One of the concepts that is prevalent in economics is the notion of moral hazard.  Generally speaking, a moral hazard is created when one party in a transaction is shielded from risk because of government protection, or access to information that the other party lacks.  This concept has received a lot of media attention recently, because of the financial crisis involving subprime debt and credit default swaps.

The way that the moral hazard plays out in the financial sector is that the government implicitly shields financial institutions from bankruptcy based on a historical precedent of bailouts for institutions deemed ‘too big to fail’ by the authorities.  When executives and fund managers become aware of the fact that the government will not allow them to go bankrupt, it creates incentives for dramatic risk taking since the gains will generate large bonuses for the company executives and any the company creditors will be made whole by the government in the event of a financial catastrophe.  This phenomenon is frequently referred to as ‘privatizing the gains and socializing the losses.’

The unique irony of our current situation is that government policy has been implemented in such a way as to purposefully manufacture moral hazard by nature of how laws and regulations were written.  The mortgage industry has long been driven by the policies of Fannie Mae, the quasi-governmental agency who purchases mortgages in the open market.  (The reason why I refer to it as quasi-governmental is because of the implicit guarantee provided by the government that Fannie Mae will be insulated from losses by bailouts from the taxpayers)  Since Fannie Mae has an implicit taxpayer guarantee, it is heavily regulated and influenced by Congress and the Senate.

Because of the status that Fannie Mae enjoys as the market leader in purchasing mortgages, its policies have the ability to ‘market make’ throughout the financial sector.  Thus, as political pressures impacted the practices of Fannie Mae in regards to high-risk lending, those practices rippled throughout the mortgage industry.  The extended impact of this ripple effect was that banks could ‘pass the buck’ of risk with subprime mortgages to Fannie Mae by selling them their mortgages.  Thus, the policy of government has been to literally manufacture moral hazard by using the power of Fannie Mae to influence incentives in the financial industry.

Another unique irony of the current situation is the conclusion reached by the political authorities in response to the financial crisis.  Since there was a noted problem of ‘privatized profits and socialized losses’ the solution sought was to socialize the industries instead of privatizing the losses.  This socialization has not taken the form of financial institutions that were forced to accept government capital, and then forced to follow a long list of constantly changing rules and regulations because of the fact that they have government capital on their balance sheet.

In the end, it seems that a much more simple and effective solution would be to simply privatize the losses from this crisis so that investors and fund managers will learn that excessive risk taking is not going to be subsidized by the government.  Most people believe in responsibility and ethical behavior.  However, it seems somewhat foolish to expect responsibility to prevail when excessive risk taking is rewarded by a government that actively manufactures moral hazard.

Running in Circles

An extremely disturbing trend has emerged lately where the Federal Reserve is directly purchasing debt from the Treasury by printing new money.  The danger from this phenomenon comes from the fact that this increase in the supply of money will eventually dilute the purchasing power of dollars currently outstanding, and that the market activities of the Federal Reserve are artificially suppressing interest rates for government debt.  (Much of this is being done to finance the current government budget deficits)

What these factors ultimately add up to is a tremendous risk that current bond holders will be impoverished by rapid price inflation from the increased supply of currency, and devaluation of their bond values when market interest rates eventually increase.  The optimal way for prudent investors to shield themselves from this risk is with fixed-rate debt that is used to finance income producing tangible assets such as rental real estate.  Under this scenario, price inflation will increase the rents and value for your property while the balance of your loan remains flat.