Avoid Moral Hazard

By Sean Hayes
Appeared in the Korea Times on January 8, 2008

President-elect Lee Myung-bak, during the campaign, pledged to create a 7 trillion won fund, managed by a presidential body, to assist in alleviating difficulties being felt by credit delinquents. The fund is equal to 5 percent of the ordinary annual budget of 2007.

It has been estimated, by the Financial Supervisory Commission, that 3 million individuals are in default on loans and an additional 4 million individuals, because of past defaults, are unable to obtain credit.

The fund, in part, will be used to restructure debts and create micro-credit banks. President-elect Lee, according to reports in this and other news sources, may also force companies to delete negative information from credit reports.

We hope President-elect Lee won’t fall into this populist trap. He has many bold fiscally sound plans that are needed to lead this country to future economic, social, and political development, however, this bailout plan will create a “moral hazard” that will be felt for generations to come.

We must take the blame that the moral hazard of easy credit, government encouragement of using credit, and the realization by banks that the government will bail them out has helped to create this present situation and fixing it with a bailout moral hazard is just passing the problem on to future generations.

America is experiencing the same learning pains with its subprime mortgage mess. Regrettably the U.S. situation is being handled in the same populist manner.

A moral hazard occurs when some policy or action assists in altering the behavior of individuals in a counterproductive manner. For example, policies that attempt to mitigate risk create an incentive for individuals and businesses to assume more risk.

A simple example is the case of the savings and loans crisis that hit the U.S. in the 1980s. The prior U.S. deposit insurance and bank-closure policies protected the capital of depositors and other bank creditors from risk in the event of failure of financial institutions.

The policy created an incentive for these institutions to take speculative positions. As we all know, many of these positions failed which led to the collapse of many savings and loans and to the government footing the bill.

The deposit-insurance policy was quickly changed in reaction to the creation of this moral hazard.

The subprime mortgage mess was also created by a moral hazard. Fed Chairman Ben Bernanke and his predecessor Alan Greenspan believe that asset bubbles can’t be adequately detected, thus, monetary policy should only focus on alleviating the pain felt when a bubble collapses.

This policy has created a moral hazard in the housing market, since now the Fed is telling us that they will take no action against bubbles, but will relive the pain felt when a bubble bursts.

This faulty logic, which Bernanke realized was faulty during the savings and loans crisis, seems to now be lost under the cloud of Greenspan. Bernanke during the savings and loans crisis stated that: “When this moral hazard is present, credit flows rapidly into rigidly supplied assets, such as real estate.

Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash.”

Let us learn from the mess created in the U.S. in the 1980s and today and realize that bailouts can generate moral hazards if they bail individuals or companies out of risk caused by their ill-advised actions.

In order for banks and individuals to learn and not be encouraged to take on ill-advised risk their misdeeds need to be felt and realized.

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SeanHayes@ipglegal.com