Tom A's Stock Picks

The True Moral Hazard

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A while ago there were quite a few references to the "Bernanke Put" as a source of moral hazard. The theory was that the belief there would be a bailout encouraged excessive risk taking among investors, lenders, etc. They were protected from the possible negative results of their actions, which created moral hazard. I believe the real moral hazard is created by a financial system which permits the use of insurance-like mechanisms to make leveraged bets in favor of negative outcomes by persons who have no other stake in the matter.

I am talking about the mortgage/credit crisis.

To provide a little background: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance would create an active desire for a loss to occur. An example would be if someone were able to buy 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.

What does that have to do with investments? Both futures and credit default swaps are insurance-like mechanisms, created to permit hedging or protection by those who are exposed to loss because of an interest in the subject matter. An airline is exposed to fluctuations in the price of fuel: and Southwest Airlines, as an example, has been careful to hedge this exposure, stabilizing and at times improving their financial performance. An organization holding notes of ABC company is exposed to loss caused by default on the notes, and a credit default swap will provide insurance.

Buying a credit default swap on a security backed by sub-prime is insurance, a very good idea if you actually own the security.

But I would submit that these mechanisms create moral hazard when used for speculative purposes. A determined group of negativists can short a companies stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors. Speculation in energy futures at times harms ordinary citizens who must buy energy.

Similarly, if a large enough group bets that sub-prime mortgages in the aggregate will be worthless, their actions can exacerbate an already troublesome situation. It is in their interest for a crash to occur: that creates a motivation to use all available means of communication to promote the belief that we are headed for a Depression. Because of the ABX index, the impression is created that all sub-prime mortgage backed securities are worth pennies on the dollar. Banks mark them to market accordingly. Liquidity vanishes. Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard.

As a fix to the system, I suggest that Congress and/or the SEC establish some sort of a watchdog unit to monitor and suppress speculative activity in the futures and credit default markets. Perhaps anyone buying such instruments should be required to file a statement of insurable interest. If you would like to buy credit defaults on ABC company, just list the bonds you own. You want to buy futures, explain the exposure to loss that you are trying to hedge. Free markets is one thing, moral hazard is another.