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Ornstein On The Economy's Moral Hazard Meltdown

Norman Ornstein is a fellow at the American Enterprise Institute and the author of The Broken Branch: How Congress Is Failing America and How to Get It Back on Track, with Thomas E. Mann.

Two key words have been largely missing from the debate over our financial crisis: moral hazard. Moral hazard is a concept used by economists for situations where no adverse consequences flow from risky behavior or failure; and where wrongheaded risky behavior that goes unpunished begets even more wrongheaded risky behavior.

Investment in a market system is supposed to balance risk and reward. Riskier investments yield higher returns--and safer investments yield smaller ones. But either way there is a risk that the investor may lose part, or all, of an investment.

The mortgage meltdown was driven by the erasure of the moral hazard formula, in two ways. First, there were the banks and brokers who offered mortgages to homeowners and then quickly sold these mortgages to others. If these banks and brokers had held onto the mortgages, they would have had a strong incentive in preventing defaults. But when these banks passed along their mortgages, that incentive diminished. The long-term solvency of their loans became somebody else's problem.

Of course, the entrepreneurs who bought these loans weren't suckers. They had their own idea. They could scoop up oodles of these mortgages--higher risk, higher interest rates--and package them together into complex financial instruments, which the ratings agencies deemed ultra-safe AAA. They then could re-sell them on the theory that even if some individual loans might go bad, the overall risk to the instrument was tiny. Even the most sophisticated investment professionals accepted the AAA rating without question and bought eagerly into the theory.

As we begin to contemplate reforming the financial system, there are a few important question to consider: Why didn't anybody blow the whistle on this scam--or at least alert the public to the risks that it posed to the whole financial system? Why did so many people credulously invest faith in the ratings agencies? (Actually, Congress should hold hearing on the methods and practices of the ratings agencies straight away.) Why did no one in authority heed the voices warning about Fannie Mae and Freddie Mac? Why did Congress not see the danger in credit default swaps, which it shielded from regulatory scrutiny?

When we ask these questions, we need to begin to re-insert the concept of moral hazard back into the conversation--and it must become a core concept of governance in the next regulatory regime. The most important thing when restoring the long-term health of the financial system is to recreate the balance between risk and reward, and between benefits for exemplary performance and punishment for malfeasance or nonfeasance.