Back during the crisis last year, when Rick Santelli – the floor trader in Chicago – first proposed the idea of a second tea party (did you forget that Howard Kurtz?), his helper jumped in saying “Moral Hazard! “.
I don’t think most of the people watching, including the reporters who cover Wall Street got the significance of that shout out – because it is a term of art in the Insurance business, not on Wall Street.
A fundamental principle of underwriting insurance is making sure that you don’t create a “moral hazard” – a reason for the owner or beneficiary of the policy to behave recklessly because they know they have insurance. In the extreme, they may deliberately cause a loss to enrich themselves.
For instance, if you sold a disability policy that paid 125% of the normal salary, people would be motivated to injure themselves on purpose. If you could take out a life insurance policy on another person with which you have no economic connection, you could be motivated to cause the death of that person.
AIG started writing policies (Credit Default Swaps – CDSs) that protected people from the possibility that Freddie Mac and Fannie Mae’s mortgage backed securities (CDOs) would lose value. Folks started buying the CDSs like crazy because they believed AIG was way underpricing the risk they were taking, and AIG was feeding a moral hazard. They were incentivizing the entities buying the securities to CAUSE the failure of Freddie Mac and Fannie Mae. The bulk of the federal bailout funds went right through AIG to pay off the people who benefited from the moral hazard of encouraging the reckless mortgage lending practices.