The Definition of Moral Hazard and A Review of The Big Short

Wikipedia defines a moral hazard as “when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.”  By this definition, the financial crisis is a classic tale of moral hazard.  I recently stayed up til 3am finishing Michael Lewis’ book, The Big Short, which explains the financial crisis in character driven terms that are accessible to non-experts.  The quick summary of the crisis is that people and companies made big bets on the real estate market not falling (since it hadn’t fallen recently), and did not understand the risks they were taking.  However, what people did is nowhere near as interesting as thinking about why they did it.

The most classic case of perverse motivation and moral hazard is the case of Wing Chau, who “was making $140,000 a year managing a portfolio for the New York Life Insurance Company.  In one year as a CDO manager, he’d taken home $26 million.” (p.142)  For what was he paid?  CDO’s are the instruments that allowed people to bet on the housing market.  Wing Chau’s clients, pension funds that only looked at the AAA ratings these instruments got from rating agencies (more on this moral hazard later), lost a ton of money, but Chau himself was “paid a fee of .01 percent off the top, before any of his investors saw a dime, and another, similar fee, off the bottom…His goal, he explained, was to maximize the dollars in his care.”  Simple put, he was paid on volume, not on performance.  This may seem odd, but other such situations exist.  Real estate agents also get paid largely on volume, as they don’t get you a higher price, but do make more money the more homes they can sell quickly.  Loan originators, such as New Century (p.169) or Countrywide, had similar incentives as they made loans and sold them, making them indifferent as to whether the borrower could actually be paid back.

The ratings agencies themselves get paid on the volume of bonds they rate.  ”Moody’s…revenues had boomed, from $800 million in 2001 to $2.03 billion in 2006.  Some huge percentage of the increase…flowed from the arcane end of the home finance sector, known as structured finance.  The surest way to attract structured finance business was to accept the assumptions of the structured finance industry.”   Pension funds often have rules that state that they can only invest in bonds that have high enough ratings, but how useful are these ratings likely to be given that the companies that create these bonds pay the agencies to rate them.  It’s the same practice that incentivized Arthur Anderson to “audit” Enron, with the fees paid by Enron, with similarly disastrous consequences for those who believed in such audits.

Still, some CEOs are paid based on the performance of their companies.  Are those incentives enough to create a lack of moral hazard?  The book gives many instances where there is still much moral hazard, as individuals have lots of upside, but very little risk.  If the company makes money, they make millions.  If the company loses money, then maybe they find a new job, but they lose nothing.  Consider the tale of Howie Hubler, whose group was at one time responsible for 20 percent of Morgan Stanley’s profits.  He was paid $25 million a year, but was “no longer happy working as an ordinary bond trader.  The best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions.”   Morgan Stanley made a deal with Hubler to pay him a lot more money, whereupon he subsequently lost $9 billion.  Hubler appears to have been honest, but mistaken, and now runs a company where the slogan “100% of the shots you don’t take don’t go in”. That makes perfect rational sense.  If you go to a casino and earn 10% of the winnings and lose 0% of the losses, you can make a lot of money just by making bigger and bigger bets.

Having limited risk, but huge potential gain means that even the dumbest individual can make money.  Based on performance, Hubler’s previous gains weren’t necessarily due to skill, but rather to circumstance.  Steve Eisman, a central character in the book who foresaw the collapse “got himself invited to a meeting with the CEO of Bank of America, Ken Lewis.  ’I was sitting there listening to him.  I had an epiphany.  I said to myself, ‘Oh my God, he’s dumb!”  They shorted Bank of America along with UBS, Citigroup, Lehman Brothers, and a few others.” (p. 174)   Dumb is perhaps too strong a word, but it seems self-evident that money managers are rewarded as if they are better at money management than they actually are.  There is a psychological dimension to this.  Both liberals and conservatives attribute their success in work life to ability and effort more than luck or circumstance.  Conservatives and libertarians (likely a majority of those who read the Wall St. Journal) are slightly more likely to attribute success to effort and less likely to attribute it to context.  Below is a graph of our YourMorals data, which mirrors previous research.

Of course, there is plenty of blame to go around for creating moral hazards.  Conservatives tend to focus on government organizations like Freddie Mac and Fannie Mae, as well as the government officials that do not let firms fail, creating a moral hazard as firms no longer suffer the consequences of their actions.  In contrast, many liberals might focus on the moral hazard created by executive compensation packages given to upper management.  This blame bias mirrors this psychology study, where Scott Morgan et. al, show that attributions are influenced by one’s feelings for the groups involved.  As shown below in our yourmorals data, conservatives feel warmer toward upper management, while liberals feel warmer toward government officials.

Liberal and Conservative Feelings Toward Rich and Poor

Both types of moral hazard are evident in The Big Short, and perhaps we as a society, can work to reduce moral hazards for both companies (e.g. let them fail) and individuals (e.g. proportional risk/reward in compensation).  Or Barry Schwartz articulates another, perhaps idealistic answer, in this video: that we need people who are less motivated by incentives and more motivated by wisdom.

- Ravi Iyer

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