Moral Hazard and Dangers to Market Stability

Abstract

Moral hazard describes a situation in which one person decides how much risk to take and keeps any gains, but passes off any losses to someone else. In other words, it’s “heads I win and tails you lose.” The U.S. has a financial system ripe with moral hazard, with an increasing amount of privatized profits and socialized losses. In an earlier white paper released in 2011, “Endogenous Risk and Dangers to Market Stability” (Pasztor, 2011), endogenous risk and the dangers it presents to market stability and investors was covered. Risk can be either exogenous, which is risk found outside the financial system and is reflected when doing fundamental analysis; or endogenous, which is risk found within the financial system itself. Endogenous risk is the most dangerous type of risk, and comes from aberrations and shocks that are generated within the financial system that then have a ripple effect throughout the financial markets and the economy. Moral hazards increase endogenous risk, and can cause extreme downside volatility, unleashing a chain of events that can be difficult to stop. The 2008 Financial Crisis is an example of this; and yet, very little has been done to bring down the amount of moral hazard risk since that crisis. In fact, both endogenous risk and moral hazard risk are increasing, largely due to the lack of holding individuals personally responsible for their actions. Huge sums of privatized profits continue to be made, with losses being paid (or would be paid if something goes wrong) by the taxpayers or by shareholders. “Too big to fail” remains a problem, and continues to encourage reckless behavior. One of the most prominent aspects of the 2008 meltdown is that both the so-called “winners” (those who bet against the subprime mortgage bonds) and “losers” (the traders and CEOs running the firms that were on the wrong side of the market and drove their firms into bankruptcy or were saved from bankruptcy by the U.S. government) got rich. Both sides recklessly leveraged their bets, turning our financial system into one big casino that ultimately collapsed. We have a system that actually encourages and rewards bad (and criminal) decisions. We also have a system that continues to work against regular investors; a current example being the growth of high frequency trading, a form of trading that has destabilized the market on more than one occasion. There has been and continues to be a dangerous complacency among both regulators and shareholders concerning the current state of affairs. Wall Street and the large U.S. banks have “captured” our regulatory and political system, to the detriment of most investors.