Over 400,000 people visited Farnam Street last month to learn how to make better decisions, create new ideas, and avoid stupid errors. With more than 98,000 subscribers to our popular weekly digest, we've become an online intellectual hub. To learn more about we what do, start here.

Bailouts and the nasty consequences of ‘moral hazard’

Gwyn Morgan, the retired founding CEO of EnCana Corp., with a great article in the Globe and Mail on Moral Hazard.

From its origin in the 1600s, the term “moral hazard” has been used to express our revulsion toward protecting reckless risk-takers from downside consequences. Over time, it has also come to describe other situations, such as when successful enterprises are taxed while failing enterprises are subsidized. The current economic meltdown and its aftermath vividly demonstrate moral hazard.

Government policies planted the seeds of the U.S. subprime mortgage debacle. For example, an affirmative action-style policy requiring lenders to report the demographic profiles of borrowers fostered mortgage loans to people with highly questionable creditworthiness. The upside for the borrower was gaining equity value as house prices rose. The moral hazard was that in contrast to Canada, U.S. mortgages bear no recourse to the borrower, allowing mortgagees to simply walk away when house prices collapsed.

Moral hazard continued right through this disastrous chain. Mortgage brokers earned bonuses on the value of mortgages written with no downside in the event of default. Next, investment dealers earned billions in bonuses for slicing and dicing mortgage loans into packages called mortgage-backed securities, for sale to unsuspecting investors who relied on appallingly flawed analyses provided by supposedly independent credit-rating agencies.

As Wall Street institutions began collapsing under the weight of their own behaviour, the greatest moral hazard in economic history occurred. Uncle Sam committed funds from taxpayers, whose own jobs and savings had been devastated by the economic meltdown, to bail out the very people who had not only caused the problem, but profited hugely from it.