The concept known as "moral hazard" will be important to understand as Congress, regulators and lenders address the aftermath of shaky mortgage lending.
meltdown, and tomorrow's bigger Alt-A debacle, will bring out a lot of politicians
who will demand that something be done to protect consumers from bad loans. But
it's going to be hard to protect consumers without bailing out the lenders and
investors who were behind those bad loan decisions. That's where moral hazard
Moral hazard is an economic and insurance term that
describes how people behave recklessly when they're insured or protected in some
way. If you sell flood insurance, people will build on flood plains. If you make
airbags and anti-lock brakes standard in all cars, people will drive faster and
tailgate more closely. If you introduce fat-free cookies (fat-free, but still
loaded with calories), people will eat more cookies than before, and get just
All examples of moral hazard.
In the last four years or so, mortgage standards became
lax because each link in the mortgage chain collected profits while believing
it was passing
on risk to the next link in the chain. Brokers weren't lending their
own money, so they were pushing risks onto the lenders. Lenders sold mortgages
soon after underwriting them, pushing the risk onto investors. Investment banks
bought the mortgages and chopped up mortgage-backed securities into slices, with
some slices being less risky and other slices being more risky. Investors bought
securities and hedged against the risk of default and prepayment, pushing those
risks further along.
All of these businesses accepted profits
and tried to leave the next guy vulnerable to risk. Participants thought they
were insulated from the negative consequences of bad decisions. That's an example
of moral hazard.
Government help as
Here's another example of moral hazard: Using government
money to help homeowners who are stuck in unsuitable loans and can't afford their
house payments. If not done carefully, this type of aid would subsidize lending
institutions that made poor choices. It would bail out the investors who bought
risky loans and now don't want to suffer the consequences of losing their bets.
for the borrowers who lose their homes in foreclosure: Let this be a cautionary
tale. Read your loan documents. Ask questions. If you don't understand, hire a
lawyer or a certified public accountant to give advice.
people hire lawyers or CPAs to review their loan documents now. But 40 years ago,
few people wore seatbelts. People have wised up since then.