Moral Hazard

Moral Hazard is not a term one hears in the news on a regular basis.  Most individuals would not even know its meaning.  Briefly the term refers to the creation of loans by individuals or institutions to other individuals or institutions that have little possibility of being repaid.  The housing industry is replete with huge amounts of such loans.  Essentially, in order to sell a house or condo a loan is allowed to be originated with little money down and insufficient income to service that loan.  What used to be the normal down payment, twenty percent of the purchase price, has been reduced to a little as zero money down.  The whole point of requiring a down payment was to create a reserve in the event of loan default.  This was compounded by allowing the qualification for a loan to be based on two incomes for a married couple and a monthly payment that might be a much as half that total income.

One can see that the probability of loan servicing (paying one’s mortgage – principle and interest) drops drastically when such methods are used to originate loans.  Of course what really matters is that many of these loans end up being sold to banks and other financial groups in bundles.  The bundles may have included good loans, those with a low risk of non performance, and many loans that were high risk.  Moral hazard is high risk, to put it as plainly as possible.  And often such high risk loans were originated with very high interest rates.  If one put twenty percent down and could report an income where the mortgage payment was no more that a quarter of one’s single paycheck, then that interest rate for the mortgage was low.  Of course with the old VA loans, one did not need a down payment since the Federal government was going to secure the loan repayment in the event of non performance.  Of course interest rates for a VA loan tended to be as much as one percent higher.  One pays a price one way or another.

And we see this same problem when it comes to new car sales.  People buy too much car, put too little down, take a higher interest rate and set the stage for default in the future.  Wash, rinse, repeat.  The creation of credit has become the new coinage of money.  I know, many economists say that credit is not money but the funny thing is that my credit card spends just as easily and currency in my pocket.  The creation of credit is one method of creating hyper inflation.  Hyper inflation is really the distrust of a particular currency, that is, one is afraid that if one cannot buy goods and services quick enough one loses the value very quickly or that currency.  We have not reached a hyper inflation yet but do not think it can’t happen.  The other thing easy credit does is to create a rise in inflation.  This is one of the reasons why there has been several housing price bubbles.

Ah, but the payback is a pain.  That is, one either repays the debts or one repudiates them (also called defaulting).  The iron law of debt is that it is either repaid or defaulted.  True, one can always extend the debt repayment schedule but eventually one must either repay or default.  But why should we worry about these things?  Well, we have that thing called the national debt.  Yes, I know, the CBO has declared that the national debt has decreased.  But that is not exactly true.  If I, as an employer, promise you, an employee, a future pension the I create a future debt.  I can fund that debt each year by putting aside such monies that would nominally cover future pension payments.  But if I don’t I have an unfunded liability or future debt.  Public service unions have demanded that local and state employees be given pensions after the minimum years of service along with heath care and other benefits.  But the major problem with these future liabilities is that the local and state governments have not funded these liabilities to the degree that one can count on future collection.  What has been created through union demands is that future moral hazard where the probability of collection of one’s pension and benefits has seriously decreased towards zero.

That brings us to the problem of derivatives.  If I create a loan and believe that you will default on it, I may wish to buy some sort of insurance.  In the beginning this financial product was deemed an acceptable way of hedging one’s bets.  If you default and I have paid the premiums on the derivative, then I collect my money and the one who originated the derivative is out of luck.  Of course those who issued that derivative may have bought a derivative against such an occurrence.  Our national debt may be about 17 trillion and add in the future payments of promised pensions, social security and what not and that debt balloons by a multiple of four.  That is quite a lot of money.  But consider this.  The amount of derivatives in the world are a quadrillion or better.  The amount of moral hazard in the world is astronomical and increasing each year by a factor of ten.  That means when a small percentage of bad lows default the system cascades.  The problem is that we have more than a small percentage of bad loans, we have a lot.  These are consumer loans, corporate loans, and government loans (also called bonds).  When that happens, not if, because it will happen, the reset button gets pushed.

You see, credit, when used, is a pledge against future earnings.  And if those future earnings are insufficient then default happens.  And if default happens then we all lose.  Why?  Because we are all entwined in the creation of credit.  Does your pension fund invest in high yield credit?  If so you can kiss your pension good bye.  Credit creation has become the ponzi scheme of the world.  It is bound to fail, there is no prevention, no government bailout, no protection.  This general failure may happen a year from now, maybe two years from now.  Or it may take ten years.  But rest assured that there is not enough money in the world to prevent the collapse of the financial and governmental sectors of the world.

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