Moral Hazard - A Danger to our Financial System

Lately Hank Paulson has drawn a line in the sand - no more bailouts - no more "moral hazard." The reasoning is, if market participants think the government will bail them out of their mistakes, they will become reckless, which is moral hazard. I disagree. The true moral hazard is created by a financial system that permits a small band of manipulators to make leveraged bets in favor negative outcomes in situations where they have no other stake in the matter.

To introduce my argument: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance creates an active desire for a loss to occur. As an example consider what would happen if someone were able to buy fire insurance on a house he didn't own, or to purchase life insurance on an enemy or a complete stranger. Moral hazard is created by the lack of an insurable interest in the life or property insured. Someone who buys fire insurance on a building he does not own wants the building to burn down: that's why he buys the policy. The motivation is arson for profit. Because of this, life insurance, as well as fire insurance, cannot be legally purchased if there is no insurable interest.

The relevance to the current market difficulties is this: credit default swaps are a kind of insurance, created to permit protection by those who are exposed to loss because of an interest in a debt or bond...

Get an in depth analysis of this moral hazard from Tom Armistead. Click here.

by The Freshman |  09/18/08  |  Stocks: AIG, FNM, FRE, GE, LEH, MBI,