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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