VaR has been discredited for over a decade

and its continued widespread use has long been indefensible (see, e.g., Artzner et al.

(1999) and Dowd 2005). In addition to these problems, there is considerable evidence

that the VaR models used by financial institutions are alarmingly inaccurate

and that sophisticated VaR models are often beaten by simplistic ones—so much for

all the risk “rocket science.”)

5  (A recurring type of abuse that periodically hits the financial pages arises with traders

using mark-to-model to value an options position. The value of options depends critically

on the values of the volatilities inputted into their option-pricing algorithm, and

this allows traders to boost options’ model-based values (and so hide losses and

increase their bonuses) by inflating their volatility estimates. The volatility of option

values to changes in the volatility of the underlying asset (known in the trade as “vega”)

is legendary, and the volatilities themselves are notoriously hard to estimate.

6Admittedly, this latter figure is something of a scare number: as with any other form

of swap, the notional principal gives an exaggerated impression of the size of the

market. Nonetheless, $60 trillion is still pretty scary.)

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fundamentally, because their values are acutely sensitive to estimates

of the parameters that determine default probabilities. They are also

very sensitive to estimates of the correlations involved, and estimates

of correlations are notoriously unstable and unreliable even at the

best of times. Add in the sizes of the markets for these instruments,

the complexities associated with the presence of hidden options, the

difficulties of assessing counterparty credit risk exposures (and in the

case of CDOs, the difficulties of assessing the impact of tranching),

and it is little wonder that observers talk morosely about “economic

dark matter” and “financial weapons of mass destruction.”

  Further problems arise when quantitative risk management

strategies are applied in practice. Let me illustrate with three very

different examples:

• We might have a good model that is abused by those who use it. An

instructive example occurred a few years ago in the CDO market.

The big technical problem in this area was how to estimate the

probability of n defaults in a pool of corporate bonds. An ingenious

solution was suggested by David Li, a Wall Street statistician, who

in 2000 proposed the use of a statistical model known as a Gaussian

copula. Li’s model was eagerly adopted by practitioners and the

market for CDOs took off. So successful was it, in fact, that it also

enabled the market to develop new higher-leverage instruments,

synthetic CDOs, in which the bonds were replaced by pools of

swaps. Everything went well until May 2005 when hedge funds

reported large losses after several of the large auto firms were

downgraded. The traders then blamed Li’smodel, but it turned out

that they had been using the model to determine their hedge ratios

and the model was not designed for such purposes.

• Another common case is where a pricing model or a risk management

strategy is predicated on the assumption of dynamic

trading and continuous liquidity. Again and again over the crisis,

we have seen pricing or risk management strategies fall

apart when liquidity had suddenly dried up, to reveal massive

losses that the models said shouldn’t have occurred because the

models had assumed continuous liquidity. Such approaches are

as useful as a chocolate teapot—that is, they are fine until you

actually need to rely on them. There is however no excuse for

practitioners who got caught out in this way, as these problems

have been well understood since portfolio insurance strategies

unraveled in the October 1987 stock market crash.

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• Traders and asset managers always have an incentive to game the

risk management system. They respond intelligently to the system

in their own interests, and identify and exploit the system’s

weaknesses (e.g., they exploit relative pricing errors and underestimated

risks). The result, almost inevitably, is that the real risks

being taken by an institution are likely to be greater than the risk

measurement system suggests, if only because no system can be

perfect and there are limits to the extent to which any system can

feasibly take account of how traders will react to it.

  These problems point to a curious paradox at the heart of modern

financial risk management: the more sophisticated the system, the

more unreliable it might be. Increased sophistication means greater

complexity (and so greater scope for error), less transparency (making

errors harder to detect), and greater dependence on assumptions (any

of which could be wrong).7We see this problem both with systems and

with risk management strategies: dynamic strategies that involve regular

trading are often superior on paper to static ones that do not, but

dynamic strategies often fail, whereas static ones are robust. In theory,

there is no difference between theory and practice, but in practice

there is—“sophisticated” risk management is overrated.8

7   (In fact, the very principle of applying statistical methods to risk management is problematic:

sometimes good risk management makes use of rules of thumb that constitute

bad statistics, and sometimes good statistics can lead to bad risk management.

This is because statistical analysis fails to allow for risk managers’ need to err on the

side of prudence. As one cynic recently wrote: “The statistician is trying to extract

information from data, whereas the risk manager is trying to manage risks with limited

information [and these are quite different tasks]. And limited information means

that a good risk manager cannot afford to be anything other than prudent. Surely it is

better to be careful a hundred times than to be killed just once?” (Dowd 2007: 20)

8There have always been those such as Richard Hoppe and Nasim Taleb who criticized

the underlying epistemology of quantitative risk management, the naïve transfer

of physics modeling techniques into social science contexts, the failure to

appreciate how intelligent agents react to control systems, and the failure to deal

with the non-stationary and dynamic interdependence of market systems (see, e.g.,

Hoppe 1998; Taleb 1997, 2007). Though many of their concerns have been proven

largely correct, I would not share Taleb’s extreme view that quantitative risk management

is nothing but charlatanry. Speaking for myself, it was clear to me that

financial risk management was in trouble when Derivatives Strategy magazine made

Enron their “risk manager of the year” shortly before it went belly up, but I can still

foresee a future for a (much) more modest and limited practice of quantitative risk

management that places (much) more emphasis on intelligent thinking and (much)

less on mindless modelling. I will nonetheless still be asking my university to rename

my chair to something a little less risible.

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But perhaps the most important reasons for the failure of financial

risk management to contain risk-taking are the basic economic ones.

Simply put, if the incentive to take risks is strong enough, then we

should expect to see excessive risks being taken.9 In this sense, risk

management is rather like the “war on drugs”: it might help to reduce

drugs coming in, but it can never conclusively win. There is also a second

and even more powerful reason for the failure of financial risk

management. However good they might be, and however good the risk

management systems they install, risk managers still take their orders

from senior management, who often pressure them to take shortcuts,

turn a blind eye, produce low-risk numbers to keep down capital

requirements, and generally not rock the boat. The ultimate responsibility

for risk management must therefore lie with senior management.

In the final analysis, if it is not in the interests of senior management to

contain excessive risk-taking, then no amount of risk management is

going to contain it. And if senior managers are themselves working on

remuneration packages that encourage excessive risk-taking—as most

real-world remuneration packages do—then that is what will result.

The whole edifice of financial risk management is thus built on sand.

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The End of Corporate Accountability

Senior management out of control means the end of corporate

accountability.10 This is an issue that has generated a huge amount of

public concern and understandably so. Again and again, we have

business leaders whose sky-high remuneration was said to be based

on their superior abilities, the heavy responsibilities they were bearing,

and so forth. They then run their businesses onto the rocks,

blame bad luck, and ask us to believe that they weren’t responsible—

9  (For example, if risk-taking is so lucratively rewarded, then risk-taking activities will

attract the talent and the risk-takers will have the edge over the risk managers. At

the same time, effective risk management is well nigh impossible if risk managers

don’t understand what the risk-takers are doing. This requires risk managers who

have been former risk-takers themselves, but why should poachers turn gamekeepers

if poaching is so much more rewarding?)

10 (Not to mention the end of political accountability. One of the most depressing

aspects of the financial crisis is the way in which so many of the “controllers”—the

politicians, regulators, and central bankers, but especially the politicians—evade

accountability for their own mistakes. One of those most responsible is Prime

Minister Gordon Brown, who set up the current UK system of financial regulation

only to see it fail in spectacular fashion. (Aren’t ministers who make blunders meant

to resign?)

and, in many cases, have no shame bailing out on generous golden

parachutes. Instead of the wise stewardship we were led to expect,

we discover after the event that they have been raiding the larder and

the taxpayer is called upon to replenish it. These cases are so commonplace

these days that they are barely newsworthy anymore, but

their commonality does not make them any the less distasteful.

These following are my particular favorites.

In fourth place is Citigroup’s CFO, Gary Crittenden, who ascribed

Citi’s large losses announced in November 2007 to the firm being the

victim of unforeseen events. As one commentator wryly noted:

”No mention was made of the previous five years, when Citi was

busily consolidating mortgage debt from people who weren’t

going to repay, pronouncing it “investment grade,” mongering

it to its clients and stuffing it into its own portfolio, while paying

itself billions in fees and bonuses. No, like the eruption of

Vesuvius; even the gods were caught off guard. Apparently, as

of September 30th, Citigroup’s subprime portfolio was worth

every penny of the $55 billion that Citi’s models said it was

worth. Then, whoa, in came one of those 25-sigma events. Citi

was whacked by a once-in-a-blue-moon fat tail. Who could have

seen that coming?” [Bonner 2007]

  And no mention of all those fancy risk forecasting models either.

In third place is Goldman Sachs’s CFO, David Viniar. In August

2007, Goldman reported heavy losses on its flagship GEO hedge

fund, which Viniar explained by saying, “We were seeing things that

were 25-standard deviation moves, several days in a row” (Larsen

2007). A single 25-standard deviation event was widely cited in the

press as one that we would expect to see 1 day in a 100,000 years—

that is, very unlikely. Goldman must have been very unlucky11—or

else Goldman was incompetent or its models were just wrong.

Viniar’s comments were met with widespread ridicule and achieved

instant notoriety.

11For the record, the true probability of a 25-sigma event is in fact almost inconceivably

smaller than what the estimated 1-day-in-a-100,000 years waiting time would

have us believe. If Goldman’s models were right, calculations suggest that we would

expect to have to wait about 1.31e+135 years—that is, 1.31 years, but with the decimal

point moved 135 places to the right—to see a single 25-event, let alone several

(Dowd et al. 2008). To put this into context, the number of particles in the

universe is believed to be no more than a mere 1.0e+85 (Clair 2001). 11

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  The runner-up is Richard S. Fuld Jr., the chief executive of

Lehman Brothers who led his firm to the biggest corporate bankruptcy

in U.S. history. At a congressional hearing on October 6,

2008, Congressman Henry Waxman said to Fuld, “You made all

this money by taking risks with other people’s money. The system

worked for you, but it didn’t seem to work for the rest of the country

and the taxpayers, who now have to pay $700 billion to bail out

our economy.” Fuld’s response was extraordinary: “I take full

responsibility for the decisions that I made and the actions that I

took.” What he meant by that is hard to fathom as he then denied

that he had made any errors or misjudgments in the period leading

up to the firm’s bankruptcy. When the touchy subject of his

remuneration then came up, he went on to defend the compensation

system that had paid him about $350 million between 2000

and 2007. As he explained, “We had a compensation committee

that spent a tremendous amount of time making sure that the

interests of the executives were aligned with shareholders.” So

that’s all right then.12

  In each of these cases, the executives involved took the line that

it wasn’t really their fault, but they could with at least the appearance

of some justification say that they were just doing what they

had always done and had got caught up in a terrible storm. In this

next case, however, the principal executive deliberately chose a risky

business model and then denied any responsibility when things

went wrong. Accordingly, the first prize goes to Adam Applegarth,

the chief executive of UK bank Northern Rock. Applegarth’s distinctive

business model involved rapid growth, large-scale reliance

on the capital markets for finance, and an innovative and very

accommodating mortgage, the racy “together loan,” in which customers

could borrow 125 percent of their property value and up to

six times their annual income: the boring days when customers

could borrow only 75 percent of their property value and a maximum

of three times their income were over. This aggressive business

model worked well in the good times and the bank grew to be

the fifth largest mortgage provider in the UK, but soon became

unstuck as the subprime crisis broke in the summer of 2007. The

12 (And it turned out that senior executives had been working on their golden parachutes

at the same time as they were pleading for a federal rescue, and that three

departing executives had been paid bonuses just days before the company collapsed.)

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bank then lost the confidence of its depositors and experienced a run in

September 2007—the first run on an English bank since Overend

Gurney in 1866—before being bailed out by the Bank of England and

subsequently nationalized.13 After the bailout, the bank’s senior executives

still insisted that the bank’s business model was a good one because

it had worked well until August that year. They also maintained that they

had done nothing wrong, while admitting that they hadn’t stress-tested

their exposure to a market dry-up. This has the same credibility as the

captain of the Titanic saying that everything was okay until the iceberg

turned up. The resulting public uproar forced them to resign, but even

then Applegarth was able to retire comfortably to his mansion to spend

more time with his money.14

  One can only wonder what these people were being paid so much

for. Cases such as these give great offence to the public who must pay

for them, and the system that gives rise to them is manifestly indefensible.

  Besides the direct damage they inflict, which is bad enough, they

also seriously undermine informed debate by giving easy fodder for ill considered

accusations that absence of accountability is (somehow) a

natural consequence of “free markets” in which the public simply gets

ripped off. Indeed, I would go so far as to say that this type of irresponsible

behavior on the part of so many senior executives has now

become the single biggest challenge to the political legitimacy of the

market economy itself.15 As Martin Wolf recently put it,

“A financial sector that generates vast rewards for insiders and

repeated crises for hundreds of millions of innocent

bystanders is . . . politically unacceptable in the long run.

Those who want market-led globalisation to prosper will

recognise that this is its Achilles heel [Wolf 2008b].”

13 (Having obtained a bailout at public expense, Northern Rock cheerily announced that

it still intended to go ahead with a planned dividend payment, presumably to protect

their executives’ bonuses. It took a public outcry to get the dividend payment cancelled.

14While the Northern Rock workforce could anticipate major job losses, Applegarth was

able to retire on a generous settlement package. It also transpired that he had been quietly

cashing in his own Northern Rock shares—a nice vote of confidence in his own leadership.

He managed to get £2m for his shares while other shareholders lost everything.

15It is for this reason—rather than because I have any love for the “controllers”—

that I have focused on the (for want of a better word) “misdemeanors” of the corporate

executives. It is indeed strange that corporate misbehavior always leads to a chorus

of calls for more regulation and better government, and yet the responsibility of

the controllers—especially the politicians—is much greater, because they are

responsible for the system and assured us that we would be safe under their wise

stewardship.)

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The End of Corporate Governance

The buck therefore stops with the senior management, and risk

management will only ever really work if senior executives have an

incentive to make it work. So the $64 trillion question is: Why didn’t

they? And why did corporate stakeholders allow them to get away

with it? The answers to these questions take us to the heart of what

is wrong with modern corporate governance and what needs to be

done about it.

The problem lies in the nature of the joint stock company itself.

One of the earliest and still one of the best critiques of the joint

stock company is that given by Adam Smith in the Wealth of

Nations:

“The directors of such companies . . . being the managers of other

people’s money than their own, it cannot well be expected that

they should watch over it with the same anxious vigilance. . . .

Negligence and profusion must always prevail, more or less, in

the management of such a company” [Smith (1776) 1976: 741].

The root problem is limited liability, which allows investors and

executives the full upside benefit of their risk-taking, while limiting

their downside exposure. David Campbell and Stephen Griffin gave

a brilliant and prescient analysis of this issue in the wake of the Enron

scandal:

  “One has to stretch the point to say that the executives of large

public companies are exposed to the economic risks of failure

in any significant way, and certainly they are more or less

completely cocooned from the most fundamental market

pressure, fear of personal bankruptcy. By in this way distancing

directors from the down-side of their decisions, the public

company based on incorporation and limited liability

severely handicaps or even eliminates the core function of

the market” [Campbell and Griffin 2006: 59–60].

  These problems were anticipated by those who opposed the

Victorian companies legislation that granted limited liability, and

the controversy on limited liability was a bitter one. To quote one

contemporary, who was the author of a successful company law

textbook:

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(The Law of Partnership hitherto has been . . . that he who

acts through an agent should be responsible for his agent’s

acts, and that he who shares the profits of an enterprise ought

also to be subject to its losses; that there is a moral obligation,

which it is the duty of the laws of a civilised nation to enforce,

to pay debts, perform contracts and make reparation for

wrongs. Limited Liability is founded on the opposite principle)

[Cox 1857: 42n38].

  He then goes on to say that limited liability deprives people of their

common law right “to recover their debts, enforce their contracts, or

obtain redress for injuries” (Cox 1857: 42n38). As Campbell and

Griffin (2006: 61–62) explain,

“Limited liability under the Companies Acts was and is not the

product of private negotiation in a market but of a public

intervention. That the state created limited liability is, of

course, allowed by all, but that by doing so it ousted the market

is by no means realised by all; indeed in our leading company

law textbooks the introduction of limited liability is

often described as the result of laissez faire, which is precisely

what it was not . . . it was and is perfectly possible for those

ceteris paribus exposed to unlimited liability to contract with

others to limit their liability as one of the terms on which they

deal. This would be limited liability established through

negotiation on the market. But the Companies Acts generally

imposed limited liability, and it is a very different matter to

negotiate to a position of limited liability than to negotiate

away from unlimited liability (even when this is allowed), for

the competitive setting is completely changed by this intervention.

  This line of thinking also suggests that repeated

attempts to reform corporate governance have been misguided.

The typical legislative response, especially in the United

States, is to impose ever more demanding and costly sets of

rules and ever more severe criminal penalties. It should be

obvious by now that this isn’t working and the reason it isn’t

working is because it does not address the underlying causes.”

What is the realistic alternative to repealing limited liability? We

could increase the rulebook and make penalties even harsher, but at

what point do we accept that the formula of even more rules and

even bigger penalties is not working?

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Policy Failure 1: Misguided Intervention in the U.S.

Housing Market

We now turn to consider some of the other policy failures that

have contributed to the financial crisis. The first of these is misguided

intervention by the federal government into the U.S. housing

market. This intervention is motivated by a long-standing desire to

expand home ownership, especially to low-income households. U.S.

government policy toward housing could almost be described as

“one where too much is never enough” in the words of Lawrence J.

White (2004: 6). Key features of this policy included the mortgage

interest deduction in the tax code, “affordable lending” requirements

and legislation such as the Community Reinvestment Act (1977),

both of which pressured bankers to make loans to people with poor

credit, and the establishment of massive government mortgage

behemoths, the most prominent of which were the government sponsored

enterprises (GSEs) Fannie Mae and Freddie Mac.

Fannie had been set up in 1938 to expand the ability of residential

mortgage finance by buying up mortgages from originators and

holding them, and was privatized in 1968. Freddie was set up in 1970

with the remit of expanding the availability of residential mortgage

finance mainly through the securitization of S&L mortgages. Both

institutions had considerable legal privileges—most notably, the

implicit backing of the federal government and lower capital requirements—

that enabled them to dominate the huge mortgage underwriting

market. They were also central players in the growth of the

mortgage securitization markets when they took off.

Both institutions were subject to congressional oversight, but over

time their relationship with the politicians took on an incestuous air:

(At heart, Fannie and Freddie had become classic examples of

“crony capitalism.” The “cronies” were businessmen and

politicians working together to line each other’s pockets while

claiming to serve the public good. The politicians created the

mortgage giants, which then returned some of the profits to

the pols—sometimes directly, as campaign funds; sometimes

as “contributions” to favored constituents) [O’Driscoll 2008c].

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  This unhealthily close relationship meant that the politicians often

blocked attempts to reform the GSEs or to investigate their activities,

and then dodged responsibility when things went wrong (see Rahn

2008). But by about 2003–2004, Fannie and Freddie were fighting

off accounting scandals and possible congressional action:

  “To get Congress off their backs they became more committed

to financing homes for families with low incomes. The

ploy worked like a charm. Congressman Barney Frank, who

now chairs the House Financial Services Committee, turned

a blind eye to their accounting shenanigans and praised their

newfound zeal.… [As a result] Fannie and Freddie became

the largest purchasers of subprime and borderline (Alt-A)

mortgages in the 2004–2007 period with a total exposure of

$1 trillion and thereby contributed mightily to the housing

bubble as well as to their own later collapse” [Hanke 2008c].

  Hand-in-hand with these developments, from the early 1990s

onwards, there was a sustained attack by virtually branch of government

on mortgage underwriting standards. The resulting fall in

underwriting standards was widely praised as an “innovation” in

mortgage lending (Liebowitz 2008: 1; see also Coats 2008). To make

matters worse, in 2002 the Department of Housing and Urban

Development imposed “affordable housing quotas” on Fannie and

Freddie (which were increased again in 2004), which encouraged

Fannie and Freddie to further increase their huge holdings of subprime

portfolios (Mitchell 2008). These policies had the desired

effect of increasing home ownership, but they also pushed up house

prices and further fuelled the growing housing bubble. Government

intervention into the housing market was thus a major contributor

both to the housing bubble and to the subprime mess.

Policy Failure 2: Loose U.S. Monetary Policy

A second contributory factor is U.S. monetary policy. The main

objectives of U.S. monetary policy are to control inflation and protect

the stability of the real economy, but the Federal Reserve has considerable

discretion in how to achieve these objectives.

Consequently, U.S. monetary policy is acutely dependent on the

views of policymakers. A key factor here is the “Greenspan

Doctrine,” set out in 2002, that the Fed could do nothing to stop

asset bubbles from occurring, but would stand by to cushion the fall

if they did occur. This effectively promised a partial bailout of bad

investments and produced the so-called Greenspan put—an option

to sell depreciated assets to the Fed (i.e., yet another moral hazard).

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   A second key concern of Fed policymakers—and of Ben Bernanke

especially—has been fear of deflation. In late 2002, then-governor

Bernanke persuaded Alan Greenspan that the main danger facing the

U.S. economy was the prospect of it falling into a Fisherian debt deflation

spiral. This “false deflation scare” led the Fed to put its foot

on the monetary accelerator and squeeze the Fed funds rate down to

just over 1 percent in July 2003, and to keep it at that level for a year.

  The combination of the Greenspan put and artificially low interest

rates then set off what Steve Hanke (2008b) memorably

describes as the “mother of all liquidity cycles and yet another massive

demand bubble. ”House prices soared and the seeds were set for

their later fall. At the same time, tiny yields pushed investors toward

higher-yield (i.e., more risky) investments and toward greater leverage

as they borrowed extensively to lever up their returns. The result

was an explosion of risk-taking: “irrational exuberance” was no longer

so irrational.16

  Inevitably, the Fed’s policy led inflation to trend upwards, which

in turn put pressure on interest rates to rise as bondholders sought to

compensate for expected inflation. From 1.01 percent in July 2003,

the Fed funds rate then climbed erratically to peak at 5.26 percent

in July 2007.

At this point, the subprime crisis broke and the Fed resorted to

loose money again. The Fed funds rate then gradually fell to almost

zero by November 2008, implying an unprecedented real interest

rate of close to minus 5 percent.17 At the same time, the latest available

(as of mid-February 2009) M2 monetary growth is over 10 percent

p.a. (if we take year-on-year growth) or 18 percent p.a. (if we

take the last three months), and the corresponding growth rates for

M1 are considerably higher. We thus have all the ingredients for rising

inflation and interest rates that will rise in its wake.

16   (For further details (and some cogent analysis) of the Greenspan-Bernanke policy

bubbles, see Hanke (2008b) and O’Driscoll (2008a).

17 (For its part, US CPI has been falling since later summer 2008, and its current latest

available year-on-year growth rate is almost zero percent. The recent falls in the

CPI inflation rate can however be attributed to a number of temporary factors—

most especially, recent falls in commodity prices and in aggregate demand, and the

temporary strength of the dollar—which are unlikely to persist for long. The longer term

prognosis is therefore for a resurgence of inflation, notwithstanding that CPI

is currently falling.)

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The Fed now faces an acute dilemma of its own making. With the

economy so fragile, it is reluctant to apply unpleasant monetarist

medicine. But from the perspective of inflation control, with negative

real interest rates, high monetary growth and the prospect of

resurgent inflation, what is now needed is tighter monetary policy

and therefore higher short-term interest rates. The twin objectives of

controlling inflation and stabilizing the real economy have never

been so strongly at odds: the Fed has painted itself into a corner.

And yet, if it is not careful, the Fed could paint itself even further

into the corner. If it does not reverse its monetary policy and rapidly

raise interest rates to above-inflation rates, then the Fed risks inflation

getting out of control as it gets caught in the quicksand of a classic

Wicksellian trap in which an unsustainable attempt to keep real

interest rates down leads to ever rising inflation. Inflation expectations

will rise further and the Fed’s credibility will continue to disintegrate.

The combination of rising inflation and the squandering of

its own credibility will then make its policy tradeoffs even more

unpalatable than they already are—and the U.S. economy will find

itself in the horrors of a stagflationary spiral. Those who call for more

cheap money need to appreciate that we can’t cure the patient by

giving him more and more of the poison that is already killing him.

Policy Failures 3: Deposit Insurance

The third major policy failure is state-mandated deposit insurance.

18 Although this might seem like a good idea on first sight—after

all, who wants bank runs?—the impact of deposit insurance on the

banking system is in fact both profound and highly destabilizing. To

appreciate this, first consider a banking system that has no deposit

insurance at all. In this system depositors’ funds are at risk, but

depositors know this and have an incentive to be careful where they

make their deposits. The bankers also know this, and know that they

18  (There are also the moral hazard problems created by the lender of last resort. If

the central bank is (or even might be) willing to assist an institution that gets itself

into difficulties, then institutions have weakened incentives to avoid getting themselves

into difficulties in the first place. Traditionally, central bankers have attempted

to deal with this problem by threatening to refuse assistance to reckless

institutions in future, but such threats have always lacked credibility—not least

because bank crises always produce intense political pressure on central banks to

cave in, and they have usually done so. The recent bailouts will have destroyed whatever

little credibility those threats might once have had.)

have to cultivate the confidence of their depositors: lose that confidence

and the bank will face a run. The banker therefore needs to be

prudent: risk-taking has to be moderate and the bank needs to maintain

levels of liquidity reserves and risk capital that are high enough

to retain depositor confidence. The bottom line is that the financial

health of the bank is ultimately determined by public demand: if the

public want safe banks, they get them. Note, however, that the public

has to pay for what they get: if they want banks to take moderate

risks, be strongly capitalized and so on, then they have to accept relatively

low interest rates on their deposits, and they have to pay relatively

high rates on their loans.

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Moral Hazard and the Financial Crisis

  Now imagine that we have a “good bank” that operates prudently

and a “bad bank” that operates recklessly, and the two banks compete

for market share. While the economy is doing well, the bad bank

appears to win: it can attract depositors with higher deposit rates and

it is popular with shareholders because it earns higher returns on its

capital. However, these are paid for by reckless risk-taking.

  Nonetheless, the good bank feels the pressure but stands its ground.

Then times turn sour, the bad bank’s reckless risk-taking is exposed

and its depositors lose confidence. Those who can, withdraw their

money from the bad bank and deposit it with the good bank. The bad

bank is then run out of business and the good bank finally wins. The

important point here is that the competitive process eventually

rewards the good bank and punishes the bad one.

  This process changes, however, when we introduce deposit insurance

into the picture. With deposit insurance in place, depositors

now know that their money is safe. They don’t care any more what

risks their bank takes: their only concern is with the interest rate they

receive. This takes the pressure off the bad banker who can now take

more risks and reduce capital levels safe in the knowledge that

depositors won’t run. As before, in the good times the bad bank pays

higher deposit rates and generates higher returns for its shareholders

and in doing so puts pressure on the good bank. When times go

bad, however, the bad bank no longer faces a run and can continue

to attract depositors by offering high deposit rates: it therefore puts

pressure on the good bank even in bad times. The bad bank therefore

wins in both states: indeed, under deposit insurance, competitive

pressures eventually force the good bank to imitate the bad bank

if it is to be able to compete. The introduction of deposit insurance

thus subverts the competitive process and makes prudent banking

uncompetitive. Systemic risk-taking increases and the financial

health of the banking system deteriorates.19

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Policy Failures 4: Financial Regulation

  The fourth policy culprit is financial regulation. Recall that all this

regulation was meant to ensure the stability of our financial system

and it is, I think, clear that it hasn’t worked. However, I would suggest

that there was never any good reason to think it would.

Consider the process that produced it. Regulations emanate from

a highly politicized committee process, and are the product of arbitrary

decisions, irrational compromises, and political horse-trading—

not to mention the personalities and prejudices of the main

participants involved. This process necessarily leads to inconsistent

treatment, regulatory arbitrage opportunities, and a compliance culture,

while imposing large implementation costs on regulated firms.

It also leads to ever-longer rulebooks that attempt to standardize

practice in an area where practice is always changing and where the

development of best practice requires competition in risk management

practice—not an irrelevant and ossified rulebook that is out of

date before it comes out.20 One is reminded here of an anecdote by

Riccardo Rebonato from a big risk management conference in 2005.

  He quotes an unnamed “very senior official of one of the international

regulatory bodies” who, in “looking over the hundreds of pages of

the brand new, highly quantitative, bank regulatory regime (Basel II)

… sighed: “It does read a bit as if it has been written without adult

supervision” (Rebonato 2007: xxiii). It is naïve to expect that such a

process of politicized committee group thinking would produce a set

of regulations that would work. It follows, too, that there is no point

“having another go” in an effort to get the regulations “right” the next

time.21 The process itself is deeply flawed and is akin to repairing a

19   (For more on the impact of deposit insurance on the banking system, see, e.g.,

Benston et al. (1986), Kaufman (1988), and Dowd (1996a, 1996b).

20   (And as Jacobo Rodriguez (2002) points out in a telling critique of the Basel regime,

it also produces a strange combination of complexity and vagueness that threatens

to stifle market-based innovation in risk management practices.

21Calls for “better regulation next time” are of course just a siren song. If it is that

easy to identify what “better regulation” might entail, then why didn’t our political

masters give it to us the last time? And if it is not that easy to identify, then what reason

is there to expect that they will happen to get it right the next time?)

structurally unsound building by merely repainting it: it might look

fresher, but it still won’t stay up.22

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Moral Hazard and the Financial Crisis

  There are also good economic-theoretical reasons to doubt that

financial regulation helps to promote financial stability. Two problems

in particular stand out:

• Endogenous risk: This refers to the risk that shocks to the system

might be amplified within the system (e.g., Danielson and Shin

2002). The potential for this problem occurs wherever individuals

react to their environment and the environment reacts to them.23

For example, when asset prices fall and traders approach their position

limits, then they will be forced to sell. However, this selling puts

further downward pressure on asset prices, which then triggers

more selling, and so on. Mitigating this problem requires institutions

to have heterogeneous trading and risk management strategies, but

the Basel system pressures them to react to shocks in similar ways

(e.g., to sell when a shock pushes institutions’ VaR numbers up).

• Procyclicality: Risks vary procyclically over the business cycle. This

means that as the cycle approaches its peak, risk assessments will

fall, leading risk-based capital requirements to fall and lending to

rise just at the point where the danger of a systemic downturn is

greatest. As a consequence, risk-based capital regulation (such as

Basel II) not onlymakes crisesmore likely but is also likely tomake

them more severe as well (see, e.g., Danielson et al. 2001).

Proponents of capital regulation (e.g.,Goodhart and Persaud 2008)

have suggested that the solution is to make capital requirements

countercyclical instead, but this essentially amounts to “taking away

the punchbowl just as the party is getting going” and it is difficult to

see how that could be done in practice. It would be better for the

central bank simply to keep money tight and inflation stable.

22Another telling anecdote comes froma 2007 conference on operational risk, where

one notable op risk expert remarked that it was just as well that they didn’t have

much op risk data as the regulators would then have forced them to use backwardlooking

modelling rather rely on scenario analysis, which attempts to anticipate possible

problems before they occur.

23Danielson (2003) elaborates on this theme further: risk models are typically based

on the assumption that that the practitioner is affected by his environment but does

not affect the environment itself. This assumption is reasonable in normal market

conditions but unreliable in a crisis, and it is for this reason that endogenous risk is

so difficult to model. He also draws an analogy to the old-fashioned macro forecasting

models, which worked well most of the time but broke down when the monetary

regime shifted and inflation took off in the early 1970s.

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These problems call into question the very principle of “risk-based

regulation”: modern capital regulation might simply be attempting

the impossible.

But perhaps the most convincing argument against financial regulation

comes fromwatching how it actually works in practice. Consider

for example the UK Financial Services Authority’s supervision of

Northern Rock. When it audited the FSA in 2006, the UK National

Audit Office praised the FSA as “a well-established regulator with an

impressive set of processes and structures to help tackle high-risk

organisations and markets.” CityMinister Ed Balls took this as a ringing

endorsement of the regulatory structure that he and hismuppeteer

Gordon Brown had created (Private Eye 2007: 1).24 Then along comes

Northern Rock, an institution that had grown very rapidly over the

period of a few years (a traditional red flag, by the way) and one which

had an extreme business model (another red flag!) that relied more

heavily than any other major UK bank on access to wholesale funding

and securitization for its financing (yet another red flag). How did the

FSA handle Northern Rock? For much of the period, it had the bank

supervised by insurance regulators who knew little about how a mortgage

bank operated. Only eight supervisory meetings were held

between 2005 and August 9, 2007, and most of those involved low  level

FSA staff. Of these meetings, five were held over just one day and

two were by telephone; then, when the internal auditors looked for a

paper trail, it turned out that the supervisors hadn’t even bothered to

take notes. From February 2007, Northern Rock’s share price started

to deteriorate (red flag #4) and, as the year progressed, concerns about

mortgage defaults started to rise (possible red flag #5?).Did it occur to

the FSA that Northern Rock might be in any danger or that it might

be a good idea for the FSA to suggest that the bank stress-test its liquidity

exposure? Not at all. Instead the FSA’s response was to approve

a dividend payment and fast-track the approval process for its models.

Northern Rock then hit the rocks shortly afterwards and all hell broke

loose. The FSA’s own internal investigation published in March 2008

reads like “a script for an episode of the Keystone Cops” as Brummer

(2008: 107) put it, and the subsequent report into the fiasco by the

Treasury Select Committee was scathing in its criticism of the FSA’s

handling of the case—“asleep at the wheel” being the gist of it.

24For more on the Northern Rock case, see Brummer (2008) and the recent issues

of Private Eye.

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Moral Hazard and the Financial Crisis

  The new FSA chairman, Lord Turner, now assures us that this

won’t happen again and that the FSA will hire better regulators in

future. So there will be no repeat of the Keystone Kops—and the

next disaster will presumably be more Laurel and Hardy.

Lessons for the Future

If anything is obvious about the current crisis, it is that the system

of managed state intervention into the financial system has failed dismally:

it is not “free”—that is, unregulated—markets that have failed,

but the statist system within which financial markets and institutions

have been forced to operate. This is not an academic issue or a case of

ideological point scoring. It matters because we need to understand

what went wrong if we are to get future reforms right. My own view is

that the edifice of modern central banking cum financial regulation

cum limited liability needs to be dismantled and 150 years of state

intervention needs to be rolled back, but I have few illusions that this

will happen. Be this as it may, my main message here is to take moral

hazard seriously. Measures that rein in moral hazard are to be welcomed

and will help to reduce excessive risk-taking measures that create

or exacerbate moral hazard (such as massive bailouts?) will lead to

even more excessive risk-taking and should be avoided. In short, a key

yardstick that should be applied to any proposed reform measure is

simply this: Does it reduce moral hazard or does it increase it?

The bottom line? If someone takes a risk, someone has to bear it.

If I take a risk, then we want to ensure that I be made to bear it. But

if I take a risk at your expense, then that’s moral hazard and that’s

bad. As the late, great Milton Friedman might have put it: there ain’t

no such thing as a free risk.

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And the second is from Wiki:

Moral hazard

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In economic theory, a moral hazard is a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk. A moral hazard may occur where the behavior of one party may change to the detriment of another after a transaction has taken place. For example, a person with insurance against automobile theft may be less cautious about locking their car, because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to hold some responsibility for the consequences of those actions.

Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

Moral hazard also arises in a principal–agent problem, where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

Contents 1 History of the term 2 Finance 3 Insurance industry 4 Economic theory 5 Management 6 See also 7 References 8 External links

History of the term

According to research by Dembe and Boden,^[1] the term dates back to the 17th century and was widely used by English insurance companies by the late 19th century. Early usage of the term carried negative connotations, implying fraud or immoral behavior (usually on the part of an insured party). Dembe and Boden point out, however, that prominent mathematicians studying decision making in the 18th century used "moral" to mean "subjective", which may cloud the true ethical significance in the term.^[2]

The concept of moral hazard was the subject of renewed study by economists in the 1960s and then did not imply immoral behavior or fraud; rather, economists use the term to describe inefficiencies that can occur when risks are displaced, not the ethics or morals of the involved parties.

Finance

This article has multiple issues. Please help improve it or discuss these issues on the talk page. Its tone or style may not reflect the formal tone used on Wikipedia. Tagged since October 2009. It may be unbalanced towards certain viewpoints. Tagged since October 2009.

Economist Paul Krugman described 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."^[3] Financial bailouts of lending institutions by governments, central banks or other institutions can encourage risky lending in the future if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return.^[4] So-called "too big to fail" lending institutions can make risky loans that will pay handsomely if the investment turns out well but be bailed out by the taxpayer if the investment turns out badly.

Taxpayers, depositors, and other creditors often have to shoulder at least part of the burden of risky financial decisions made by lending institutions.^[5][6][7][8] According to the World Bank, of the nearly 100 banking crises that have occurred internationally during the last 20 years, all were resolved by bailouts at taxpayer expense.^[9]

Many have argued that certain types of mortgage securitization contribute to moral hazard.^[10] Mortgage securitization enables mortgage originators to pass on the risk that the mortgages they originate might default and not hold the mortgages on their balance sheets and assume the risk. In one kind of mortgage securitization, known as "agency securitizations", default risk is retained by the securitizing agency that buys the mortgages from originators. These agencies thus have an incentive to monitor originators and check loan quality. "Agency Securitizations" refer to securitizations by either Ginnie Mae, a government agency, or by Fannie Mae and Freddie Mac, for-profit government sponsored enterprises ("GSEs"). They are similar to the "covered bonds" that are commonly used in Western Europe in that the securitizing agency retains default risk. Under both models, investors take on only interest rate risk, not default risk.^[10]

In another type of securitization, known as "private label" securitization, default risk is generally not retained by the securitizing entity. Instead, the secrutizing entity passes on default risk to investors. The securitizing entity, therefore, has relatively little incentive to monitor originators and maintain loan quality.^[10] "Private label" securitization refers to securitizations structured by financial institutions such as investment banks, commercial banks, and non-bank mortgage lenders.

During the years leading up to the subprime mortgage financial crisis, private label securitizations grew as a share of overall mortgage securitization by purchasing and securitizing low quality, high risk mortgages. Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private label securitizations, and performed far better in terms of default rates.^[10]

Economist Mark Zandi of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis. He wrote that "the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote, "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."^[11]

Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend with their cards, because without such limits borrowers may spend borrowed funds recklessly, leading to default.

Securitization of mortgages in America started in 1983 at Salomon Brothers and was done in such a fashion that the people arranging the mortgage passed all the risk that the mortgage would fail to the next group down the line. With the mortgage securitization system in the United States, many different debts of many different borrowers are piled together into a large pool of debt, and then shares in the pool are sold to lots of creditors.

Thus, there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language that the papers that he/she signed were written in, or even that the paperwork exists and is in good order. It has been suggested that this may have caused subprime mortgage crisis.^[12]

Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of musical chairs) is the one who faces the potential losses. In the subprime crisis, however, national credit authorities (the Federal Reserve in the US) assumed the ultimate risk on behalf of the citizenry at large.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout would prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and burdens of loss became apparent to Lehman Brothers (who did not benefit from a bailout) and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuation plunged during the subprime mortgage crisis.^[13][14][15]

Insurance industry

The name comes originally from the insurance industry. Insurance companies worried that protecting their clients from risks (like fire, or car accidents) might encourage those clients to behave in riskier ways (like smoking in bed or not wearing seat belts). This problem may inefficiently discourage those companies from protecting their clients as much as the clients would like to be protected.

Economists argue that this inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions (like smoking in bed or not wearing seat belts), allowing them to provide thorough protection against risk (fire, accidents) without encouraging risky behavior. But since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information.

Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information rather than hidden actions.

The same underlying problem of unobservable actions also affects other contexts besides the insurance industry. It also arises in banking and finance: if a financial institution knows it is protected by a lender of last resort, it may make riskier investments than it would in the absence of this protection.

In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service—which would otherwise not be necessary. In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services.

Two types of behavior can change. One type is the risky behavior itself, resulting in a before the event moral hazard. In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms).

A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs. This may be called ex post (after the event) moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health. But after medical insurance becomes available, some may ask an insurance provider to pay for the cost of medical treatment that would not have occurred otherwise.

Sometimes moral hazard is so severe it makes insurance policies impossible. Coinsurance, co-payments, and deductibles reduce the risk of moral hazard by increasing the out-of-pocket spending of consumers, which decreases their incentive to consume. Thus, the insured have a financial incentive to avoid making a claim.

Moral hazard has been studied by insurers^[16] and academics. See works by Kenneth Arrow,^[17][18][19] Tom Baker,^[20] and John Nyman.

John Nyman suggests that two types of moral hazard exist: efficient and inefficient moral hazard. Efficient moral hazard is the viewpoint that the over consumption of medical care brought forth by insurance does not always produce a welfare loss to society. Rather, individuals attain better health through the increased consumption of medical care, making them more productive and netting an overall benefit to societal welfare. Also, Nyman suggests that individuals purchase insurance to obtain an income transfer when they become ill, as opposed to the traditionalist stance that individuals diversify risk via insurance.

Insurance analysts sometimes distinguish moral hazard from a related concept they call morale hazard.

Economic theory

In economic theory, moral hazard is a situation where the behavior of one party may change to the detriment of another after the transaction has taken place. For example, a person with insurance against automobile theft may be less cautious about locking their car, because the negative consequences of vehicle theft are now (partially) the responsibility of the insurance company. A party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently than how it would if it were fully exposed to the risk.

According to contract theory, moral hazard results from a situation in which a hidden action occurs.^[21] Bengt Holmström said this:

It has long been recognized that a problem of moral hazard may arise when individuals engage in risk sharing under conditions such that their privately taken actions affect the probability distribution of the outcome.^[22]

Moral hazard can be divided into two types when it involves asymmetric information (or lack of verifiability) of the outcome of a random event. An ex-ante moral hazard is a change in behavior prior to the outcome of the random event, whereas ex-post involves behavior after the outcome.^[23] For example, in the case of a health insurance company insuring an individual during a specific time-period, the final health of the individual can be thought of as the outcome. The individual taking greater risks during the period would be ex-ante moral hazard whereas lying about a fictitious health problem to defraud the insurance company would be ex-post moral hazard. In a second example, imagine the case of a bank making a loan to an entrepreneur for a risky business venture. The entrepreneur becoming overly risky would be ex-ante moral hazard, but willful default (wrongly claiming the ventured failed when it was profitable) is ex-post moral hazard.

Management

Moral hazard problems also occur in employment relationships. When a firm is unable to observe all actions taken by its employees, it may be impossible to achieve efficient behavior in the workplace: for example, workers' effort may be inefficiently low. This is called the principal–agent problem, which is one possible explanation for the existence of involuntary unemployment.^[24] Similar problems may also occur at the managerial level because owners of firms (shareholders) may be unable to observe the actions of a firm's managers, opening the door to careless or self-serving decision-making.

Moral hazard can occur when upper management is shielded from the consequences of poor decision making. This situation can occur in a variety of situations, such as the following:

• When a manager has a secure position and cannot be readily removed.
• When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects.
• When funding and/or managerial status for a project is independent of the project's success.
• When the failure of the project is of minimal overall consequence to the firm, regardless of the local impact on the managed division.
• When a manager may readily lay blame on an innocent subordinate.
• When there is no clear means of determining who is accountable for a given project. The software development industry has specifically identified this kind of risky behavior as a management anti-pattern^[which?], but it can occur in any field.
• When senior management has its own remuneration as its primary motivation for decision making (hitting short-term quarterly earnings targets or creating high medium term earnings, without due regard for the medium term effects on, or risks for the business so that large bonuses can be justified in the current periods). The shielding occurs because any eventual hit to earnings can most likely be explained away, and in the worst case, if an executive is terminated, usually the executive keeps the high salary and bonuses from years past.
• When a numbered company is used for construction projects as a subsidiary of a larger enterprise. For example: a numbered company is incorporated to construct a condominium in Vancouver. It is built to meet the minimum building code requirements, but is not designed for Vancouver's typical weather patterns (mild temperatures, lots of moisture). A few years later, the exterior cladding of the building is disintegrating with mold and rot. The numbered company that built it has no assets, so the condominium owners must suffer a large expense to rebuild it. In this scenario, the senior officers of the numbered company, and its shareholders used the protection of a numbered limited liability company in order to take higher risks in the design and construction. Unless the law and the regulators have some effective means to hold those responsible to account, the Moral Hazard would be expected to continue to future building projects. In extreme cases, moral hazard can lead to or permit control fraud to occur, where actual illegal activities take place.

See also

• Conflict of interest
• Externality
• Feedback
• Free rider problem
• Game theory
• Information economics
• Offset hypothesis
• Perverse incentive
• Samaritan's dilemma
• Systemic risk
• Unintended consequences

References

1.                               ^ Dembe, Allard E. and Boden, Leslie I. (2000). "Moral Hazard: A Question of Morality?" New Solutions 2000 10(3). 257-279

2.                               ^ David Anderson, Ph. D. "The Story of the moral"

3.                               ^ Krugman, Paul (2009). The Return of Depression Economics and the Crisis of 2008. W.W. Norton Company Limited. ISBN 978-0-393-07101-6.

4.                               ^ "Low Risk High Return Investments". Bad Credit Loan Center. Retrieved 2012-2-19.

5.                               ^ Summers, Lawrence (2007-09-23). "Beware moral hazard fundamentalists". Financial Times. Retrieved 2008-01-15.

6.                               ^ Brown, Bill (2008-11-19). "Uncle Sam as sugar daddy". MarketWatch. Retrieved 2008-11-30.

7.                               ^ Common (Stock) Sense about Risk-Shifting and Bank Bailouts. SSRN.com. December 29, 2009. SSRN 1321666.

8.                               ^ Debt Overhang and Bank Bailouts. SSRN.com. February 2, 2009. SSRN 1336288.

9.                               ^ Boyd, John H. (April 2000), "A User’s Guide to Banking Crises". World Bank, pp. 1-3.

10.                           ^ ^{a b c d} Michael Simkovic, Competition and Crisis in Mortgage Securitization

11.                           ^ Zandi, Mark (2009). Financial Shock. FT Press. ISBN 978-0-13-701663-1.

12.                           ^ Holden Lewis (2007-04-18). "'Moral hazard' helps shape mortgage mess". Bankrate.com. Retrieved 2007-12-09.

13.                           ^ David Wighton (2008-09-24). "'Paulson bailout: seizing moral high ground can be hazardous'". TimesOnline. Retrieved 2009-03-17.

14.                           ^ HFM (2009-03-16). "'The SEC Makes Wall Street More Fraudlent'". Justput.com Post # 17-26. Retrieved 2009-03-17.

15.                           ^ Frank Ahrens (2008-03-19). "Moral Hazard': Why Risk Is Good'". The Washington Post. Retrieved 2009-03-17.

16.                           ^ Crosby, Everett (1905). "Fire Prevention". Annals of the American Academy of Political and Social Science (American Academy of Political and Social Science) 26 (2): 224–238. doi:10.1177/000271620502600215. JSTOR 1011015. Crosby was one of the founders of the National Fire Protection Association, NFPA.org

17.                           ^ Arrow, Kenneth (1963). "Uncertainty and the Welfare Economics of Medical Care". American Economic Review (American Economic Association) 53 (5): 941–973. JSTOR 1812044.

18.                           ^ Arrow, Kenneth (1965). Aspects of the Theory of Risk Bearing. Finland: Yrjö Jahnssonin Säätiö. OCLC 228221660.

19.                           ^ Arrow, Kenneth (1971). Essays in the Theory of Risk- Bearing. Chicago: Markham. ISBN 0-8410-2001-9.

20.                           ^ Baker, Tom (1996). "On the Genealogy of Moral hazard". Texas Law Review 75: 237. ISSN 0040-4411.

21.                           ^ A. Mas-Colell, M. Whinston, and J. Green (1995), Microeconomic Theory. Chapter 14, 'The Principal-Agent Problem', p. 477.

22.                           ^ Holmstrom, B. (1979), "Moral hazard and observability". Bell Journal of Economics, pp. 74-91.

23.                           ^ Mark William Jenkins. "Essays on consumer credit markets". p. 90.

24.                           ^ C. Shapiro and J. Stiglitz (1984), 'Equilibrium unemployment as a worker discipline device'. American Economic Review 74 (3), pp. 433-444.

• JSTOR.org, A working link to the Everett Crosby article "Fire Prevention"
• JSTOR.org, A working link to the Kenneth Arrow article "Uncertainty and the Welfare Economics of Medical Care"

External links

• Saintjoe.edu, Discussion of moral hazard and insurance by Robert Schenk
• Gladwell.com, The Moral Hazard Myth (in Health Care)
• TheBigMoney.com, What is Moral Hazard
• Press.illinois.edu, What's so Moral about the Moral Hazard?
• Marketwatch.com, Uncle Sam as sugar daddy; Marketwatch Commentary: The moral hazard problem must not be ignored
• PBS.org, Inside the Meltdown, PBS's Frontline episode uses the idea as a central theme
• Mises.org, A comparison of the conventional views of moral hazard, with that by Austrian economists

Principal–agent problem

From Wikipedia, the free encyclopedia

In political science and economics, the principal–agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem of potential moral hazard and conflict of interest, in as much as the principal is—presumably—hiring the agent to pursue the principal's interests.

Various mechanisms may be used to try to align the interests of the agent in solidarity with those of the principal, such as piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), the agent posting a bond, or fear of firing.

The principal–agent problem is found in most employer/employee relationships. Political science has noted the problems inherent in the delegation of legislative authority to bureaucratic agencies.

As another example, the implementation of legislation (such as laws and executive directives) is open to bureaucratic interpretation, which creates opportunities and incentives for the bureaucrat-as-agent to deviate from the intentions or preferences of the legislators. Variance in the intensity of legislative oversight also serves to increase principal–agent problems in implementing legislative preferences.

where one party, called an agent, acts on behalf of another party, called the principal. The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned.

Spreading entitlement lies

In "Cat on a Hot Tin Roof," family patriarch: Big Daddy says, "There ain't nothin' more powerful than the odor of mendacity!" Well, Robert J. Samuelson's column "The origins of entitlement! (Opinion, April 9) reeks of it.

Samuelson provides a convoluted explanation of how your years of Social Security contributions were not actually contributions toward your own retirement, but were really just your contributions toward someone else's welfare. "Your contributions weren't saved. They were really more like your taxes. They went to support the "dole."  Well, what other government benefit is actually funded by the recipients?

He said that Social Security has "evolved." This supposedly explains why you shouldn't feel "enti­tled" to a benefit We Further on, he lays the groundwork for means testing, asking, "Who among the elderly need bene­fits?" Never mind that you paid for your benefit for 40 or more working years. I guess it's a matter of "fairness."

Mendacity! The current administration could not have said it better. 

Bert W. Zahn Twinsburg   PD 16 Apr 2012