More on the Subprime Bailout: Moral Hazard
New York Sun: Wall Street critics are coming out in force against President Bush's proposal to prevent subprime mortgage lenders from foreclosing on some homes.
Chief among the complaints is the notion of moral hazard — that borrowers who voluntarily took on too much risk are now being rewarded for their bet.
Let's review moral hazard:
Moral hazard is the prospect that a party insulated from risk may behave differently than it would if it were fully exposed to the risk. For example, an insured party's behaviour might be more risky than it would have been without the insurance. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.
Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.
Moral hazard can also occur with borrowers. Borrowers may not act prudently when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend using their cards, because without such limits those borrowers may spend borrowed funds recklessly, leading to default.
Bottom Line: Because of moral hazard alone, the subprime bailout is a BAD idea.