Moral Hazard

Kevin Dowd has written a fine article titled “Moral Hazard and the Financial Crisis” for the Cato Journal.  Some of his very well articulated points include:

  • Moral Hazard comes from the ability for individuals to benefit from gains without having an equal share in losses.  (I would add that that has almost nothing to do with government bailouts.  It exists fully in the compensation of most executives of most firms in most economies. )
  • Bad risk model (Gaussian).  That ignore abnormal market conditions. 
  • Ignoring the fact that others in the market all have the same risk management strategy and that that strategy does not work for the entire market at once. 
  • Mark to Model where model is extremely sensitive to assumptions. 
  • Using models that were not designed for that purpose. 
  • Assumption of continuously liquid markets. 
  • Risk management system too rigid, resulting in easy gaming by traders. 
  • “the more sophisticated the [risk management] system, the more unreliable it might be.”
  • Senior management was out of control.  (and all CEOs are paid as if they were above average!)
  • Fundamental flaw in Limited Liability system.  No one has incentive to put a stop to this.  Moral Hazard is baked into the system.

Unfortunately, there are two flaws that I see in his paper. 

First, he misses the elephant in the room.  The actual exposure of the financial system to mortage loan losses in the end was over 400% of the amount of mortgages.  So without the multiplication of risk that happened under the guise of risk spreading had not happened, the global financial crisis would have simply been a large loss for the banking sector and other investors.  However, with the secret amplification of risk that happened with the CDO/CDS over the counter trades, the mortgage crisis became a depression sized loss, exceeding the capital of many large banks. 

So putting all of the transactions out in the open may have gone a long way towards allowing the someone to react intelligently to the situation.  Figuring out a way to limit the amount of the synthetic securities would probably be a good idea as well.  Moral Hazard is a term from insurance that is important to this situation.  Insurable interest in one as well. 

The second flaw of the paper is the standard Cato line that regulation should be eliminated.  In this case, it is totally outrageous to suggest that the market would have applied any discipline.  The market created the situation, operating largely outside of regulations. 

So while I liked most of the movie, I hated the ending. 

We really do need a Systemic Risk Regulator.  And somehow, we need to create a system so that 50 years from now when that person is sitting on a 50 year track record of no market meltdowns, they will still have enough credibility to act against the mega bubble of those days.

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Explore posts in the same categories: Disclosure, Financial Crisis, Hedging, Risk Management, Tail Risk, Trading

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