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Can You Say, "Moral Hazard?"

January 11, 2009, 1:20 pm

Moral hazard is the term for what occurs when one shelters an entity from the full cost or downside of taking risks.   The result is that the entity will tend to take on more risk than it would have had it had to bear the full costs.  For example, if a company knows that the government will make up the shortfall if its pension investments suffer, it will tend to invest in high-risk, high-return investments that reduce the company's need to contribute funds in the good years.   This is sometimes called privitizing profits and socializing losses.

One of the problems with demonstrating moral hazard is that the hazard often occurs years after the action (usually a government action) that creates the hazard.   But this week we have an amazing opportunity to see moral hazard operating within days of a government bailout:

Immediately after GMAC became eligible for TARP money, GM reduced to zero the interest rate"¦ on certain models. This, of course, penalizes GM competitors, including Toyota, Honda and other "transplants" whose cars are made in America by Americans for Americans, and Ford, which does not have the freedom of maneuver conferred by TARP money because Ford is not taking any"¦

GMAC has begun making loans to borrowers with credit scores as low as 621, a significant relaxation of the 700 minimum score the company adopted just three months ago as it struggled to survive. America's median credit score is 723"¦

If you pay people trillions of dollars in response to a bad behavior (in this case, credit lenience) then you will just encourage more of that behavior, even if everyone achnowleges it to be a bad behavior.

Tags: , , , ,
Category: Economics, Government
  • HS

    It is very easy for people to think a certain way. That certain way has usually been done on purpose.

    Maybe Cerebus, who owns 51% of GMAC and Chrysler, forced GM and Chrysler to talk.
    Maybe part of the force was to increase credit rates above 700 to push GM.
    Maybe Cerebus pushed GM into tapping the government for help. Or maybe it was a way to show the government it was struggling (by pushing up credit requirements, that also reduces sales).

    I am sure these are just your views but lets not get so blind sided into thinking a certain way. We should explore all posibilities and be sceptical of everything. When we are not, we become brainwashed into thinking certain ways.

  • Zach

    "GMAC has begun making loans to borrowers with credit scores as low as 621, a significant relaxation of the 700 minimum score the company adopted just three months ago as it struggled to survive. America’s median credit score is 723"

    Last year it was the real estate bubble, so is this the year of the car bubble? If repossessing lots of homes (normally an appreciating asset) winds up crushing banks, how will repossessing lots of cars (a depreciating asset) work out for 'em?

    I've got an idea: let's put these clowns in charge of health care.