Moral Hazard and Panic

By Debra J. Saunders
Sunday, September 23, 2007

This week, thousands of anxious Britons spent days queuing in front of bank branches to withdraw their savings from Northern Rock, a British mortgage lender caught up in a credit crunch. Many emptied their accounts, even after British Chancellor Alistair Darling announced that the government would guarantee existing savings accounts in an attempt to stop the panic.

Whom did movers in British financial circles blame for the bank panic? They blamed Northern Rock for high-risk investment practices. They blamed Darling for letting the situation deteriorate to the extent that it did. Then they blamed Darling for promising that the government would guarantee investors' accounts beyond what British law had guaranteed -- 90 percent of savings of about $60,000, according to the Daily Telegraph.

And they blamed the United States.

Specifically, financial gurus cited America's subprime mortgage crisis.

On the one hand, Our Betters in Europe are quick to blame their shortcomings on this country. I don't recall many Western European articles acknowledging America's role in European security or prosperity.

On the other hand, as Sidney Weintraub, an economic scholar at the Center for Strategic and International Studies, told me, it is "not unreasonable to blame" the United States for the British bank's woes. "They're part of the global market, and they got themselves involved. That's the way the world works."

In the age of globalization, every world citizen owns a piece of the rest of the world's bad habits. Outside America, plenty of people complain about U.S. economic practices. They probably don't appreciate how many Americans also complain about those practices -- even if U.S. voters have enjoyed little success in trying to curb economic excesses.

For a few years now, lenders have been issuing variable-rate mortgages to home buyers with marginal credit ratings who didn't put any money down, could not afford the higher monthly payments sure to follow and only qualified because the loans were interest-only with a balloon payment due in a couple of years. We all have friends who qualified for such loans, and we've all shaken our heads when they got those loans.

So how is it that professional lenders didn't know better than folks like you and me? And how is it that sophisticated investment firms didn't realize that they had sunk too much of their investors' money into reckless lenders' bad loans?

"They didn't know that the housing market would collapse the way it did," Weintraub answered. "They didn't realize the extent of what was going on."

Oh, great. The experts didn't have a clue.

Weintraub's explanation: "The more money people make, the greedier they become."

Because the rapacious (read: greediest) lenders aren't likely to suffer the most, politicians like Chancellor Darling and Bank of England Governor Mervyn King found themselves forced into changing longstanding government policies to keep innocent investors from being the biggest losers. I doubt many small-account holders at Northern Rock would object.

In the long term, however, government proposals to remedy private market excesses create more "moral hazard" -- perverse incentives that reward risky behavior. With globalization, each bad business practice can have a domino effect felt around the world. Ditto each stretching of regulations to remedy the fallout from bad practices.

Think about it. A few years ago, there must have been loan officers who looked at no-deposit, no-interest, no-fixed-rate mortgages and smelled a rat. At business meetings, some must have voiced their reservations about approving loans that were bound to result in foreclosures.

But there was no percentage in making their objections known. If they had talked about the need to approve mortgages that a large majority of clients could afford, savvy, global-thinking professionals would have dismissed them as dinosaurs.