Sometimes, I hate Glenn Reynolds of Instapundit. I started writing a post on moral hazards in the financial system last night and then I pop onto Instapundit today to find a link to a Popular Mechanics article he wrote about moral hazards. He even uses the example of auto-safety improvements that I intended to use.
Glenn makes something like the point I intended to make:
This approach could be taken beyond the world of personal transportation. We’re in the current financial mess in part because things that were actually dangerous—from subprime mortgages to risky financial instruments that no one fully understood—felt safe and ordinary. Modern financial markets, with computers, regulations, deposit insurance and bond ratings, felt as routine and as smooth as that four-lane highway in Spain, causing a lot of people who should have been paying attention to doze off. Investors might have been more careful if it had felt like they were driving down a twisty mountain road with no guardrails, especially since we really were engaged in the financial equivalent of high-speed mountain driving, only without the discipline of fear.
The current financial crisis definitely resulted from government generated moral risk. The massive federal-government-created and -managed enterprises, Freddie Mac, Fannie Mae and the Federal Home Loan Banks, aka Flubs, (henceforth, collectively the GSEs) are ground zero for the crisis. They were simply too big not to dramatically impact the market. Collectively, the GSEs purchase half of the mortgages issued in the U.S. Collectively, they issued most of the mortgage-backed securities (MBSs) currently in circulation. By design, these institutions created a vast moral hazard that built up over four decades until the system collapsed under the weight of risky behavior.
The GSEs created moral risk in several ways.
(1) By design, the GSEs separated the profit earned from a particular mortgage from the risk of issuing that mortgage. Prior to the GSEs most institutions who issued a mortgage had to hold the mortgage, because few people would trust a private institution’s judgment about the safety of the mortgages it issued but did not keep in-house. If the borrower defaulted then the mortgage issuer lost money. This created a strong feedback system that tied benefit and risk tightly together. Politicians decided that this aversion to risk caused lenders to loan too conservatively, so they created the GSEs to remove the risk from issuing mortgages. Now the only feedback on the risk of mortgage came from the GSEs, and with their government backing they paid far less attention to risk posed by mortgages.
By analogy to autos, this is the same effect you would get if the government started providing free, full coverage, no-fault collision insurance. Suddenly, the economic risk from dangerous driving would disappear. People would no longer have a financial incentive to avoid fender benders, nor would they worry that risky driving would raise their insurance rates. Everyone can see this kind of moral hazard clearly but most have a problem seeing the same moral hazard in the financial system.
(2) By design, the GSEs hid the hazard of buying their MBSs by using their implied government guarantee. With private MBSs, the purchaser of the MBS has to trust that the seller has correctly calculated the risk of the collection of individual mortgages that back each unit of the security. Again, prior to the GSEs, few people would take that risk. Privately issued MBSs covered only a few percent of the residential real estate market, and those few percent dealt with high-value properties that historically held their value in good times and bad. The GSEs solved this “problem” in two ways. First, they used the presumption of political oversight and regulation (which in fact turned out not to exist) to convince buyers that the GSEs would properly calculate the risk of the mortgages the GSEs bought. Second, they used the implied guarantee to assure buyers that even if the GSEs made a mistake, the government would make good the payout on the securities.
By analogy with autos, this is the same effect you would get if the government claimed to protect against lemons at an auto dealer. Imagine if an auto dealer could claim that (a) the government checked the dealer’s car inventory for lemons and that (b) the government implied it would make good any financial loses that a buyer might incur if he got a lemon anyway. How carefully would people check out cars before they bought them?
(3) By design, the GSEs had much better credit ratings than did any private actors. All credit-rating agencies, both in America and overseas, rated the GSEs as much safer than their private-sector counterparts, due solely to their presumed government oversight and backing. This in turn made insurance against their defaults, called Credit-Default Swaps (CDSs) much cheaper than it should have been. Since most CDS issuers hedged by bundling GSE-based CDSs with private ones, this artificially lowered the prices of all CDSs.
By analogy with autos, this is the same effect you would get if the government generated the actuarial tables for auto insurance to make accidents seem less common than they actually are. Auto insurance would be cheaper but the entire industry would be built on a flawed understanding of the risk of driving. Also, imagine that it turned out that the government wouldn’t pay for damages and lemons and that the insurance companies had to take up the entire slack.
So, by extended analogy, imagine an automobile-based transportation system in which people (a) paid no financial penalty for reckless driving, (b) paid little attention to the mechanical quality of the cars they purchased and (c) private insurance companies operated on faulty accident statistics. Eventually, such a system would collapse. People would recklessly drive unsafe cars and the auto insurance companies would go bankrupt trying to pay damages.
This vast moral hazard explains most of the financial collapse. Lenders issued increasingly risky mortgages because, like government-insured drivers, they paid no penalty for making risky loans. Buyers of MBSs ignored the dangers of MBSs because, like drivers protected against lemons, they assumed that the MBSs were safe. Insurers charged too little for MBS default insurance because, like insurance companies using government statistics to price risk, they misjudged the true risk of MBSs.
I can’t repeat this often enough: By design, the GSEs were intended to distort the markets in favor of more-risky lending and that is exactly what we got. The private institutions that failed did so because they (a) mimicked the business model and practices of the GSEs, (b) bought GSE-issued MBSs, and GSE stock, based on their high ratings and/or (3) issued insurance against the default of the GSEs’ MBSs based on their high ratings.
Without the GSEs, the circumstances of the collapse would have never developed. To use automotive metaphors, fewer of us would have cars and we would pay higher insurance, but the cars we did have would be mechanically safer, we would drive them more safely and our auto insurance could pay out any damage claims if we had an accident. Instead, our political impulse to get something for nothing has led us to the financial equivalent of a nationwide pile-up of rust heaps driven by meth-crazed teenagers.