Wednesday, September 17, 2008

Moral Hazard and the Senator

It seems ironic to me that Senator McCain has discovered the concept of moral hazard in financial markets rather late in the game. The senator announced yesterday in a political stump speech that AIG should not be saved because of the moral hazard engendered. In a system broken by its own market forces and complexities, to wait until financial Armageddon to politically discover the dangers of moral hazard is insulting.

It is fitting that the issue should arise to the level of popular political speech writing with regard to AIG, the world largest insurance company. Insurance by definition confronts moral hazard everyday. Compensating for loss by circumstance and by extension through behavior is what insurance is about. The writing of insurance is "regulated" by a company's underwriting procedures. It is usually quite clear, or at least written, what losses will be covered and which will not be covered. In our current regulatory environment, to allow an opaque and essentially invisible financial structure to grow to the extent that failure will create catastrophe is too great a risk to accept.

The current financial crisis is significantly the result of bad information and bad incentive. The derivative market which has dwarfed the financial system's ability to absorb it has benefited from standards which permitted information to be hidden either by shear complexity or by "off balance sheet" accounting. Such arcane financial engineering as Credit Default Swaps are in danger of taking both Wall Street and Main Street to its knees.

The compensation structure of the industry is focused on short term result and performance metrics based on short term measurement. When behaviour has no need to address long term costs it creates a "take the money and run" environment.

The establishment of standards which will enhance clarity and disincentivize gambling in lieu of investment behavior is not an act of anti-capitalism. It is the stuff of preserving social and financial infrastructure for the nation and citizens for years and generations to come.

As I mentioned earlier this week AIG would not be allowed to fail. It could not be allowed to fail. It was a teetering domino in a line of far too many dominos covering the globe. So now the taxpayers own it. It should have never had to happen.

John Barnyak