Moral Hazard

I am learning about a lot of different things as I work on this blog. It has become a part of both my financial and my spiritual life. Sometimes I learn things that I would rather not know about, but we live in interesting times. While reading reports in a variety of sources concerning the ongoing financial debacle, I have discovered a new term, moral hazard. It seems to be used in two ways, neither is very good.

The first definition seems to come from game theory. The principal agent problem is pervasive in our society. It occurs when someone with more power, the principal, attempts to control the behavior of someone with less power, the agent, through a set a rules that ideally provide sufficient rewards to assure behavior by the agent that benefits the principal. The problem is that the interests of the principal and the agent seldom coincide. As it is written, “The camel has his schemes and the camel driver has his schemes.”

In the recent catastrophes suffered by organizations like AIG, a particular type of the principal agent problem, termed moral hazard, occurred. The agent, in this case the management of AIG rigged the game against the interests of the principals, the shareholders. By insulating themselves from the negative consequences of risky behavior, the management created a situation where they could not lose, but their principals, the shareholders could be totally wiped out. As they were entering into a variety of insanely risky ventures, the agents paid themselves enormous bonuses running into millions of dollars per individual per year. If the gamble paid off the agents would all be billionaires and the stock price would rise significantly. If the gamble failed, they were already millionaires and if they were fired, their contracts guaranteed golden parachutes in the $20 to $60 million range. Imagine that, getting a $40 million dollar firing bonus for wrecking a great financial institution. That is just what Charles Prince of Citibank received after destroying something like 60% of his company’s value.

Moral hazard also seems to be used when describing situations where bad behavior is rewarded and virtue is punished. In numerous psychological studies, it has been proven that behavior can be modified by means of rewards. In fact psychologist managed to teach a pig to ride a little toy bicycle using nothing but food rewards. One of the maxims derived from these studies is, “If you want more of a particular behavior, reward it.” Using this definition our government is engaged in so many different kinds of moral hazard, it would be hard to list them all. For example the government recently fired the chairman of GM. He walked with something like a $23 million golden parachute. I have lost track of how many billions of my current and future tax dollars have been spent on GM and Chrysler. The primary beneficiary will be the United Auto Workers, who have a share in responsibility for the demise of their company. The bond holders, who were willing to place their hard earned money at risk under a contractual arrangement providing certain guarantees, have been told to go pound sand. AIG, Citibank, Fannie Mae, Freddie Mac, and others deemed too large to fail are receiving benefits paid for by healthy responsible corporations, in some cases their direct competitors. The government is underwriting and rewriting mortgages that benefit the irresponsible at the expense of individuals who bought less house than they could afford and paid it off in less than the required 30 years. Finally, the government is offering to pay people a bonus to trade in their worthless old gas guzzling SUVs to buy a new more efficient automobile. If you bought a reliable car that gets 28 miles per gallon, you are out of luck.

Such behavior does have extraordinary bad effects in the real world. The link below connects to a half hour news documentary on the current economic condition of Las Vegas. It includes footage of a real “no notice” eviction. A renter with a valid lease, who paid his rent on time, is thrown out of his house without warning because the landlord took his money but did not use it to pay the mortgage. I could not believe that such an example of moral hazard could occur in this country but it did. Be warned, while this is a primetime news special, it deals with Las Vegas, ground zero for all sorts of moral hazards not covered by the two definitions listed above. If you are exceptionally sensitive to such things you might want to pass on this one. I would rate it PG-13.

http://www.youtube.com/watch?v=rFTZ3flsipE

None of this is new. King David railed on economic injustice on numerous occasions. Two of the Psalms are particularly hot. I choose to include a large portion of Psalm 37 for my concluding meditation, but I could have just as easily used the other example, maybe I will in some future post.

Psalm 37

[1] Fret not thyself because of evildoers, neither be thou envious against the workers of iniquity.
[2] For they shall soon be cut down like the grass, and wither as the green herb.
[3] Trust in the LORD, and do good; so shalt thou dwell in the land, and verily thou shalt be fed.
[4] Delight thyself also in the LORD; and he shall give thee the desires of thine heart.
[5] Commit thy way unto the LORD; trust also in him; and he shall bring it to pass.
[6] And he shall bring forth thy righteousness as the light, and thy judgment as the noonday.
[7] Rest in the LORD, and wait patiently for him: fret not thyself because of him who prospereth in his way, because of the man who bringeth wicked devices to pass.
[8] Cease from anger, and forsake wrath: fret not thyself in any wise to do evil.
[9] For evildoers shall be cut off: but those that wait upon the LORD, they shall inherit the earth.
[10] For yet a little while, and the wicked shall not be: yea, thou shalt diligently consider his place, and it shall not be.
[11] But the meek shall inherit the earth; and shall delight themselves in the abundance of peace.
[12] The wicked plotteth against the just, and gnasheth upon him with his teeth.
[13] The Lord shall laugh at him: for he seeth that his day is coming.
[14] The wicked have drawn out the sword, and have bent their bow, to cast down the poor and needy, and to slay such as be of upright conversation.
[15] Their sword shall enter into their own heart, and their bows shall be broken.
[16] A little that a righteous man hath is better than the riches of many wicked.
[17] For the arms of the wicked shall be broken: but the LORD upholdeth the righteous.
[18] The LORD knoweth the days of the upright: and their inheritance shall be for ever.
[19] They shall not be ashamed in the evil time: and in the days of famine they shall be satisfied.
[20] But the wicked shall perish, and the enemies of the LORD shall be as the fat of lambs: they shall consume; into smoke shall they consume away.
[21] The wicked borroweth, and payeth not again: but the righteous sheweth mercy, and giveth.
[22] For such as be blessed of him shall inherit the earth; and they that be cursed of him shall be cut off.
[23] The steps of a good man are ordered by the LORD: and he delighteth in his way.
[24] Though he fall, he shall not be utterly cast down: for the LORD upholdeth him with his hand.
[25] I have been young, and now am old; yet have I not seen the righteous forsaken, nor his seed begging bread.
[26] He is ever merciful, and lendeth; and his seed is blessed.
[27] Depart from evil, and do good; and dwell for evermore.
[28] For the LORD loveth judgment, and forsaketh not his saints; they are preserved for ever: but the seed of the wicked shall be cut off.
[29] The righteous shall inherit the land, and dwell therein for ever.