Moral hazard occurs when a party protected from risk behaves differently than it would if it were fully exposed to the risk. It arises because an individual or organization does not take full responsibility for its actions so that the consequences of bad behavior do not befall on that party. Instead, responsibility passes to another party that covers the cost of the risky behavior. The recent bailout of troubled financial institutions is an example of moral hazard.   It is also the theme of the movie Wall Street: Money Never Sleeps that is a follow-up to the original 1987 movie Wall Street. The original promoted the idea "greed is good" that some people point to as causing the financial crisis on Wall Street.

Imagine if you had some money to invest in a security or other financial product and were told that any loss you sustain would be covered by another party. You might decide to invest in a riskier product with the hope of a higher return. This is exactly what happened in the recent financial bailouts of Fannie Mae and Freddie Mac, two government-sponsored-entities (GSEs) that purchased asset-backed securities from investment banks that had made real estate loans to borrowers without proper documentation. Congress decided that Fannie and Freddie were too big to fail.

The banks knew they could package the mortgages and sell them to Fannie and Freddie so that the risk of nonpayment was transferred to these GSEs. Little incentive existed to establish stricter requirements for loans especially because Congress was pressuring the banks to make home ownership more affordable. With the downturn in the economy in 2007, many homeowners failed to make their mortgage payments on time and houses went into foreclosure because homeowners lost their jobs and were unable to pay or they simply decided to walk away from their obligations. The reason was they had more debt in their home than what it was worth at current market value – an underwater mortgage. To date, the government has spent $145 billion to bail out Fannie and Freddie to keep them afloat, or $1,300 per citizen, and the final amount may be as high as $400 billion. Some critics charge that the GSEs knew the government would bailout them out so purchasing the securitized mortgages held little risk.

From an ethical perspective, the question to ask is whether protection against risk leads to irresponsible behavior that costs the public and may lead some people to conclude that if the big financial institutions are bailed out then why not me? Irresponsible behavior that is protected begets more irresponsible behavior. Last May a 60 Minutes segment focused on homeowners who were walking away from houses that were worth as little as half of what they paid for them. Some people did the math and decided making monthly mortgage payments was a waste of money so they strategically defaulted on their loans leaving the banks to clean up the mess. It has been estimated that 15.2 million American households hold mortgages that exceed the value of their homes. The 60 Minutes segment noted that at least a million of Americans who can afford to stay in their homes simply walked away.

Adding to the moral hazard effect are three government programs developed in the aftermath of the real estate meltdown. The Home Affordable Modification Program (HAMP) allows homeowners to modify mortgage terms with their banks to enable them to stay in their homes. The Home Affordable Refinance Program (HARP) enables homeowners to refinance their debt if it is no more than 125% of the current fair market value of their home. The most glaring example of moral hazard is the Mortgage Forgiveness Debt Relief Act and Cancellation that enables a taxpayer to exclude from income the discharge of debt on their principal residence if certain conditions are met. The Act was recently extended through 2012. Here’s an example of how it works.

Assume that a residential home was purchased in 2005 for $400,000. The value of the home has declined to $300,000 and payments are in arrears. The delinquency has added interest and late fees to the mortgage balance, which is now $396,000. The bank forecloses on the home and later resells it for $286,000. The result is the cancellation of $110,000 of debt ($396,000 - $286,000) that would have been taxable as ordinary income absent the Debt Forgiveness Act.

What does this all mean? Well, I have a house with a $445,000 mortgage that has been appraised for $200,000. I can make the monthly payments but, at least on a financial level, there is a significant incentive to simply walk away from my debt because of the Debt Forgiveness Act. I already feel I’ve been unfairly treated because I can’t refinance under HARP and take advantage of an interest rate that is more than 2% lower than my fixed rate since my mortgage doesn’t come close to meeting the 125% loan-to-value test. My bank won’t modify my mortgage terms under HAMP because it knows I can afford to keep up my payments. I can rationalize walking away from my obligation but I don’t because it would be wrong to do so. I signed on the bottom line and must meet my commitment. 

This brings up the point that ethics is not relative to the situation. If we define right from wrong based on how it affects us in a particular situation then we adhere to the principal of ethical relativism and that is a dangerous path to take. It means my neighbor may decide to walk away and rationalize that action while I do not. Relativism holds that all points of view are equally valid and the individuals determines what is true and relative for them. Ethical relativism represents the position that there are no moral absolutes, no moral right or wrong. You may have heard the expression: What’s right for you may not be what’s right for me. But, how can that be? Is it acceptable for one person to steal from another because of financial need while another in a similar situation does not? If we allow for ethical relativism then the end result may be moral chaos.