My Uncle Sam’s Solution To The Moral Hazard Problem

What is moral hazard?

Let’s say that you have a gambling problem. You like to bet on football, baseball, basketball, and hockey. Professional, college, or high school — it doesn’t matter. You visit your local casino to bet on cards. You bet on the coin flip at the start of a football game. You will bet on anything.

Now generally people like this will end up in trouble at some point or another if they cannot control their vice. I have seen friends of mine get into this sort of trouble. It isn’t pretty. At some point they hit a losing streak and end up owing a “bookie”, more than they have. At some point after this happens, their debts get called. If the debt is called and you don’t have the money, “something bad” will happen.

However, lucky for you, your Uncle Samuel is wealthy. When you get into trouble, you call Uncle Samuel to “bail” you out of this mess. Being a loving uncle, he gives you money to keep you from being the victim of “something bad”. Now maybe this scares you straight and you give up your gambling vice and you never gamble again. More likely than not, this “bail out” will only fuel your appetite for gambling (risk taking). Since you didn’t have to experience the pain of “something bad”, you will feel free to engage in the same destructive behavior as before. This time you might take greater risks with your bets. Why not? Your wealthy Uncle Samuel can come to your aid, and he has a lot more money than you do. So the pattern continues.

As your behavior continues, the pattern repeats itself. As you continue to get bailed out, your appetite for risk increases. This is an example of moral hazard. Moral hazard is a lack of incentive to protect against risks because someone else is bearing the risk for you. The best example of moral hazard is the treatment of large financial institutions in 2008 by the US government and related government entities.

The US government bailouts of 2008

Back in 2008, the global financial markets experienced a meltdown which was life changing for many people. While there is no one single factor that caused the financial destruction that happened during that 2nd and 3rd quarter of 2008, one of the largest factors is Moral Hazard.

“I have seen old traders and I have seen bold traders. I have not seen any old, bold traders.” – Wall Street saying, author unknown

The 2008 financial crisis caused chaos across the globe in financial markets everywhere. The US government, the US Treasury, and the Federal Reserve all worked together to keep the economy working in this time of crisis. However what they also did was enforce the understanding that large firms are not allowed to fail. They were too important in the eyes of the government.

This quiet understanding between the large financial firms and the US government has caused financial firms to grow even larger and become even more important to fail. While the size of these financial firms is not ideal, that in itself is not what causes the problems. The problems are caused because of the highly risky leveraged trading that these “too big to fail” firms are engaging in. If these firms are limited due to their “importance” in the US financial system, this will mitigate the majority of the problems inherent in being “too big to fail”

A brief history of Wall Street

Moral hazard causes financial crisis

Prior to the 1960s, Wall Street banks and financial service companies were almost entirely set up as private partnerships. Essentially what this means is that the firm makes money on an annual basis from providing services to its clients, then the partnership pays out the profits to the partners. While this type of partnership can provide some significant monetary benefit for the partners, it also provides unlimited liability to the partners individually. This means that if the partnership loses money, they might be required to pay their personal funds into the partnership to cover the loss, or if the losses are big enough, the partners could get wiped out financially.