« »

Monday, March 21, 2011

How moral hazard influences investment decisions

Moral hazard can influence investment decisions when investors overestimate the level of financial security offered by financial insurance or a financial transaction. Financial security can come in the form of insurance such as that offered by the Federal Deposit Insurance Corporation (FDIC), or it can come from perceived obligations between borrowers and lenders.(3)  Moral hazard can occur anytime risk is believed to be lower than it turns out to be due to insurance and financial activities such as hedging which in effect is like insurance.


To illustrate how moral hazard can influence investment decisions, retiree A has a FDIC insured Individual Retirement Account (IRA). Since it is insured by the FDIC, the IRA holder may believe the IRA is virtually risk free. However, the investor may have failed to take into account one of the many types of risk that his or her investment strategy aimed to reduce i.e. country risk. While this type of moral hazard is probably less risky than others, it remains a moral hazard. Riskier types of moral hazard may be those that use elaborate investment hedging techniques that are designed to insure investments. In such case the risk that the unpredictable nature of the market, or 'market risk' is accounted for, may be hazardous.

Several types of risk exist including the aforementioned country risk (3) which can directly affect national insurance programs such as the one offered by the FDIC. Other risks such as systematic risk may also be difficult to account for because they pertain to unknown or difficult to forecast future events. Even if investing strategy is enhanced via various financial strategies, any risk that affects investments can override the 'risk insurance' if  the event that allows that risk to occur is significant enough.

The problem with moral hazard is it is often a part of human nature and practical thinking. Ron Paul, a Congressman from Texas refers to how the government makes decisions using moral hazard because it is simply not feasible to try and take into account every tiny probability of something going wrong.(4) His point is that not even the government necessarily knows what it is doing 100 percent of the time yet people may feel very confident in its financial decisions thereby creating a moral hazard of their own when making investment decisions.

A very well known case of moral hazard influencing investment decisions was during the housing bubble prior to 2007. Investment banks that created mortgage backed securities that were supposed to be insured using mortgage default swaps were making investment decisions strongly influenced by moral hazard. Interestingly, this moral hazard was well observed by researchers such in a 2004 report called 'Testing for Adverse Selection and Moral Hazard in Consumer Loan Markets' by Wendy Edelberg.

In the report, Edelberg finds strong evidence supporting the high risk lower credibility borrowers actually take.(2) Thus assets bought under such risk when re-packaged were thus riskier than insurers themselves estimated as evident in the financial problems faced by American International Group (AIG) after it became unable to honor insurance obligations following the collapse of the U.S. housing market. In the case of AIG, the insurer, the lender banks and the sub-prime adjustable rate mortgage (ARM) borrowers were all making purchase or investment decisions using moral hazard.

Sources:

1. http://bit.ly/diND3q (FDIC)
2. http://bit.ly/a8W78h (Edelberg)
3. http://bit.ly/5FcA0m (Investopedia)
4. http://bit.ly/c7GVCo (Ron Paul)
5. http://bit.ly/a9cwzi (The Economist)