How moral hazard works

by Russ Roberts on October 7, 2009

in Financial Markets, Podcast

Commenter netsp does a nice job summarizing how government rescues distort decisionmaking on Wall Street:

Lenders expect to be covered Lenders have a rational expectation that they will be covered in a worst case scenario. This is not a sure thing or an explicit promise. But, it is likely enough that they factor it in to their lending rates, they mis-price risk because part of the risk belongs to tax payers.

The price of borrowing money to make a high risk bet decreases Too-big-to-fail companies are able borrow money at rates that do not truly reflect the chance that these will not be repaid in the event of a collapse. As prices decrease, they consume more (loans).

Shareholders/Equity – Shareholders do not expect to get money back in case of failure. Share price will be zero if they fail. The risk of a bad bet cannot go above the total amount of equity they have in the company. However, the reward of a successful and highly leveraged bet is higher then it should be because the cost of borrowing/leveraging is lower then implied by the risk.

The risk/reward situation becomes more attractive Risk hasn’t changed. If the company fails, equity goes to zero. Rewards have gone up. The cost of borrowing has decreased. This means that for good bets, shareholders get to keep a bigger piece then otherwise. Since they are incredibly leveraged, returns are very sensitive to small movements in the cost of borrowing. Slightly lower costs lead to much greater profits. It is rational to accept risk if you are being compensated for it. Risk can be managed via diversification.

Comment on this observation or listen to the podcast here.

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  • Nice comment.

    However, if a shareholders expect a government bailout, then they don't necessarily expect their stock price to go to zero in the event of a failure. They expect wealth to be transferred from taxpayers to shareholders (which may or may not happen if if the day of doom comes). This serves to inflate the stock price.

    I think an underlying assumption in the post (which cannot be taken for granted) is that the additional cash flow resulting from taking on more leverage is enough to offset the increase in risk from additional leverage. If the increase in cash flow offsets, the stock price should remain the same. If the additional cash flow more than offsets the additional risk, the stock price should rise and vice versa if the additional cash flow doesn't at least offset the additional risk.

    Too often, the additional risk of leverage is underestimated - In this case, because the taxpayer to shareholder wealth transfer is overestimated - and the stock sells at a price well above fair value.

    Diversification is helpful. However, during times of crisis, usually uncorrelated assets suddenly become very correlated. So, a hedging strategy relying purely on diversification will not work when your portfolio is most in need of a hedge.
  • vikingvista
    "during times of crisis, usually uncorrelated assets suddenly become very correlated. So, a hedging strategy relying purely on diversification will not work when your portfolio is most in need of a hedge."

    Then the government comes in and bans short-selling, ensuring that you have no way to protect your assets.
  • Yep. And it doesn't lift the restrictions once the crisis is behind us, ensuring that the market has a bias and making it more volatile in the long run. Go Government! Way to accomplish those goals of tamping down volatility.
  • netsp
    Methinks,

    The interesting part is that the story does not require a bailout of shareholders. It is enough to promise to cover loans. It is enough to hint at it. The transfer of wealth happens in the good years from the public to shareholders. The shareholders are being compensated for taking on huge risks while the public is actually taking the risk.

    The mechanics of this process are discussed in the podcast.



    The moral hazard story in this podcast impressed me a lot. It requires very few assumptions (no secret meetings between bankers and politicians, no real industry-wide understanding, etc.) and involves very little hand waving. Even if the market has priced in a very soft "expectation" (for example, 'a 25% chance that the government will cover outstanding loans from big banks in the event of a collapse') could plausibly (it think) produce this moral hazard. An open cheque with a 25% chance of being honoured is definitely worth "something." Capital markets know what to do with these kinds of cheques.

    In my opinion, needing only weak assumptions makes this a very strong theory. It does not necessarily mean that this moral hazard is "the" or "the only" reason for the crisis, but I think we can be confident it exists and we should agree that it must be eliminated.

    *Finance Gurus, is it possible to infer what kind of an expectation the market had priced in?
  • Netsp,

    That's true. It's implied subsidized gambling for shareholders. I guess I was thinking of it from the perspective of the buyer of the stock during the good times, once the expectation is fully priced in (or even overpriced).

    I'm not a guru, but I'll take a stab: it's theoretically possible but almost impossible in practice - at least to any meaningful degree. All stock prices are the discounted future cash flows and too many assumptions about too many variables are baked into everyone's model to parse a single variable.
  • netsp
    There is a subtlety here because those who have been subsidised are those that got wiped out. At first (or fifth) glance a counterargument would seem completely reasonable. You couldn't possibly be implying that those who's shares are worth zero have been the beneficiaries of wealth transfer, but it's true.
  • muirgeo
    Yeah there's all that and then there also is the libertarian supported " person-hood" and "free speech rights" of corporations to donate as much "speech" to politicians and their campaigns.

    That is the moral hazard. That is the origin of the moral hazards you allude to above.... a government owned and operated by corporations who paid and received rent to get everything they wanted. They wanted regulations loosened.. .they got it. They wanted lending standards and leverage standards loosened ... they got it. They wanted their guys on the Fed boards and in the treasury ... they got it. They wanted cheap money and lower interest rates ... they got it. They wanted to combine commercial banks and investment banks into too big to fail monsters and they got it. Now they hold us all hostage and libertarians insist on protecting their rights of free speech.

    Why would you think government run by corporations wouldn't result in moral hazards?
  • tw
    Just don't forget the fact that if our government didn't have enough power to be able to give corporations what they asked for, there would be no need for corporations to pay "rent" to the politicians. This is yet another symptom of the actual problem.
  • johndewey
    tw, I'm sure you realize this, but let's clarify where the responsibility lies:

    Corporate leaders are bound by contract and by law to act in the best interests of shareholders. As long as the act within the confines of the law, there is nothing illegal or unethical about seeking favorable government laws or contracts or guarantees.

    Elected officials, on the other hand, are obligated to represent the interests of the electorate. The elected officials - not the corporate leaders - bear the burden of ensuring that taxpayer money is not wasted, that the power of government is applied fairly. When elected officials design programs to transfer risk to taxpayers - when elected officials enact laws which legalize bribery - when elected officials use the power of government to benefit contributors - it is elected officials who have failed in their duty.

    To lay the blame for government malfeasance onto corporate leaders - corporate leaders who are fulfilling their contractual and legal obligations to shareholders - shows a complete misunderstanding of the duties of the parties involved.
  • muirgeo
    I somewhat agree with you John. A corporations job is to make profit. Governments job is to represent people and their interest.

    Allowing corporations personhood and unlimited access to politicians is in conflict of the interest of persons and people.

    Corporations understood this and they, in the interest of profits, were able to secure the bogus claims of corporate personhood winning the case of Plessy v. Ferguson, 163 U.S. 537 (1896).

    That ruling is bogus and has undermined our representative democracy. That's all I am saying. But it seems to be libertarians who want to protect the liberty of corporations even though they are not real people and to the deteriment of reall people having to pay rent to corporations.

    "Corporations do everything people do except breathe, die and go to jail for dumping 1.3 million pounds of PCBs in the Hudson River."
    Stephen Colbert

    http://www.colbertnation.com/the-colbert-report...

    It's not a denial of liberty when the thing being denied is not an actual being.
  • Name
    But I take it MoveOn.org, Center for American Progress, ACORN, and other organizations that are "not real people" (your words not mine) have the same 1st amendment rights as C-corporations, right?
  • Solomwi
    The corporations won Plessy v. Ferguson? Really, muirgeo? That's absolutely priceless. I hope you, too, can see the irony once you figure out who really won that case (hint: it was the guys whose successors you hold up as saintly and infallible).
  • John Dewey, the problem isn't corporations fulfilling their obligations to shareholders by seeking favourable treatment but that politicians have the ability to bestow favourable treatment of some and rob others. While elected officials are obligated to represent the interests of their constituents, they are incentivized to monetize their power by selling it to the highest bidder.

    I believe tw is implying that politicians should therefore be stripped of the power they are monetizing.
  • tw
    "I believe tw is implying that politicians should therefore be stripped of the power they are monetizing."

    Bingo!
  • johndewey
    Agree with everything you wrote. The powers we allow elected officials to exercise is the whole problem.

    I wasn't contesting any point TW made. I was just trying to further emphasize that corporations are not evil. Unfortunately I got caught responding - through TW's intermediate post - to remarks made by the person I had pledged to ignore. And now I'm pissed because I violated my pledge.
  • I'm guilty of bashing my head against brick walls after promising to never do it again too.
  • Elected officials, on the other hand, are obligated to represent the
    interests of the electorate.

    Just like a corporation. Of course, these corporate officials have a good deal more power than private corporate officials.
  • libertarian supported " person-hood" and "free speech rights" of corporations to donate as much "speech" to politicians and their campaigns.

    I don't think you will find much support among libertarians for corporate law.

    You make your usual assumption from your biased perception that because libertarians oppose regulation of business, that they are therefore pro-corporation. Not The Case.

    Why would you think government run by corporations wouldn't result in moral hazards?

    Our government is a corporation. In courts, it is treated as a corporate person.
  • brotio
    You support welfare for corporations that you feel make products necessary to the survival of Mother Gaia, Hypocrite. Then you bitch that corporations spend money lobbying the government for corporate welfare, Stooge.

    You'll never grasp the fact that it's not corporate free speech that's the problem. They can talk all they want, but unless government has the power to grant them the privileges you say they should have, their talk is ineffective.

    The government gives special treatment to some corporations over others, based on political correctness. You wouldn't have it any other way.
  • johnpapola
    From my hobby horse of Hayekian macro, it seems like a way to think of this is that the interest rate on lending is effected partly by the supply of loanable funds as well as the risk premium lenders place on their bets.

    So expansionary monetary policy can move the supply curve to the right. Similarly, suppressed risk premiums do the same. Both push rates below the market rate.

    Does that make any sense?
  • BoscoH
    Russ, I saw your tweet this morning, and what I read into it was that you thought nobody was interested in this week's podcast. Far from it. This was 1 hour of "wow" and frankly, I'm just speechless. It's still not clear what happened exactly, but what is very clear is that bringing what was a technical matter into the political realm with bailouts was a recipe for disaster. In my mind, the moral hazard isn't just about taking too much risk with too little consequence. It's how you do it. Since we will at least bailout some (and probably most) big players, even with increased regulation (however that plays out), there is now an incentive in place to find some path of action that rigs the system and causes a large failure that puts the taxpayers on the hook.

    This week I've been battling ants in the kitchen. Until this morning, it's been a few stragglers here and there. I spray boundaries, inside and outside the house. This morning, motivated more by a quick change toward cold outside than the bounty inside, they found a new way in that involved climbing all over the glasses and dishes. Do any of you really think the financial sector is any different?
  • muirgeo
    This moral hazard thing is IMO just one more way to shift blame from the corporate capitalistic model to the government.

    I don't think this sort of moral hazard existed leading up to the 1929 crash and everyone before that.

    Who in their right mind is OK with a $5 dollar per share government bailout of their stocks that were otherwise worth $50 per share? I think there were plenty of clever enough Wall Streeters who knew to stop ripping off the public and to get out well before any government bailout went into effect. They are doing much better then any fool who counted on a government bailout to make them whole.
  • johnpapola
    Did you miss the point that the creditors and bond holders were made whole? They are the ones whose main concern should be solvency since they make their return on interest (though not exclusively).

    Bear’s creditors were 100% bailed out.

    As for the 1929 crash, that one, as with today, appears to have been the result of the end of a credit expansion as the Fed raised rates from 3.5% to 5% in 1928.

    It’s all about why the bet were bad ones. They were rational bets. They were bets chasing the highest return. The problem was that the relative returns were being driven by public and private credit expansion, not a sustainable shift in consumer preferences. The savings weren’t real. Consumption was up and savings rates were down.

    Moral hazard enabled the higher leverage in a systemic way, adding to an unsustainable inflation.

    At least, I think that’s the story.
  • John, he misses all points.

    He’s an anti-business zealot, especially anti-Wall Street, and then he apologizes for legal manipulation of bankruptcy because unions benefited in the fascist GM & Chrysler bailouts.

    Don’t waste your time.
  • I don't think this sort of moral hazard existed leading up to the 1929 crash and everyone before that.

    Hmmm, before government was so powerful. Maybe it has something to do with the creation of the FED (at the urging of bankers) in 1913.
  • The SEC didn’t exist leading up to the 1929 crash (1933 & 1934 Acts), and there was far less moral hazard. And the Depression was extended by these very interventionist moves purporting to “solve” the problem.
  • George is suggesting that there was less moral hazard back when there were fewer regulations and government was smaller and less powerful.
  • George is actually arguing both (see previous comments).

    He is suggesting that things were out of control before the Depression, which caused it (post hoc ergo propter hoc), and then says thanx to FDR and regulation, lenders of last resort, etc., things got better, except for moral hazard, which doesn’t really matter, except that we’re talking about moral hazard, which is what made our current situation worse, and we’re talking about moral hazard.

    Other than that, his logic is spot-on.
  • txslr
    Equity is really a call option on the assets of the company. The strike price on that call is payoff on the debt. Option value increase with volatility, so equity value increases with the volatility of returns on the assets of the company. The best thing for the shareholders is to sell debt and then alter the nature of the assets of the firm to make them riskier. This amounts to a transfer of wealth from debtholders (the value of whose holdings decreases) to the shareholders (whose value - option value - goes up). To stop management from engaging in this type of unilateral wealth transfer bondholders place limits on the activities of management using mechanisms like bond covenants. However, when the government guarantees the debt the need to monitor and bond the actions of management decreases. Now, if the shareholders get their way and increase the risk of the assets the bondholders don't much care because the risk is being shifted not to the bondholders but to the government. Result - more risk!
  • So, since slightly lowered costs lead to much greater profits, the payback of not hiring people will raise costs, and lower profits dramatically. Expect higher unemployment as a result of moral hazard.

    This will cause either social unrest or the government will buy more bread and circuses to keep the populace in an acceptable state of lethargy as the looting of America continues.
  • netsp
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