Moral Hazard

In last week's article, "Fannie & Freddie and the Banks", we began our story with the present [dismal] state of their affairs. That is, we didn't really talk about how or why they reached that state. That entire topic will fill numerous books and PhD dissertations in months and years to come. Today, we want to highlight one aspect here, the so-called "moral hazard" endemic to their structure and position in financial markets. Apparently, "moral hazard" is a term unfamiliar to many of you. But these words used by economists describe an ethical dilemma you have surely faced and probably given counsel about any number of times.

Fannie & Freddie's Risky Business
As we did say last week, Fannie Mae and Freddie Mac are privately owned, but they were founded by the federal government to foster the development of national mortgage markets, helping to maintain the availability of reasonably priced loans for middle-income Americans. The firms conduct their business in three ways. First, they buy mortgages from local lenders or brokers, combine groups of these mortgages together in "pools" and issue bonds transferring ownership of the pools to private investors; through elaborate computerized systems, the investors receive the principal and interest payments on the specific loans in the pools. These investors, not Fannie & Freddie or the original lenders, bear the ultimate risk of loss should the borrower default. The bonds are called "mortgage-backed securities" (MBS). Second, Fannie & Freddie buy mortgage loans and hold them in their own portfolios. Third, they buy MBS securities for their own portfolios; these may have been issued by themselves, by their counterpart institutions, and by non-government-connected institutions. These last are "private label" MBS, sold by Merrill Lynch and other similar investment banks. While the mortgages comprising their own MBS have specified minimum credit quality and maximum size, the loans they choose to keep in their own portfolios and the other MBS securities they buy can include lower quality items, especially subprime mortgages.

Their Government "Connection"
While, as we also emphasized before, Fannie and Freddie have no direct, concrete government guarantee, everyone has always assumed that the federal government would back them up somehow. This "connection" [our phrase] means they can borrow in money and capital markets at low cost, markedly lower than purely private debt would cost.

Further, we said last week that, despite their recent multi-billion-dollar losses, their capital position remains well above legally mandated minimums. However, it is also the case that those minimums are considerably more liberal than general accounting standards would permit for a similar business without a government connection. This means they can borrow more and do more business with a given size capital base than ordinary firms can.

At the same time, these firms believe they must have skilled managers, people who might just as well choose to work in the private financial sector. So the scales and provisions of their compensation plans are at least as generous as those available for similar positions at private institutions: the packages include stock options and bonuses in addition to base salary.

A Recipe for Moral Hazard
So here's the picture: we have highly paid executives, whose pay increases with the size and volume of the firm's business, operating with low borrowing cost, liberal capital constraints and pass-through of much of the risk to downstream investors, along with a fuzzy, but apparent government "guarantee". Your low cost structure means more business opportunities are profitable, and risky business – assuming it pays off – is more profitable still. The government connection means that you can reach for that risk because someone else will suffer the loss if the risk winds up going against you. Fannie and Freddie have behaved in response to these incentives.

Reaching for more risk than you would otherwise incur because someone else will bear the cost of failure is moral hazard. Critics of the government's efforts to prop up Fannie and Freddie argue that the support validates the threat of moral hazard. Moreover, since it's the government, other institutions might see this rescue as a precedent and behave more recklessly as well, thinking they can make a plea for a similar rescue. Moral hazard begets more moral hazard.

Finance is hardly the only field that faces it. A classic example is seat belts. Accident rates have increased since imposition of mandatory seat belt laws. The injuries in car accidents are perceived to be less severe, so people drive less carefully, which is hardly the desired outcome. Damage per accident may be less, but total aggregate damage may remain the same or even increase. Insurance is another area of widespread moral hazard: the availability of health insurance has led to increased usage rates for various optional medical services. People "have it done" just because "the insurance pays". Teenage behavior is subject to moral hazard: if Dad is likely to pay off the arrears on the credit card bill or talk the English teacher into a better grade on the term paper, then the initial effort could well be less prudent. And your siblings think if he's done it for you, he'll do it for them too. Moral hazard.

No Simple Remedy
Now that your mind is on these issues, you've probably already come up with three or four other examples. And you know this is tricky. Clearly the dental insurance company means for you to get that new crown. And clearly seat belts prevent much serious injury. So too, the availability of government loans to Fannie and Freddie – as formalized over the last few days in new Congressional legislation – should prevent the spread of chaotic conditions that might otherwise paralyze mortgage and other financial markets. So we shouldn't withhold protection altogether.

We can put conditions on the protection, though. Dad can set inviolate limits on his bailout of Suzie's credit card bill and a new regulator can put more concrete determinants on the scope of Freddie's and Fannie's operations. The new law, passed this past Saturday (yes, Saturday) forms the Federal Housing Finance Agency to conduct their regulation; it is empowered to oversee their investment and loan practices as well as to lend them money, a specific quid pro quo arrangement. These things never turn out exactly as they are intended, but this approach looks to have good potential to effect reform. We hope so!