Moral Hazard: A Never Ending Problem

As I have continued to watch the fallout from the subprime mortgage fiasco stemming from this summer, I have delved further into the implications and history of such massive loss generating trades on Wall Street.

A recent Wall Street Journal article illustrated the magnitude of the problems resulting from the troubled subprime mortgages and the need for the federal government to intervene. As hedge funds have blown up, senior Wall Street professionals been fired, and wealthy investors lost billions of dollars, the average citizen will most likely endure the greatest hardship of all.

An estimated two million citizens who purchased adjustable rate mortgages expect to see interest rates jump in the distant future. In other words, a significant proportion of homeowners – at least 2 million in fact – will face significantly larger mortgage payments within the next two years. In fact, interest rates on as much as $362 billion in subprime home mortgages are expected to rise in the coming year, according to Banc of America Securities.

To prevent home foreclosures stemming from these increased mortgage payments, the Bush administration is leaning on Congress. Treasury Secretary Henry Paulson is pushing for legislation that would change the financing terms of these troubled subprime mortgages “and support a new White House proposal to use tax-exempt bonds to refinance troubled subprime mortgages” (Phillips). Additionally, Mr. Paulson believes that the administration will be aided by private industry that will place a freeze on adjustable rate mortgages sometime this upcoming week. The thinking goes that both actions when combined should sufficiently respond to the subprime problems aggressively enough and bring stability to the markets.

Imy opinion, the strength of the Fed’s suggested response to the subprime problem remains unclear. Programs already exist that would significantly decrease the cost of loans to a large portion of homeowners with subprime adjustable rate mortgages. The president of the Federal Reserve Bank of Boston actually believes that this option should be available to half of the subprime ARM market according to a recent speech. The need for this option to be exercised is all the more prescient upon repeatedly reading how home owners were “duped” into borrowing at potentially exorbitant costs that they would be unable to meet in the future. For example, “In an interview, Mr. Rosengren said some borrowers with relatively good credit may have been steered into a subprime loan because it was more profitable for the lender. Other borrowers ‘who might have been considered prime based on their credit score’ wound up in subprime loans because they didn't have adequate funds for a down payment, didn't wish to document their income or assets or wanted to buy a home that was more expensive than they could have qualified for” (Phillips).

However, the Treasury is officially calling for a freeze on interest rates in the mortgage industry that would affect lenders and investors in mortgage-backed securities. Hopefully Mr. Paulson’s proposal achieves its most moral goal of preventing further home foreclosures in addition to bringing calm to the markets. However, the notion that such a “bail out” of lenders, borrowers, and investors alike orchestrated by the Fed suggests “moral hazard.” As the Wall Street Journal defined this term recently in August 2007, “moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly” (Browning).

The recent possibility of moral hazard strongly stirs in my memory the history of Long Term Capital Management, the private investment partnership that was once the envy of Wall Street. This obscure arbitrage fund borrowed nearly $100 billion in assets from Wall Street’s most respected investment banks and institutions throughout the 1990s. The fund participated in trading derivative contracts often intertwined in fact with mortgage securities and making astronomical bets on borrowed money was its jeu de guerre.

However, Long Term Capital Management, just like several recent and highly respected, risk management funds nearly collapsed bringing down with it nearly $1 trillion worth of exposure to a variety of markets (Lowenstein 206 – 210). To prevent LTCM’s default, the Federal Reserve invited the heads of every major Wall Street bank such as Bear Stearns, Merrill Lynch, Morgan Stanley Dean Witter, and Goldman Sachs. They were brought together to stop the panic that led to exuberant and highly irrational selling off all types of securities on the market – even the most historically risk free Treasury bills, for example. While LTCM did not default, the parternship was eventually dissolved and all of the fund’s investments were stripped by its institutional investors – the aforementioned investment banks.

The federal government was instrumental in forcing these companies to cooperate with each other and effectively “bailed out” LTCM to prevent further battering of the markets. Indeed, you can bet that many intelligent individuals cried foul and said the risk of moral hazard was too high to rescue LTCM at the time. However, the Fed believed that the cost of failing to do so would be greater than saving the fund.

I find it so interesting that again the federal government is devising plans to stop another market (this time the subprime mortgage market) from naturally correcting itself. To allow the market to do so would simply be unfettered free market competition, laissez-faire as it should be. Indeed, investors in the future would more carefully scrutinize making such risky bets as they did with subprime mortgages, collateralized debt obligations (cdo’s) and other related instruments. However, as history has proved time and again, the Fed has appeared ready and willing to bail Wall Street out such as during the recent financial crises in Mexico, Thailand, South Korea, and Russia (where a bailout was attempted).


Works Cited

Lowenstein, Roger. "When Genius Failed: The Rise and Fall of Long Term Capital Management." 2000. 21 Nov 2007.