Moral hazard: If you are not taking socially excessive risks, you aren’t doing your job

Tyler Cowen recently quoted from a paper by Cheng, Raina and Xiong (in the AER) on the banking crisis:

We analyze whether mid-level managers in securitized finance were aware of a large-scale housing bubble and a looming crisis in 2004-2006 using their personal home transaction data. We find that the average person in our sample neither timed the market nor were cautious in their home transactions, and did not exhibit awareness of problems in overall housing markets. Certain groups of securitization agents were particularly aggressive in increasing their exposure to housing during this period, suggesting the need to expand the incentives-based view of the crisis to incorporate a role for beliefs.

The title of Tyler’s post is:

Further evidence that the housing crisis is about screwy beliefs, not moral hazard

But why not both?  And indeed why not 75% moral hazard and 25% screwy beliefs? What does the “moral hazard is to blame” hypothesis actually claim?

One thing it does NOT claim is that moral hazard caused bankers to begin taking excessive risks in the early 2000s.  Rather the claim is that with moral hazard bankers would always take excessive risks, and that they got a “bad draw” around 2006-09.  Thus without FDIC, banks might target a loan portfolio with risk X, and with FDIC and TBTF they might target a loan portfolio with risk factor 3X.  But even with FDIC and TBTF, the subjective probability that the typical bank’s loan portfolio will lead to bankruptcy will be rather low.

It seems like all I write about these days is cognitive illusions.  When the once in a century bad draw occurs, it will be tempting to focus on the specifics of that event, and not the underlying regulatory regime that leads to this size disaster occurring once a century, instead of once a millennia.  And then of course there is also the issue of unstable monetary policy, which makes these black swans somewhat more frequent.  It will also be overlooked.

I am not saying there weren’t lots of screwy forecasts—as I indicated the bankers did make some poor choices (underestimating black swans) and deserve some of the blame for the crisis.  As do all the government regulators that encouraged them.  BTW, I am indebted to Neil Wallace for the observation that a banker is not doing his job unless he is taking socially undesirable risks.

The irony here is that while the government should be encouraging less risk taking (I defer to John Cochrane on the best methods) they were encouraging even more excessive risk taking than the bankers actually took.  It would be like giving your teenage son the keys to the car, and then topping it off with a gift certificate to buy beer.

PS.  Of course “cognitive illusion” is an easy charge to throw around.  Let it be noted that while I consider myself above average at avoiding them, Tyler Cowen is a world class avoider of cognitive illusions.  So keep that in mind when evaluating who is right in this case.

Traveling today–comments may be delayed.  



40 Responses to “Moral hazard: If you are not taking socially excessive risks, you aren’t doing your job”

  1. Gravatar of dave dave
    30. August 2014 at 16:49

    Tyler’s observation is interesting, but meaningless. Until you attach names and job descriptions the data is suspect. Wall St is remarkably specialized. Those having the macro/micro view of the loans generated and securitized is very small. Plenty of cogs were limited to working on their small piece of the puzzle. It is further diluted by status. E.G. I will make a bad investment if the net benefit compensates me for the loss. In practice,the nicer house and club membership makes the wife happy and possibly leads to more/better business opportunities.
    There is no indication in the study cited that tells me what people knew, or believed.

  2. Gravatar of Major.Freedom Major.Freedom
    30. August 2014 at 17:03

    Sumner is right. Moral hazard and wrong/illusory beliefs are not mutually exclusive. In fact, they often go together.

    Moral hazard often prevents bad beliefs from being nipped in the bud earlier.

  3. Gravatar of Kevin Erdmann Kevin Erdmann
    30. August 2014 at 17:41

    I agree with everything here. I’m no expert on the inner workings of bank trading, but it seems to me that in addition to FDIC and TBTF, Repos are a major problem. It seems like they are a big part of the reason that the shadow banking sector was so over-leveraged. They seem to be an accounting fiction that mimics a lot of the moral hazard issues of FDIC deposits and creates them outside of the deposit-taking banking sector.

  4. Gravatar of ChrisA ChrisA
    30. August 2014 at 18:57

    As I said over at MR the people who were responding to the moral hazard incentive were the actual bond investors, not the banks. The banks in this case were an intermediary, they were basically being given a bunch of cash by people and told to invest it in housing. The bankers could well have seen this wall of money and assumed that it would continue when they made their own personal housing investments. The real question in this is whether bond investors over invested due to the implicit guarantees and whether the fall out could have been handled better to prevent such mal-investment in the future. I think it is pretty clear that there was malinvestment (I won’t call it a bubble because Scott doesn’t like that). Malinvestment however occurs all the time. Businesses invest in areas that turn out to not be as successful as they wanted. we generally don’t have systematic risk issues with this however. But I don’t know if this was the situation with housing bust. Should the US Govt have bailed out the bond holders like they did or not? I tend to lean on the side of saying they should have let the bond holders take the losses, so to prevent future issues, and use monetary policy to keep the damage spreading. That actually worked with the dotcom bust in 2000 when Greenspan basically allowed equity investors to lose trillions, but kept the economy going by his clear willingness to loosen monetary policy.

  5. Gravatar of Scott Sumner Scott Sumner
    30. August 2014 at 23:11

    Everyone, I agree.

  6. Gravatar of Brett Brett
    31. August 2014 at 00:15

    The banks in this case were an intermediary, they were basically being given a bunch of cash by people and told to invest it in housing.

    I disagree with that. They were being given tons of money . . . eventually. But even before that, and definitely during the period before 2007, they were running around selling housing-backed securities and generally promoting them as much as possible (while also trying to lobby for less oversight).

  7. Gravatar of Peter K. Peter K.
    31. August 2014 at 03:51

    As a big government, left winger I agree with Erdmann and ChrisA. There was a run on the shadow banking system. People panicked and pulled their money because there was no FDIC-type insurance backstop. If insurance had been required, the shadow banking system wouldn’t have been as profitable. It was a mistake for Greenspan to allow the system to arise unregulated.

    As DeLong has written, the Bush and Obama administrations should have followed Bagehot’s advice and enacted penalties on the bond holders and taken equity stakes in exchange for bailouts. Fearing further panic after Lehman was allowed to fail, they were overly solicitous towards the banks. Further fiscal/monetary policy could have cushioned whatever fallout occurred from making the bondholders pay for their poor risk assessment.

    Investors suffered less from moral hazard and the belief that government would bail them out, then from the bizarre belief that housing prices would never go down. There was no memory of a financial crisis of such magnitude. This bled into policy making as deregulation became the rule and government regulatory agencies were corrupted as credit agencies gave toxic MBSs AAA ratings and credit standards were weakened.

  8. Gravatar of Motorcycle Crashes Motorcycle Crashes
    31. August 2014 at 06:02

    What is the role of the Fed? With the idea of having the oversight powers of the Fed expanded, it seems critical to understand what the Fed was designed to do in the first place. Can anyone tell me if it is fulfilling that role and if it is subject to regulation itself on any level now?

  9. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    31. August 2014 at 06:39

    ‘…deregulation became the rule and government regulatory agencies were corrupted….’

    Sounds like deregulation would have been just the proper medicine for a corrupt regulatory system. No?

    Are you sure there was ‘deregulation’?

  10. Gravatar of Joel Aaron Freeman Joel Aaron Freeman
    31. August 2014 at 11:31

    from “The National Homeownership Strategy”, 1995:

    “Many low-income families do not have access to sufficient funds for a downpayment. While members of the partnership have already made significant strides in reducing this barrier to home purchase, more must be done. In 1989 only 7 percent of home mortgages were made with less than 10 percent downpayment. By August 1994, low downpayment mortgage loans had increased to 29 percent….The [political] partnership should support continued Federal and State funding of targeted homeownership subsidies for households that would not otherwise be able to purchase homes.”

    from “Fragile By Design”:

    “Politics was driving the decision making. A July 14, 2004 email from senior vice president Robert Tsien to Dick Syron, chair and CEO of Freddie Mac, suggests as much: ‘Tipping the scale in favor of no cap at this time was the pragmatic consideration that, under the current circumstances, a cap [on no-doc lending] would be interpreted by external critics as additional proof we are not really committed to affordable lending.’ “

  11. Gravatar of Lorenzo from Oz Lorenzo from Oz
    31. August 2014 at 17:06

    One thing Calomiris & Haber point out in “Fragile by Design” is that regulatory authority was given to the Fed partly so as to insure it would be diffident in using it.

    In Australia, we have a separate authority, the Australian Prudential Regulatory Authority (APRA) which deals with such matters.

    Our “bank bargain” is that the big four banks (ANZ, NAB, Westpac, Commonwealth) get ring-fenced but have to put up with balancing prudential regulation. (Pausing here, at one stage the market capitalisation of Australian banks–pop 23m–was greater than the market capitalisation of all the Eurozone banks–pop 334m. A WTF moment.)

    This is why I get impatient with blaming things on “deregulation”. Australia was a avid financial “de-regulator”, it just balanced out the guarantees.

    The US also had “deregulation” but it handed out “too big to fail” subsidies and implied GSE guarantees without balancing the prudential regulation. Naturally the financial system inflated and naturally it turned out to have poorly balanced risk structures. And the belief that housing prices would not go down is surely just a manifestation of not balancing risks properly–you have x loans, you need y backing regardless of what you think about any particular market.

    So, handing out even more guarantees to the shadow banking sector without balancing prudential requirements seems an implausible “solution”.

  12. Gravatar of Lorenzo from Oz Lorenzo from Oz
    31. August 2014 at 17:23

    I should add that I agree the problem for the real economy was incompetent monetary policy.

    Nevertheless, central bankers should not be bank regulators (lender of last resort is a different matter). They should certainly not be required to worry about asset prices as such, just be prepared to provide liquidity if required.

    After all, the fire brigade is not expected to be building regulators.

  13. Gravatar of Andrew_M_Garland Andrew_M_Garland
    31. August 2014 at 18:30

    “A banker is not doing his job unless he is taking socially undesirable risks.”

    Wow. I am not nuanced enough to understand that statement. It seems crazy. Is that the official macro economic view of what banks and the Federal Reserve should do?

    Private investors can take any risks they want because they are paying for the opportunity. If they lose money, then it is their own money or the money of privately accountable signers-on.

    Public banks insured by government agencies are not supposed to take “undesireable” risks in any form. They are supposed to be diversified and invested in projects with easy analyses so they will almost never lose money.

    Classic analysis of housing loans denied loans to people and projects that did not have at least 5:4 coverage (20% down). Government directives persuaded banks to accept much more risk, a supposedly “socially desirable” risk, and it blew up.

    Now Mr. Sumner says that banks should be taking socially UNDESIREABLE risks! What could those be? And more, insured by public guarantees.

  14. Gravatar of Luis Pedro Coelho Luis Pedro Coelho
    1. September 2014 at 00:34

    As a mostly-efficient market believer myself, I think that the moral hazard hypothesis applies to market behavior, not individual players. In fact, the selection of the individual players and their beliefs are, at least partially, caused by incentives.

  15. Gravatar of Ralph Musgrave Ralph Musgrave
    1. September 2014 at 01:21

    James Tobin drew attention to the “risk encouraging” effects of state support for banks in two papers a few decades ago. See:

    His conclusion (shared by Milton Friedman and John Cochrane) was that the bank industry should be split in two. On half would simply accept deposits which would be lodged in a totally safe manner (e.g. at the central bank and/or invested in short term government debt). The second half would offer normal loans to mortgagors, business, etc, but that would be funded just by shares. That way, it’s virtually impossible for banks to suddenly collapse, though a SLOW DECLINE resulting in a takeover by a stronger bank would be perfectly possible.

  16. Gravatar of TravisV TravisV
    1. September 2014 at 06:12

    Prof. Sumner,

    Noah Smith just wrote a fascinating new post on China and Russia:

    Is he right that China’s leadership regime has strong geopolitical ambitions? It always seemed to me that the regime is very pragmatic and concerned primarily with self-preservation (and therefore economic growth). But maybe I’m wrong……

  17. Gravatar of Philippe Philippe
    1. September 2014 at 08:07


    “That way, it’s virtually impossible for banks to suddenly collapse”

    You think it’s virtually impossible for a business to become insolvent?

  18. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. September 2014 at 09:08

    In honor of Labor Day, enjoy a clip from the greatest movie ever made about labo[u]r relations;

  19. Gravatar of Ralph Musgrave Ralph Musgrave
    1. September 2014 at 09:44


    Banks are different to other businesses. Essentially a bank just borrows $X from depositors, bondholders & shareholders and lends the money to mortgagors, etc. If for example 95% comes from depositors and bondholders and the mortgages drop by more than 5% in value, the bank is technically or actually insolvent.

    On the other hand if a bank or other lending entity is funded just by shareholders, and the mortgages are a disaster (say they drop to 25% of face value), the bank is not insolvent. All that happens is that the shares drop to about 25% of their face value.

  20. Gravatar of ssumner ssumner
    1. September 2014 at 10:26

    Andrew, I think you misunderstood my comments. I meant “maximizing shareholder wealth” when I referred to the bankers doing their job. I certainly agree that it would have been socially desirable if banks had taken less risk.

    Travis, Just the opposite, I think China has very weak geopolitical ambitions.

  21. Gravatar of John Carney John Carney
    2. September 2014 at 07:17

    Really, credit should go to Jeffrey Friedman and Wladimir Kraus for advancing the argument that ignorance and error played a much stronger role in the events leading to the crisis than is typically realized.

    Good summary of this is here:

  22. Gravatar of TravisV TravisV
    2. September 2014 at 09:35

    Prof. Sumner,

    You might enjoy this long conversation between Krugman, Steve Randy Waldman and Kevin Drum:

  23. Gravatar of TravisV TravisV
    2. September 2014 at 09:50

    ???? China: Soft landing vs. hard landing

    Michael Pettis:

    “The choice, in other words, is not between hard landing and soft landing. China will either choose a “long landing”, in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing – a few years of continued growth of 6-7% – followed by a collapse in growth and soaring unemployment.

    A “soft landing” would, in this case, simply be a prelude to a very serious and destabilizing contraction in growth. Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms that it knows it must implement. A “soft landing” should increase our fear of a subsequent “hard landing”. It is not an alternative.”

  24. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    2. September 2014 at 10:07

    Brad DeLong is professing to be baffled by this;

    ‘During the first and second quarters of 2014, the velocity of the monetary base2 was at 4.4, its slowest pace on record. This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession. This implies that the unprecedented monetary base increase driven by the Fed’s large money injections through its large-scale asset purchase programs has failed to cause at least a one-for-one proportional increase in nominal GDP. Thus, it is precisely the sharp decline in velocity that has offset the sharp increase in money supply, leading to the almost no change in nominal GDP (either P or Q).’

  25. Gravatar of Scott H. Scott H.
    2. September 2014 at 10:45

    Hello Scott!

    I would really like some examples to support this claim…

    “the gov’t was… encouraging even more excessive risk taking than the bankers actually took.”

  26. Gravatar of Lorenzo from Oz Lorenzo from Oz
    2. September 2014 at 12:37

    Scott H: The short answer is “too big to fail”. For a more elaborate answer, read “Fragile by Design”, which I review here.

  27. Gravatar of ssumner ssumner
    2. September 2014 at 13:46

    Everyone, Thanks for the links.

    Scott, There are many many examples. Congress and the President (both parties) were encouraging more lending in almost every way possible. They leaned heavily on the banks, they leaned on Fannie and Freddie, they gave tax breaks for home mortgages, etc etc. The goal for the GOP. was a home ownership society. For the Dems it was low income borrowers, and for both parties it was helping the bankers, realtors, home builders, etc.

    BTW, I am not claiming this pressure CAUSED the crisis. That’s a separate debate. rather my claim is that the government (both parties) supported the madness. That’s a problem for the argument that more regulation would have helped. If they had done more regulation, it would have been even more pressure on bankers and GSEs to pump up housing.

  28. Gravatar of TravisV TravisV
    2. September 2014 at 19:20

    Good new post by Nick Rowe:

    “It’s the Inflation Fallacy, duh!”

  29. Gravatar of Chuck E Chuck E
    3. September 2014 at 07:01

    Interesting take by Bill Gross about our “Credit based” economy.

  30. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    3. September 2014 at 09:30

    Turns out that it was fiscal policy that had ‘shot its wad’. Cash for Clunkers provided $3 billion of dis-stimulus during the recession;

    ‘We estimate that over the ten-month period during which the programme had no effect on the likelihood of purchase, barely eligible households who purchased under the programme spent an average of five thousand dollars less on new vehicles than did barely ineligible households. In short, while both groups of households were going to buy vehicles sometime during the next ten months, the difference is that barely eligible households were incentivised to purchase earlier and spend less.’

  31. Gravatar of Kevin Erdmann Kevin Erdmann
    3. September 2014 at 10:19

    TravisV, the fundamental axiom of modern Progressivism is “Poor people are stupid. Rich people are evil.” Issues where the poor and rich agree, like inflation-phobia, only serve to confirm this axiom, as do all other issues where “the rich” either side with or differ from “the poor”.

  32. Gravatar of Major.Freedom Major.Freedom
    3. September 2014 at 16:58

    Kevin Erdmann:

    Inflationism is deflation-phobia, and deflation-phobia is where stupid rich people and evil poor people agree.

  33. Gravatar of TravisV TravisV
    4. September 2014 at 04:26

    Positive surprise from the ECB this morning:

    However, it’s unlikely to have much positive impact, right?

  34. Gravatar of TravisV TravisV
    4. September 2014 at 05:39

    Is anyone else worried by the high odds analysts and the market are estimating for Rand Paul to be the 2016 Republican nominee?

  35. Gravatar of Kevin Erdmann Kevin Erdmann
    4. September 2014 at 09:26

    +1 Major. Touche.

  36. Gravatar of TravisV TravisV
    4. September 2014 at 11:08

    Good stuff from Bryan Caplan, Nick Rowe and Lorenzo from Oz:

  37. Gravatar of ssumner ssumner
    6. September 2014 at 17:58

    Travis, Isn’t Rand Paul less bad than the others? At least he’s raised questions about militarism, the war on drugs, and civil liberties.

  38. Gravatar of TallDave TallDave
    8. September 2014 at 06:02

    In the case of housing, the government deliberately set out to create “cognitive illusions” by destroying information in the lending sector. The systemic effects of this should have been totally predictable: increased risks that no market participant could be aware of.

  39. Gravatar of TallDave TallDave
    8. September 2014 at 06:10

    Of course, all the same people who said the policy of promoting home ownership now blame the whole mess on “greed.” It’s reminiscent of the internal reports on every failed Five Year Plan.

    This was all definitively debunked years ago, of course, but the truth has sufficient complexity that those who wish to can persuade themselves it isn’t true.

  40. Gravatar of TallDave TallDave
    8. September 2014 at 06:11

    s/b Of course, all the same people who said the policy of promoting home ownership wasn’t going to increase risk now blame the whole mess on “greed.”

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