PAUL SOLMAN: The housing crisis, the Federal Reserve, and now Congress bailing out bad loans and lenders, like Fannie Mae and Freddie Mac, and, in the process, raising two white-hot questions.
Near term, will the bailouts patch the housing market, save the system, but, long term, might they create another crisis due to what’s being called the mother of all moral hazards, the hazard, that is, of encouraging too much risk because the risk-takers think they’re protected?
That’s what this story is about, from the strategy of the Federal Reserve, to the residents of Vernon, Florida, from the economists at Brandeis University, to this much-viewed British comedy interview on the Internet with a mock investment banker.
ACTOR: Can we talk about moral hazard?
ACTOR: About what, sir?
ACTOR: Moral hazard.
ACTOR: Yes, I know what hazard means. What’s the other word?
PAUL SOLMAN: The word is moral because of the hazard of inducing bad behavior, even with the best of intentions.
BEN BERNANKE, Federal Reserve Chairman: Helping the financial markets return to more normal functioning will continue to be a top priority of the Federal Reserve.
PAUL SOLMAN: Government bankers like Fed Chairman Ben Bernanke, that is, by bailing out lavish lenders to save the system, may create more lavish lending next time around.
The aura of safety leads to risks
PAUL SOLMAN: But moral hazard is a common economic problem, says Brandeis professor Catherine Mann, formerly with the Fed. Indeed, we encounter it every day.
CATHERINE MANN, Brandeis University: So, the car gives us lots of examples of how technological innovations or regulations could induce people to undertake more risky behavior -- seat belts, for example, and air bags.
PAUL SOLMAN: Safety innovations to reduce risk and regulations to insure their use. But the aura of safety can have just the opposite effect. Think of car insurance.
CATHERINE MANN: Theft insurance, auto theft insurance. People may not make an effort to make sure that they lock their car, take the GPS out, for example.
PAUL SOLMAN: A recent example of moral hazard is flood insurance, which bankrolls rebuilding in the same spot, thus upping the cost of devastation by the next flood.
Insurance can even provide incentives to do the bad thing being protected against, arson, for example, because the house is insured against fire. A famously grisly case of moral hazard occurred in the 1970s in Vernon, Florida. Filmmaker Errol Morris began a documentary of Vernon, known as Nub City, because its citizens had cashed in on personal injury insurance by shooting off their own fingers.
Morris wound up profiling other Vernonites, instead of the members of the so-called Nub Club, who had threatened to kill him. One of the digitally unenhanced was, however, caught on tape -- the man with the hook on the left -- in news footage of a Vernon city council brawl in the early '80s.
ACTOR: Junior Armstrong (ph) was convicted of aggravated battery and battery, and sentenced to four months in jail and fined $500.
PAUL SOLMAN: Now, if insurance were always correctly priced, this would presumably be less of a problem, even in the unruliest of towns. High premiums and/or deductibles would discourage insurance fraud.
But make insurance too expensive, and too few can afford it, especially in poorer places like Vernon.
Let's get back to finance, though, and the moral hazard of bank insurance.
The upside of insurance deposit
PAUL SOLMAN: John Ballantine was a banker in the '80s who now, as a Brandeis professor, is a depositor like the rest of us. But back then, his bank, its deposits insured, made risk-laden real estate loans that failed.
JOHN BALLANTINE, Brandeis University: And that is when the insurance, federal insurance stepped in and said, 'Whoa, we have insured your depositors. We cannot let your depositors lose money.' And that was the savings and loan crisis of the 1980s.
PAUL SOLMAN: Without deposit protection, there might have been bank runs, as depositors realized their banks had made lousy loans and couldn't recover the money.
But that protection created moral hazard, as bankers were encouraged to take too much risk, leading to the S&L debacle.
Just this week, President Bush was stressing the upside of deposit insurance.
GEORGE W. BUSH, President of the United States: The depositor must understand that the federal government through the FDIC stands behind the deposit up to $100,000, and, therefore, which leads me to say that, if you're a depositor, you're in good -- you're protected by the federal government.
PAUL SOLMAN: But there's also the downside of deposit insurance: moral hazard.
CATHERINE MANN: If the depositors never take their money out, then the bank has the incentive to lend to riskier borrowers than they otherwise would have. So, there ends up being more risk in the loans than there otherwise would be.
PAUL SOLMAN: So, is that the same basic story with bankers making loans for housing in developments like this one, say, today?
JOHN BALLANTINE: That's correct, except the one major change is that I found that I could make these loans and then package them up into securities and then sell them into the capital markets.
PAUL SOLMAN: Ah, this is this mortgage-backed securities that's so much of the story now?
JOHN BALLANTINE: Right.
PAUL SOLMAN: And so that's really not much different than having insurance.
CATHERINE MANN: Right, because he's made the loan, but he doesn't have any risk.
JOHN BALLANTINE: I have passed off the risk to someone else, and I have figured that they have evaluated that properly and have some sense of that risk.
PAUL SOLMAN: Or you don't care.
JOHN BALLANTINE: And I don't care, right. I have got the fee.
PAUL SOLMAN: So, the securitizing of loans for a fee then passed on to investors was a source of moral hazard, as was yet another supposed layer of protection -- so-called ratings agencies, company's like Fitch, Moody's and S&P, that allegedly vetted the securities to make sure the mortgages backing them wouldn't default. And even that's not all the protection there was.
JOHN BALLANTINE: And then there are these institutions called bond insurers, which make sure that the risk in the security is covered.
PAUL SOLMAN: Companies, that is, whose whole business was insuring bonds.
CATHERINE MANN: So you don't have to figure out how risky it is because you have a rating agency and you have actual insurance. So, if you're an investor, you're kind of covered twice.
PAUL SOLMAN: And so, now again, you're taking...
CATHERINE MANN: More risk than you otherwise would.
The influence of moral hazards
PAUL SOLMAN: So, in many ways, moral hazard induced bankers to take the risks that led to the crisis, which has now become the stuff of satire.
ACTOR: People are saying the crisis is likely to turn into financial meltdown. I mean, can that be avoided?
ACTOR: It can be avoided provided that governments and central banks give us -- the financial speculators -- back the money we have lost.
ACTOR: But isn't that rewarding greed and stupidity?
ACTOR: No. No.
ACTOR: It's rewarding what the prime minister, Gordon Brown, called the ingenuity of the markets.
PAUL SOLMAN: Meanwhile, at the Brandeis International Business School, we had assembled a cast to play the role of investors -- those who bought the risky mortgage-backed securities at the heart of the crisis.
Professor Alfonso Canella said there's plenty of blame to go around.
ALFONSO CANELLA, Brandeis International Business School: You can start with the homeowners, the buyers who actually were trying to get a house on zero percent down or whatever they could get. There were also the originators who were trying to just get more volume. There were also the packagers and then the rating agencies, and then us at the very tail end. So, everybody has to take the blame. There's no innocents here.
PAUL SOLMAN: No innocents because everybody was getting away with something on the assumption that they were protected.
Reducing risky loans, investments
PAUL SOLMAN: Steve Cecchetti, Brandeis professor, used to be with the Fed, representing the Fed here, investors took risks, thought they were insured, weren't, lost their money. Why did the Fed get involved?
STEVE CECCHETTI, Brandeis University: Well, the job of the Federal Reserve is to insure the system. The job of the Federal Reserve is to make certain that no one has to worry about the collapse of the system. That's what was at risk here, was that they were not -- that we were going to get up one morning and that the financial system would simply not be operating any longer.
You would go to the grocery store, you would run your debit card through at the checkout, and the payment wouldn't go through because your bank wouldn't be operating.
PAUL SOLMAN: In the process, are you now making it more likely for players in the system, like those investors over there, to take imprudent risks in the future, because they know, if they do, you will bail them out?
STEVE CECCHETTI: The total loss in the banking industry alone has been in the hundreds of billions of dollars. Bear Stearns' stock was trading at more than 10 times what the buyout price was. Employees of Bear Stearns, many of them have lost their life savings. Managers have lost their jobs. So, they clearly have not been bailed out. So, it is difficult for me to see a moral hazard problem in the current circumstance.
PAUL SOLMAN: Catherine Mann has worried since Bear Sterns was bailed out.
CATHERINE MANN: The actions they took to help resolve the Bear Stearns situation, those actions signal to the investment community that the government entity will stand as a backstop to those financial institutions and ones like those, those large financial institutions. That gives those institutions a green light to engage in riskier investments than they otherwise would have.
To that extent, they create an environment of moral hazard.
PAUL SOLMAN: Chairman Bernanke, of course, is well aware of the problem.
BEN BERNANKE: We need to take action to make sure that moral hazard doesn't induce excessive risk-taking.
PAUL SOLMAN: His solution is the classic one: government supervision in return for government largess. But if the chairman is somewhat vague about the specifics, the British comedy team of Bird and Fortune take a rather more plainspoken view.
ACTOR: The point about moral hazard is that the fault is that executives like yourself will go on making more and more stupid and more and more risky loans in order to put up the profits of their bank because, when everything goes wrong, the Bank of England is going to come along and bail them out.
ACTOR: Well, I certainly hope so. I'm looking forward to it.
ACTOR: I don't want to be insulting, but it does seem to me that you haven't learned anything from this whole episode.
ACTOR: On the contrary, I have learned one very important lesson.
ACTOR: And what is that?
ACTOR: And that is, if you are going to make a cock-up, be sure you make it an absolutely enormous cock-up, because then the government will bail you out.
PAUL SOLMAN: That the hidden long-term danger of the government's actions of the past year or so. But given the fears of the moment, it's pretty obvious why they're willing to risk it.