Part 1: Moral Hazard Defined

In this blog series I am going to cover off Moral Hazard and some ponderings (unfounded) about how we may be seeing this manifest in the modern era.

The Fall of Evergrande Group

You will have read, watched or heard lately about the possible impending default for Evergrande Group. China’s largest property development company, building over 600,000 homes per year, has accumulated in excess of USD$300bn of debt and is rumored to be defaulting on its interest payments. There have been comparisons to Lehman Brothers in 2008 and concerns raised over the possible impact on both the Chinese domestic and international markets.

The fear is that if Evergrande were to go bankrupt, it would set off a cascade of events that would have a catastrophic effect on the economy and society. Lenders would incur losses and retreat from the market, builders and other producers would face huge losses and lack of demand, average people would lose their investment in off plan properties and the business, jobs would be lost and many other things. It is, as the name Evergrande may suggest, ‘too big to fail’.

That fear has prompted talk of the Chinese Central Bank and Government intervening to prevent this, much like the US did in 2008 during the financial crisis. This intervention is deemed by many as necessary, with the consequences of not doing so being so dire. Those opposing this often raise the specter of Moral Hazard, and that is what I want to talk about today.

What is Moral Hazard?

Moral Hazard is well defined by the Economist Paul Krugman as ‘any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly’. It’s origins come from the insurance industry where the behavior of parties often change when insured, as they no longer fully bear the costs of that behavior (the insurer pays out). It extends to other industries in the format of public sector bailouts. This was most extensively seen during the Global Financial Crisis with the bailouts, risk insurance and other assistance the US Treasury, Federal Reserve and other Government entities provided the banking and insurance sector during that time.

The argument to do so was, as above, that the impact on the global economy would be catastrophic if these major organisations failed (think AIG, Bear Stearns, Goldman Sachs etc.). These organisations all contained financial contracts that were intertwined with almost every other financial institution and, as we saw, the prospect of, or indeed real failure of these institutions resulted in a freezing of the Money Markets (think business lending) and near complete erosion of liquidity in all markets. This flows to significant corrections in asset prices, job losses and massive economic downturns. Everyone will recall the trope of ‘too big to fail’ that did the rounds during that time. This, however, can create Moral Hazard.

The Effects of Moral Hazard

If institutions believe they are ‘too big to fail’ and will be bailed out by the government (or in the case of Long-Term Capital Management, the private sector) then they are likely to take risks beyond what they usually would if they believed that failure and true personal financial loss were a real prospect. In 2008, this was most widely seen in the Securitisation industry. Securitisation is where mortgage originators sell down the mortgages to third party investors. These parties then bear the risk of those mortgage failures (in exchange for the return). The incentive therefore sits with originating as many mortgages as possible and not necessarily the quality of those mortgages. This resulted with a large amount of investors and others holding onto assets that were massively mispriced and overly risky. In the normal course of business, the investors would wear the losses incurred on those assets and suffer the consequences of not adequately assessing the risk of their investments.

In the sub-prime crisis, however, the national credit authorities (Federal Reserve & Treasury in the US) assumed the ultimate risk and therefore losses on behalf of the citizenship. Purchase of assets (TARP), capital injections (in some cases nationalization) and massive amounts of money printing injected security and liquidity into the market thus ‘bailing out’ the lenders. There was also foreclosure relief legislation passed providing assistance to homeowners to avoid foreclosure on loans.

To be fair to the government and authorities, there were legislation and rules put in place in an attempt to curtail risky behaviour and prevent a repeat of these events. There were better capital requirements put in place for banks and some rulings around compensation packages for those that accepted government assistance.

What does this all mean?

It is hard to ascertain if the bailouts have had the desired effect of providing for economic recovery and growth and the prevention of a further crash. On the one hand, we have seen (prior to Covid) some economic recovery and growth for much of the world. On the other, there has been an enormous public and private expansion of credit to fuel that growth, arguably providing the ingredients for another credit event in the future. Did the bailouts spur further reckless lending and investment behaviour?

My belief is that the events of 2008 and more recently, the reaction to Covid 19 has demonstrated a desire to avoid an economic correction at all costs. This has resulted in an environment that has allowed for continued expansion of credit and greater systemic risk in the global economy. Borrowers and lenders are allowed and at times encouraged to trade with little regard to risk.

In Part two of this series next week, I cover the overleverage in both the agri and private sectors of New Zealand and the bank and government response to both in challenging times.