The regular attendees of the Friday night open swim managed to find adequate thrills on the 5‑meter platform by introducing a game that involved running off the lower platform and leaping to catch a football tossed from the deck. The new game also sent the occasional wounded student to the college health center, but we had learned not to tell them the cause of the injuries. In essence, we increased the degree of difficulty—and risk—to compensate for the lower height.
That, in a nutshell, is why we had the financial crisis.
And that, in turn, brings us to the new book, Foolproof, by Greg Ip, reporter and columnist par excellence for the Wall Street Journal. Ip has written a magisterial and fascinating book on the role that moral hazard—assuming more risk when previous risk has been mitigated—plays in our lives and in particular how it affects financial markets.
Greenspan put / Moral hazard stinks. It seems like every time the government tries to make people’s lives safer, we undo their munificence somehow. For some of us, this predilection manifests itself in stupid activities in a pool; for others it is risky investments.
It’s not that we can’t make the world safer. It’s just that as we make it safer, we become inclined to take more risks, knowing that steps have been taken to protect us from ourselves. We see this sort of behavior everywhere. When I lived in Wisconsin, I asked some softball teammates from the county sheriff’s office to record the proportion of cars towed out of ditches in the next snowstorm that had four-wheel drive. They gleefully did this for an entire season and we discovered that fully 90 percent of the ditched cars had four-wheel drive, even though such vehicles made up well less than half of all vehicles on the road in the region.
While moral hazard—manifested here by people driving more aggressively with a safer car—can nudge us to take more risks in our lives, it can have an even more profound effect on financial markets. Perhaps the most famous example of this is the so-called “Greenspan put,” whereby stock market traders counted on Alan Greenspan and the Federal Reserve Board intervening with some sort of monetary stimulus whenever the stock market took a serious tumble.
Greenspan’s successor as Fed chair, Ben Bernanke, saw the problems inherent with the Federal Reserve having such a reputation. But by the time he assumed the reins there wasn’t enough slack to fix the problem. Moral hazard was being compounded by the market, most famously by the giant global insurer AIG. The company’s financial products division at the time offered what was essentially insurance for a variety of financial products, most notably on the value of collateralized debt obligations (CDOs). Most of these were mortgage-backed securities.
Banks would sell the cash flow from the mortgages they issued, which would be packaged with various other mortgage payments from across the country and then resold to investors. By dint of these mortgages coming from all over the country, in places where real estate prices typically don’t move together that much, the belief was that these things should not be all that risky. If home prices fall in Michigan there’s no reason to think they would simultaneously fall in Orlando. The very notion that we might see an economy-wide decline in real estate prices seemed absurd to most people at the time—such a thing had never happened before, after all.
And while geographic diversification might not remove all the risk inherent in such a product, insurance would theoretically do precisely that. AIG had developed a product to insure the value of CDOs, allowing investors to buy these mortgage-backed securities and be sure that they would hold their value—provided the insurance company makes good on its guarantees, at least.
And that’s the rub: AIG woefully underestimated the risks inherent in these assets and criminally (perhaps literally, although the courts never concluded as much) underpriced the cost of the insurance. Investment banks went heavily into CDOs and leveraged up their bets to goose their returns, not caring whether the loans underlying their securities were likely to be repaid. No one had any incentive to check that, it turned out.
As a result, when real estate prices fell (not all that far in most of the country, truth be told) it caused the value of these investments to plummet. AIG couldn’t make good on its insurance, as it hadn’t set aside nearly enough to cover the guarantees. After that, as Ip points out, what befell the financial markets was simply a good old-fashioned bank run, as people rushed to get out and invest in something—anything—that was safe.
Too big to fail / Ultimately, the government stepped in and bailed out most—but not all—of the actors. Some entities—most notably Goldman Sachs, whose former chief executive was treasury secretary at the time—were made whole, while others—most notably the shareholders of AIG and Lehman Brothers—lost most or all of their investment.
Ip points out that the government didn’t have much choice but to bail out the economy; letting the banks fail en masse and potentially destroying the global financial system simply wasn’t a viable political choice. But bailing them out has sown the seeds for some future market crisis precisely because of the moral hazard engendered by the bailout.
Some of the most contentious parts of the 2010 Dodd-Frank Financial Reform Act try to address this specific problem. Notably, the legislation designates some large banks and insurance companies as being systematically important and makes them subject to stricter capital standards and enhanced regulations. In turn, the government seems poised to bail out these entities if they get in trouble once again. Few people seem happy about this, and the dissatisfaction doesn’t break down neatly by party affiliation.
Some believe that the designated banks can use this implicit government backstop to improve the terms under which they borrow money. That, in turn, gives them an advantage over smaller banks. Because the large banks, which operate branches all across America, tend to be somewhat reluctant to lend to places where they don’t possess some inherent advantage, they’re inclined to take deposits but not make loans in smaller communities.
On the insurance front, economists have pointed out that the very notion of a run on these companies is somewhat absurd given the nature of insurance. People with term life insurance don’t have money in some account that they can simply yank out on a moment’s notice; if they don’t pay their premium next year, then they won’t be insured and that’s about the end of it. But what’s left of AIG has to be, for political reasons, subject to enhanced standards, and it’s a bit awkward if they’re the only ones, so a couple other insurance companies join them.
Ip shows us how government’s attempt to get us to behave in a way that comports with what might be deemed as in the best interest of society is often defeated by our rational self interest. If government makes things safer for us, we are inclined to take more risks. Foreclosing all avenues by which we can exploit this paternalistic behavior is neither possible nor necessarily desirable.
What Ip’s tour through the wicked world of moral hazard teaches us is that our policymakers can do a much better job in anticipating how we will respond to their various edicts and not regulate under the assumption of some sort of behavioral stasis. This is easier said than done of course, and assumes a level of knowledge and capacity for acting in the public interest that may go beyond the ken of most government entities.
And coming up with the optimal regulations is not always in the self interest of the particular principal. I say this after witnessing more than one former government regulator grow prosperous by exploiting problems with the very regulatory structure he helped to create.
This isn’t a unique story or even an unexpected one. It begs the regulator—and his ostensible boss, the politician—to act reluctantly, and only when absolutely necessary in the workaday world.
