Biden's Moral Hazard Problem
President Joe Biden seems to have some difficulty with the concept of “moral hazard.” This term refers to a lack of incentive to guard against risk when one is protected from its consequences. When moral hazard creeps in, people feel like they are playing with “house money,” and take on wild risks they otherwise never would with their own earnings. Three examples here come from the last year alone: the student loan bailout, the attempt to crack up credit reporting agencies, and the depositor bailouts at Silicon Valley Bank and other institutions.
A lot has been written about the student loan and bank bailouts, but it’s always good to reinforce the basic reason these are bad policies. If you’re keen to go out for a Master’s degree in cis normative Marxist-feminist basket weaving, you might hesitate if you’re presented with the $30,000 bill to do so. But if the government is essentially picking up that check in the form of a student loan – a loan which you strongly suspect will be forgiven or you can otherwise easily walk away from – suddenly the degree looks more attractive. That’s a form of government subsidy–paying you to do something you otherwise would never do.
It’s similar for depositors at banks. Ordinarily, there is a rule that a bank can protect a customer up to $250,000 of cash deposits under FDIC insurance. What happens when depositors have more money at one bank? They are taking on the risk of the bank being too cavalier with its portfolio and defaulting, as basically happened at Silicon Valley Bank. When the Biden White House and the Treasury Department rushes in over a weekend to promise that all deposits are “safe,” even those north of the FDIC insurance limit, it sends a signal to other banks that they can take risks with their portfolios, too. If they bet on the ponies and win big, the bank wins. If the bets turn out to be made on glue factory horses, the government is there to bail out the bank customers and the bank still wins.
As if this isn’t enough, the Biden Administration wants to resurrect a classic moral hazard from the last financial crisis – pushing mortgages out the door to buyers who just aren’t ready to be homeowners yet. In 2008, junk mortgages abounded, and were split up into derivative investment products, so investors owned little pieces of worthless debt. When smart analysts found this out, it led to the biggest financial crisis since the Great Depression – and served as the plot for a great movie of the time, Margin Call.
Now we’re on the road to starting this process anew, and it begins with issuing too many bad mortgages to unqualified buyers. When you or I want to buy a home or refinance a mortgage, a lender runs a credit check on us. This is known as a “tri-merge” report, since it’s derived from the Big Three credit rating agencies. This blended analysis takes into account our credit history, and gives us the credit score so important to borrowing. Because there are three agencies, it’s very difficult for a red flag to fall between the cracks – lenders will know if there is a quality issue with a borrower. And thanks to the fact that exotic mortgages (zero down, interest only, etc.) are largely a thing of the past, we’ve had housing market stability for well over a decade.
In October of last year, the Biden Administration announced that it was going to replace this neutral, private sector tri-merge standard in favor of a bi-merge standard. On the surface, it seemed benign – but in reality, requiring government-controlled Fannie Mae and Freddie Mac (which backstop most mortgages for low-income borrowers) to only use two of the three agencies may leave lots of information on lenders’ tables. This is especially true since the announcement included no objective reasons why any of the credit rating agencies should be ignored by lenders.
In the same announcement, the administration argued that Freddie Mac and Fannie Mae would be required to use government-approved credit score models which have the “right” information. However, the agencies would not have the same requirement to use private-sector “tri-merge” reports. What this means in real terms is that the same administration which says more information is good…also believes that less information is good.
And one word in the entire release gives away the game - that the new credit score models are “inclusive.” Alongside questions of whether credit cards get paid off every month could be rewards for participating in green activity, or being the right race or ethnicity, or any number of politicized criteria. An objective test of risk is being substituted for a subjective process.
And therein lies moral hazard and the next housing bubble. Millions of Americans who should not be getting mortgages (or bigger mortgages than they can afford) may get them because of their government-approved inclusivity – and those who don’t fit the approved category may be unjustly denied in what is an opaque, ill-defined approval process.
Knowing this, favored in-group borrowers will buy when they really should spend the next few years renting and helping their credit score. Others will buy a McMansion when they should be getting a starter home. Still others will borrow every penny of equity they can get away with even if they have no way of paying the lender back. They will have a lack of incentive to guard against risk because they are shielded from the results of its consequences.
What happens then? At some point, the music stops and the chairs run out and too big to fail becomes a must pass government bailout. The homeowners are “protected” and those unfortunate enough to own the notes are made whole. Meanwhile, borrowing costs for responsible Americans with high credit ratings will go up, punishing them for playing by the rules and being responsible with their budgets.
The Biden Administration has many problems, but in the area of banking, borrowing, and lending they would do well to take a startup course in Moral Hazard 101. They have failed so far to guard against it in student loans and bank deposits–will a housing crisis be strike three?
Ryan Ellis is president of the Center for a Free Economy.
