How Moral Hazard Impacts You

One economist's interpretation of the hazards investors don't understand about financial products, hedge funds, private equity and more.

Wikipedia’s definition of moral hazard as the “Lack of incentive to guard against risk where one is protected from its consequences…” has little personal implication to most people. In “Moral Hazard and the Financial Crisis” — which delves into the underlying cause of the financial meltdown — Kevin Dowd brings the meaning home.

• "I might sell you a financial product (e.g., a mortgage) knowing that it is not in your interests to buy it.

• "I might pay myself excessive bonuses out of funds that I am managing on your behalf; or

• "I might take risks that you then have to bear."

Dowd’s point is, “If I take risks that you have to bear, then I may as well take them; but if I have to bear the consequences of my own risky actions, I will act more responsibly.”

professor of financial risk management at the Centre for Risk and Insurance Studies at Nottingham University Business School.

Dowd wrote about moral hazard for the Cato Institute, (Volume 29, #1; winter, 2009) when he was Now he is a visiting professor at Cass Business School in London, one of the United Kingdom’s top schools.

A perfect example of moral hazards in the financial industry is hedge fund and

private equity compensation, according to Dowd. Investors split any profits with the managers in an 80% investor/20% manager split. In addition, investors pay an annual 2% managing fee. However, losses are not shared. Here the hit is 100% on the investor. In addition, the investor still pays that 2% managing fee even though he or she is losing money.

The fact that the investor is totally responsible for taking any loss makes it advantageous for the manager to take risk, because leverage makes gains greater and the manager participates in this payoff. However, when using leverage, losses also are larger and are completely borne by the client. Further, since bonuses are not typically recoverable, there is no long-term perspective on the part of the manager.

“The absence of deferred remuneration thus institutionalizes short-termism and undermines the incentive to take a more responsible longer-term view,” Dowd writes.

The subprime mortgage debacle is the same as moral hazard in the financial industry, according to the author. Dowd cites another specialist, Martin Wolf, who stated that no other industry but finance “has a comparable talent for privatizing gains and socializing losses” instead of “creating value,” as we were repeatedly assured.

What can Americans do? It seems little. But, if each and every person were to take this point of view nothing would happen. So, if we take control of what we can, it might help. For example, you can take charge of your own investments or question your financial managers more pointedly. Both avenues put power in the person who should own it

— the individual with the money, not the person or organization that he or she has entrusted it to, sometimes foolishly.

Next week: A segment follow up that is fun:

Angelina Jolie and Doctor Spock Lookalikes Talk Moral Hazard (only theoretical, not personal).