I have some background in economics. When I was taking classes in International Economics and spent any time on third-world economic issues, one of the frequent topics was "Moral Hazard". Moral Hazard is defined as the situation that arises when a party or a group of people are insulated from risk and therefore end up behaving differently than if they were fully confronted with the risk.
Third-world economies were often the example because state-supported banking, or telephone companies, or oil companies, don't really need to compete or be efficient and productive because of their government-supported status. Therefore, they were somewhat immune from financial difficulties as the government was always willing to give them more money.
The term "Moral Hazard" has come up a few times in the United States. One of the times was when the government bailed out Chrysler Corp (circa Lee Iacocca). This issue was that the auto companies would behave differently if they knew that someone would bail them out.
Well, a different form of Moral Hazard is now upon us but few understand the consequences and we are just starting to see the results. I'm referring to the subprime crises and resulting "freeze on foreclosures" and renegotiation of the interest rates. In essence, a bail-out of both the homeowners as well as the lenders.
Now before you jump on me for being insensitive, hear me out.
The real Moral Hazard started years ago when many States required that homeowners would no longer be responsible for mortgages if they defaulted --personal bankruptcy was not required. Today, most mortgage loans in the United States are non-recourse. Meaning that the lender’s only remedy in case of default is to repossess the house. That is, the lender cannot pursue you personally in case of default.
While that may be kind and humane in some cases, it shouldn't be applied to everyone. It isn't like we have debtors' prisons in the country and many can certainly find a way to repay the principle. To show you the extent of this "forgiveness" issue, President Bush signed the Mortgage Forgiveness Debt Relief Act of 2007 which also provides forgiveness to the defaulting homeowners' income tax owing since loan forgiveness is considered a taxable event (think about it...not as strange as it sounds).
The Moral Hazard arises because people now BEHAVE differently. If someone can go and speculate that a house may appreciate quickly in value, they will borrow as much as a lender will possibly allow and if the house goes up, they gain greatly. A ten percent down payment on a house that goes up in value just 10% is a 100% return on the investment.
Conversely, if someone can't lose anything other than the house, why not be reckless? If the home value goes down 10%, they walk away and lose only the 10% Therefore, why not just get into the most house (or houses) one can possibly afford, especially if there is a little down payment (or a second mortgage which can also be forgiven).
When people are no longer obligated to pay off a debt, behavior changes. When lenders take a huge risk on lower credit quality applicants but the government comes in and provides tax incentives and direct subsidies to the lenders, we have a Moral Hazard.
And a continuing Moral Crises.
