Moral Hazard

1. Moral Hazard ManEc 300 Prof Bryson

2. Definition: Post-contractual Opportunism • The definition: • MH is the form of post-contractual opportunism that arises because actions that have efficiency consequences are not freely observable and so the person taking them may choose to pursue his or her private interests at others’ expense.

3. Definition: Post-contractual Opportunism • The term originated in the insurance industry, where the tendency of people was observed to change their behavior in a way that led to larger claims against the insurance company (e.g., being lax about taking precautions to avoid or minimize losses

4. Important Principles • When those with critical information have interests different from those of the decision maker, they may fail to report completely and accurately the information needed to make good decisions.

5. Important Principles • When buyers cannot easily monitor the quality of the goods or services that they receive, there is a tendency for some suppliers to substitute poor quality goods or to exercise too little effort, care, or diligence in providing the services.

6. Information and Monitoring • Cases of MH often have the crucial feature of insurance: the decision makers do not bear the full impact of their decisions. The difficulties of monitoring permits them to avoid bearing the full costs and benefits.

7. Examples of Moral Hazard • 1. Doctors in the US protect themselves from malpractice suits by practicing conservative medicine, ordering tests and procedures that may not be in the patient’s best interests and, in any case, are certainly not worth the costs, which are borne by the patient or the insurer, not by the doctor making the decision.

8. Examples of Moral Hazard • 2. Some firms may make shoddy or unsafe products when quality is not easily observed.

9. Examples of Moral Hazard • 3. Security brokers may “churn” their clients’ portfolios, encouraging them to trade more frequently than they really should because each additional trade generates commissions for the brokers.

10. Examples of Moral Hazard 4. Rented apartments and housing may be less well maintained than owner-occupied ones because the renters do not get the full benefits of their efforts at maintenance

11. Examples of Moral Hazard • 5. An office employee may spend time during the day studying for an accounting exam, thinking about a new business idea that he or she hopes to pursue, or chatting on the phone with friends when there is work waiting to be done. • All sorts of shirking are MH problems.

12. Examples of Moral Hazard 6. Senior executives may pursue their own goals of status, high salaries, expensive perks, and job security rather than the stockholders’ interests, and so they may push sales growth over profits, treat themselves to huge staffs and corporate jets, and oppose takeovers that would lead to their dismissal but would increase the value of the firm.

13. Principal-Agent Relationship • Each of these examples can be cast in terms of an agency relationship • One individual (the agent) acting in behalf of another (the principal), is supposed to advance the principal’s goals.

14. Principal-Agent Relationship • The MH problem arises when agent and principal have differing objectives and the principal cannot easily determine whether the agent’s actions are being taken in pursuit of the principal’s goals or are self-interested misbehavior.

15. Case Study: The US Savings and Loan Crisis • These three elements of MH were responsible for the generation of one of the greatest crises in recent US financial history. • -- divergent interests, • -- decision makers being insured against some of the consequences of their actions, and • -- monitoring and enforcement being imperfect.

16. Case Study: The US Savings and Loan Crisis • Savings and Loan associations (S&Ls) borrowed money from the public (deposits) and loaned it out again (like banks), traditionally this was almost always for home mortgages. • The deposits were insured by a federal agency, until 1990 the FSLIC, which was established in the 1930s to protect depositors against bank failures. (Designed to eliminate bank “runs.”)

17. Case Study: The US Savings and Loan Crisis • At the time the crisis arose in the 1980s, the S&Ls were limited in how they could invest their funds. Primarily, they invested in home mortgages, making loans secured by the mortgage, to individual home buyers. During the 1980s many S&Ls turned to much riskier investments, including loans on commercial real estate and high-yielding but very risky corporate borrowing called “junk bonds.”

18. Case Study: The US Savings and Loan Crisis • In this period the commercial real estate market collapsed in several parts of the country, borrowers ceased payments on their loans, the S&Ls were left holding property they could not rent or sell. • Defaults by some corporations on their junk bonds undercut the value of all high-risk debt, further reducing the S&Ls’ assets.

19. Case Study: The US Savings and Loan Crisis • Fraud became widespread through the industry. • Over 500 S&Ls slipped into bankruptcy. The FSLIC’s reserves couldn’t cover the protection needs and US taxpayers faced the bill -- hundreds of billions of dollars of bad investments.

20. Case Study: The US Savings and Loan Crisis • The cause of all this was moral hazard. • The insurance relieved the depositors of investigating the integrity of the S&L invested in, and the S&Ls of the need to accept the burden of responsibility for their own risky investments or to shy away from fraud.

21. Case Study: The US Savings and Loan Crisis • In the early 1980s “deregulation” relaxed the regulations controlling the sort of investments the S&Ls could make. The amount of insurance afforded to each depositor was increased and the resources devoted to enforcing the regulations were reduced.

22. Risk-taking under Moral Hazard • Risk-taking of the S&Ls was encouraged by these institutions because when returns were high, the owners gained exceptionally high profits. When low (not enough earnings to pay depositors’ claims) the FSLIC absorbed the rest of the loss. As long as investments were financed by borrowing, the borrowers would have an incentive to undertake riskier investments than the lenders would want.

23. Risk-taking under Moral Hazard • Competition actually intensified moral hazard of the S&Ls. Many conservative S&L executives had no choice but to gamble on risky investments in order to survive. To get the cash to do so, they offered higher interest rates on their deposits than were being paid by the competition.

24. Risk-taking under Moral Hazard • To stay in business, others also eventually had to raise their interest rates. Given their operating costs, these rates were higher than they could pay from their normal, relatively safe investments.

25. The Story Continued • In 1979 and 1980, a change in monetary policy by the Fed caused interest rates to shoot up throughout the economy. The S&Ls had much of their money tied up in long-term, fixed-rate mortgage loans, the rates on which were less than what they would now have to pay for their deposits.

26. Aggressive entrepreneurs stepped in to buy the failing companies at low prices, trying to make them profitable by radical means -- offering savers very high rates on large ($100,000) deposits and investing in risky commercial real estate, “junk bonds,” and other similar ventures. • Soured, risky investments brought not only losses, but fraud as well. Top S&L officers made loans to themselves, their other companies, their friends, and their family members at reduced interest rates and without adequate collateral.

27. The Story Continued The Whitewater Kids • They paid large dividends to investors and generous salaries to themselves and their relatives, even as their firms were sliding into bankruptcy. They would loan extra money to clients unable to make payment on their loans, increasing their losses. There was fraud in at least 25 percent of the S&L bankruptcies.

28. Moral Hazard and the S&Ls • The MH involved in the S&L crisis: • -- S&L owners who made excessively risky investments or committed fraud. • -- depositors who failed to monitor the S&L investments because they were insured.

29. -- the politicians who favored the industry at the expense of the general taxpayer, raising the amount of insurance the FSLIC could provide, relaxing regulations on their loans, and not monitoring. When the S&Ls first headed for financial trouble, politicians blocked the regulators from intervening to protect the FSLIC and the taxpayers.

30. Government Insurance and Moral Hazard • Government insurance programs seem to have severe difficulties with MH.

31. Government Insurance and Moral Hazard Look at some of the major governmental insurance and guarantee programs, estimated to involve commitments of more than $5 trillion, c. twice the U.S. national debt and five times annual federal government spending.

32. The Pension Benefit Guarantee Corporation • The PBGC was established in 1974 to ensure that promises of retirement benefits made by employers would be honored. • In the case of default, it collects what it can from the company that terminated the plan and uses the proceeds to pay the pensioners.

33. To finance the remainder, it collects a tax called an insurance premium imposed on other pension plans. The act allowed dramatic under funding of certain kinds of plans, and many plans aggressively expanded benefits beyond what their limited funds could possibly justify. • When some of the plans later terminated, the PBGC held the bag for the promised benefits.

34. Federal Crop Insurance Program • The FCIC was established in 1939 to protect farmers against crop losses caused by the vagaries of weather.

35. . But the Corporation has few inspectors and has been raked by fraudulent claims. • --Some farmers have defrauded the FCIC by claiming crop losses in one name and selling the harvest in another. • --One crop was planted 30 days after the freeze that had triggered the insurance payment.

36. Federal Crop Insurance Program • Even without fraud, MH arises. Insured farmers may take greater risks by planting less hardy or more water-thirsty crops than is prudent. If they don’t make it, no problem the FCIC pays.

37. The Government National Mortgage Association • The GNMA exists to make it easier for homeowners to obtain mortgage loans, mostly by providing insurance to lenders against defaults on the mortgages they write.

38. The Government National Mortgage Association • It thus becomes profitable for brokers to write very risky mortgages. They receive a large commission to write the policy, but have little capital to lose in the event of a default. • GNMA protects itself by specifying limits on the loan amount as a proportion of appraised property value.

39. The Government National Mortgage Association • But appraisals are subjective and unscrupulous brokers have on occasion vastly exaggerated the value of properties in order to justify large loans, leading to default and large losses paid for by the taxpayer while the borrower and the broker profit.

40. Student Loans • Federal government guarantees enable many students to obtain loans on more favorable terms than the market would provide. • Incentives for the banks to ensure collectibility are blunted by government guarantees. .

41. Student Loans • Not surprisingly, a huge proportion of guaranteed student loans aren’t repaid. Just tracking who the debtors are often exceeds the government’s capacity to administer the loans.

42. Private Insurance Less Hazardous • Problems seem less severe in the private sector, since private corporations cannot sustain such large losses without going bankrupt. • Nor can they rely on taxpayers to pay for their financial ineptitude. • The private sector will not, of course, undertake socially desirable insurance programs in which the costs of MH are high.

43. Problems of Government Insurance • Some governmental programs could cut losses if regulations were tighter and inspectors more plentiful. • The “output” or effectiveness of inspectors is not easily measured though, so when there are large budget deficits, the false economy of reducing the number of monitors on government payrolls becomes appealing.

44. Problems of Government Insurance • Moving insurance programs to the private sector reduces the potential MH somewhat, but not completely, of course. • Some socially desirable programs (as chosen by the electorate) would be lost if all guarantees and insurance programs were cancelled.

45. Primary Cause of MH in Organizations The problem is shirking. • Frederick Taylor, father of “scientific management” wrote: “Hardly a competent worker can be found who does not devote a considerable amount of time to studying just how slowly he can work and still convince his employer that he is going at a good pace.”

46. Primary Cause of MH in Organizations Evidence of how frequent the problem appears is seen in the many ways firms provide incentive or performance contracts to workers: • piece rates for manufacturing workers, • bonus clauses for large numbers of touchdown passes caught by pro football players, • pay linked to sales,

47. Primary Cause of MH in Organizations • pay linked to productivity improvements, • pay linked to profits (including employee stock ownership plans), • Japanese annual bonuses tied to firm profitability, • various executive compensation schemes, • etc.

48. Separation of Ownership and Control and Managerial Misbehavior • This is a classic principle/agent problem. • Stockholders, the principles, don’t control their agents, the managers. CEOs can pursue their own goals rather than goals beneficial to the corporation’s owners.

49. Separation of Ownership and Control and Managerial Misbehavior • Some managers invest earnings in low-value projects to expand their empires (rather than pay dividends). • They retain control of badly performing corporations when other management teams could run them more profitably.

50. Separation of Ownership and Control and Managerial Misbehavior • They pay themselves exorbitantly and enjoy lavish perquisites • They resist attempts to force more profitable operations, especially by resisting takeovers that could cost them their jobs.