Behind this brouhaha was an idea that Americans seem particularly preoccupied with. It is called “moral hazard” — an obscure insurance term that has taken on new currency in our troubled economy. We’ve heard a lot about moral hazard lately, first in connection with the bailouts for big banks, and now with efforts to help homeowners who got in over their heads.
Moral hazard sounds like the name of a video game set in a bordello, but in economic terms it refers to the undue risks that people are apt to take if they don’t have to bear the consequences. In other words, if the money is free, why not spend it on a designer purse? If you know that you’ll be bailed out, why not roll the dice on some tricky mortgage investments — or splurge on a home that you can’t really afford?
Moral hazard became part of the national conversation in the financial crisis of 2008, when ordinary Americans wondered why they should rescue banks that helped drive the economy off a cliff. Now those same banks point to moral hazard to explain why they can’t do more to help people with mortgages. And it’s not just banks — the Tea Party movement was inspired by outrage over a government plan to, as Rick Santelli put it in a famous rant on CNBC, “subsidize the losers’ mortgages.”
The cherished American ideal of self-reliance has a flip side: discomfort with the idea of bailouts and safety nets. The notion that even a small portion of such aid might find its way to the undeserving can be enough to scuttle support, or restrict help so drastically that few can use it. The specter of moral hazard haunts a basic tension in American life: to what extent are people responsible for their own problems? The more trouble you’re in, moral hazard suggests, the less we should help.
Bankers say that generously easing loan terms or reducing mortgages outright would only encourage homeowners who can pay to pretend they can’t. It would also, the bankers say, send a dangerous message: a financial commitment isn’t really a commitment. Economists and policy makers say the bankers are right — but only to a point. Shaun Donovan, the secretary of the Department of Housing and Urban Development, said that there was a “nugget of truth” to the moral hazard argument. But he also said that only about 10 or 15 percent of Americans who can still pay their mortgages try to walk away from their debt. Most troubled homeowners, like the Katrina victims, are genuinely hard up.
Kamala D. Harris, the attorney general of California, is adamant that homeowners are not looking to abuse the system. “I have met with these families,” she said, “and every single one of them wants to pay to stay in their homes.”
Still, the $26 billion deal that authorities struck with banks this month over foreclosureabuses — a main element of which will require the banks to reduce homeowner debt — angers some. Homeowners who keep paying their mortgages, even if their homes have lost value, reasonably wonder why neighbors who weren’t as responsible are getting help.
On the other hand, the problems in the housing market are a problem for all of us. Many economists and housing experts agree that the debt that now looms over homeowners is holding back a broad recovery.
Since the settlement was announced, pressure has mounted for Fannie Mae and Freddie Mac, the mortgage giants whose loans are not eligible for the deal, to allow debt relief for their borrowers as well. But concerns over moral hazard, among other things, have held them back.
MORAL hazard has long been used to explain why social safety nets like welfare, unemployment insurance and workers’ compensation should be less generous. It is almost always applied to the recipients, rather than the providers, of such benefits. A lot of energy has gone into arguing that higher workers’ comp payments, for example, make workers careless. Far less is said about how lower workers’ comp invites moral hazard for employers by, say, making them less attentive to workplace safety.
Economists have longcomplained that moral hazard could easily be described in more neutral language, like “misaligned incentives.” But the term, with its implied judgment, has stuck.
It seems to have originated in the 19th-century insurance industry. (Hazard was a popular game of dice.) Insurers drew a bright line between natural hazards, like storms, and moral hazards, like playing with matches, that stemmed from what the 1867 edition of the Aetna Guide to Fire Insurance called “carelessness and roguery.”
Today, insurers battle moral hazard with co-pays and deductibles. If you have health insurance, you are, based on the theory of moral hazard, less likely to avoid smoking, and more likely to go to the doctor for a common cold. But in a 2005 article in The New Yorker, titled “The Moral Hazard Myth,” Malcolm Gladwell noted that people with insurance do not check into hospitals for their enjoyment, and that people without insurance forgo preventive care that could save thousands of dollars. Moral hazard also overlooks the noneconomic costs of risky actions like smoking — costs like ruined lungs, suffering and death.
“The economics of moral hazard work to convince us that, however well intentioned, social responsibility is a bad thing,” Tom Baker, a law professor at the University of Pennsylvania, wrote in “On the Genealogy of Moral Hazard,” a historical account published in 1996. “Moral hazard signifies the perverse consequences of well-intentioned efforts to share the burdens of life, and it also helps deny that refusing to share those burdens is mean-spirited or self-interested.”
That is not to say that there is no such thing as moral hazard. Economists point to a 2008 settlement in which Countrywide Financial announced that it would modify subprime loans for people who were delinquent. Suddenly, many of Countrywide’s subprime customers stopped paying.
But remedies can be designed to reduce moral hazard, said Adam J. Levitin, a Georgetown University law professor and mortgage expert. He points out that Countrywide, now owned by Bank of America, offered help only to those in default, instead of to all those who were given suspect loans. In the case of the debit cards, an investigation found that FEMA neither checked the identity of recipients nor told them how the money could be spent.
Under the new foreclosure settlement, only homeowners who were already delinquent will be eligible for principal reduction.
Plenty of other factors keep homeowners from trying to shirk commitments, said Elyse D. Cherry, C.E.O. of a community development group, Boston Community Capital. Ruined credit makes it harder to borrow money, get an apartment and, with employers increasingly doing credit checks, find a job. Moving is hard on families. And then there are the larger social costs: pockmarked neighborhoods and declining property values.
Moral hazard, Ms. Cherry said, “is hogwash.” That is an interesting view coming from a woman who runs what might be considered a petri dish for moral hazard. Boston Community Capital buys homes that have gone into foreclosure, then sells them back to the original owner at a price they can afford. If homeowners later sell at a profit, they must split the proceeds with Boston Community Capital.
Presumably anyone who heard about the program, which is small, would be tempted to default. Banks are so sensitive to this possibility that many forbid the resale of a foreclosed home to its original owner, even though it would make no difference to the banks’ bottom line.
But usually, the clients have defaulted long before hearing about the program. Some, in fact, are packed and waiting for eviction.
Consider the case of one Boston Community client. In one view, she might seem like a classic case of moral hazard — the kind of person many Americans are loath to help. When the banks offered to lend her money against the rising value of her home, she happily accepted. Now she owes $400,000 on a house worth closer to $100,000. Aiding her now might only encourage that type of behavior.
Another view is that she is a working person striving for the American Dream. She had every reason to believe that her bankers knew more about finance than she did. She paid a contractor for renovations; he absconded. When the recession hit, her work dried up and her home’s value dropped. Now, she’d love to buy back the home for its current market price.
WHICH view is correct?
Ms. Cherry answers that question with a question: Does it matter? Moral hazard, she said, has been used to fend off solutions long enough.
“Let’s assume that the guy who says, ‘I paid my mortgage; why shouldn’t she pay hers?’ wins, right?” Ms. Cherry said. “Now what do we do? How is that a strategy for getting out of the problem that we’re in?”
Photo: Patrick Fallon/Bloomberg News, Homeowners lined up for a mortgage information event in Los Angeles.