Moral Hazard

Moral hazard is the prospect that a party entering a contract becomes insulated from a risk and that insulation causes him or her to behave differently to the other party's peril. The contract changes incentives and the changed incentives causes one party to behave differently. A few examples will clarify this.

If you rent a car or your residence to someone, you, as the owner, run the risk that your renter will not treat it the way you would treat your own property. By entering into the rental agreement, you, the lessor, incur moral hazard. If you doubt moral hazard exists in rental contracts, ask yourself why landlords require deposits, and why you as a used car buyer worry more about a rental car than one you buy from the sole owner.

Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore acts less carefully than he or it otherwise would. This leaves another party bearing some responsibility for the consequences of those actions.

Insurance is rife with moral hazard: Why? An insured party's behavior will be riskier than it would have been without the insurance.

In life insurance, moral hazard can arise when the insured can self select. A life insurance company bases its rates on the actuary tables for the average person. If I know everyone in my family has died young, it make sense for me to buy more insurance than normal. This adverse selection will cause the life insurance company to undercharge me for the true risk of my living less the actuarial tables predict.

In banking, deposit insurance creates moral hazard. Consider a hypothetical bank we could call Loan Prone Savings and Loan. The FDIC insures Loan Prone's deposits. The bank gets in trouble. Loan Prone's loans are not sufficient to pay off its depositors. Perhaps its books do not yet show its true condition. They comply with banking regulations, but they do not show the true value of the loans. What can Loan Prone's managers do?

They note that if the bank can get more funds (by taking in more deposits), it could make some new loans. So Loan Prone offers an above market interest rate to attract more deposits. There is no risk for the depositors, their deposits are insured. Note: without deposit insurance, depositors would have a strong incentive to investigate a bank's soundness. With deposit insurance, that incentive is gone.

The bank does not care if its losses grow, Lone Prone is already "in the soup." Maybe it can recover enough from the new loans to get back in the black. Thus Loan Prone hopes that it can find some profitable investments to recoup its loses. It goes for higher interest, but riskier loans. It is gambling to get back into the game. The depositors do not care: the FDIC is going to get stuck paying off them off even if the loans go sour.

Neither the the bank nor the depositors are behaving the way they would in the absence of deposit insurance. That is the essence of moral hazard.

Is The Creation of Citigroup in the Running for the "Deals From Hell?" Award?

Wichita's Unemployment Rate is 3.9%

The Bureau of Labor Statistics announced that the unemployment rate in Wichita was 3.9 percent in November. This comes after Friday's report that the national unemployment rate rose to 5.0 percent in December. Although Wichita's November unemployment rate was up from October, I believe the rate reported for October was low due to sampling error.

While the national economy has slid into an economic recession, Wichita's economy led by aerospace and natural resources continues to grow. The number of jobs grew 3.9 percent over November, 2006.

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Are We In A Recession?

[Graph courtesy of the federal Reserve Bank of St. Louis. Click on the graph, to enlarge it.]

The employment report issued by the Bureau of Labor Statistics (BLS) on Friday sent the stock market down by 250 points. Although employment as measured by firms' payrolls rose, there was virtually no growth over November and the unemployment rate jumped to 5.0 percent (from 4.7 percent.)

Few are saying we are already in a recession, but more are thinking the danger is increasing. Look closer, particularly at the unemployment data: they are a real worry!

There are two separate surveys the BLS uses to gauge the strength of labor markets: the establishment survey and the household survey. For the establishment survey, firms are asked how many employees they have on their rolls. In the household survey, households are contacted and asked who is working and who is looking for work. In recent years cyclical analysts have largely ignored the household survey for two reasons. The month to month noise in the household survey is greater. Secondly, the population controls for the survey from the Census Bureau distorted the time series in the early years of the decade.

Ignoring the household survey is a big mistake. Right now it is giving off strong signals that we are already in a recession.

The unemployment rate has risen from 4.4 percent in March to 5.0 percent in December. Although the drop in November and the jump in December were noise associated with an early Thanksgiving, a decline of six tenths of a percent over nine months is not noise! It is difficult to find a comparable rise that was not part of an economic contraction.


Total unemployed have risen by almost a million (917,000) since March. See the attached graph. Although the population benchmarks through off comparisons in the number of unemployed from one year to the next, they do not affect the measured change from March to December.

A positive note for Wichita's economy, employment in transportation equipment other than cars and trucks continued to rise.

Is Alan the Culprit?

Who or what caused the Mortgage Crisis? Alan Greenspan claims he should not be blamed! He tells us that "Bubbles can not be safely defused by monetary policy before the speculative fever breaks on its on." Of course Fed's flood of liquidity after 9-11 would have had nothing to do with the bubble's inflating in the first place, now would it have?

Those of us with the more mundane worry of whether the crisis will translate into a recession will be reassured The Wall Street Journal already has the remedy: use fiscal policy not monetary policy. The paper's editors believe the dollar's virtue can not take any more ease. Read its editorial, "False Savior."

The Subprime Mortgage Credit Crisis & the Bursting of the Housing Bubble Drops Mortgage Mail Solicitations By 62%

Mintel Comperemedia research tracks direct mail sent to households. Their data show mortgage solicitations in the mail fell 62 percent in the third quarter from the same period last year. Not surprisingly, ARMs (adjustable-rate mortgages) no longer predominate. The proportion of offers for for adjustable-rate mortgages fell from 56 percent to 22 percent.

Prominent mortgage brokers and mortgage banks have gone bust while major players have with drawn from the market.


DM News reports that the Treasury facilitated plan to selectively freeze the rates on some ARMs is causing direct marketing pros to adjust their offers.

Electronic Payments Now Outnumber Checks by 2-1!

The Fed has done yet another study of how payments are made in the United States. The study, which did not include payments by cash, showed American households and businesses made twice as many payments electronically than they made by check.

Check usage by 6.4 percent a year from 2003 (the last year studied) to 2007.

Economic Terms and Concepts

The Present Value of a future cash flow discounted at X% is the amount of money you would need to invest today earning interest compounded annually at X% to accumulate that future amount. It answers the question "How much do I have to invest now to end up with that future sum if I earn the discount rate?"

A bond's Yield to Maturity is the one discount rate that equates the present value of the cash flows (interest payments and principal) to the price.

A security's Current Yield is its annual income divided by its current price. For a bond it is the coupon interest divided by the price. For a share of common stock, it is the annualized dividend divided by the price.