Moral Hazard: Deposit Insurance and Subprime Bailout

Moral hazard refers to the fact that if people don’t have to face the consequences, they tend to take on more risk than they should. I learned a great deal of this from the book The Greatest-Ever Bank Robbery. In the 1980s savings and loan crisis, some banks were widely known for losing a lot of money, yet people still continued to pour in large sums of money to them through brokered CDs because they offered higher interest rates than other banks, and because the deposits were insured by the federal government. The troubled banks were gambling with the deposits on high risk loans or stealing them outright. If they won, the bank owners would profit. If they lost, the deposit insurance would pick up the tab. But because the deposits were insured, people didn’t care whether the banks would lose them or not. The crisis became much larger than it otherwise would have been.

The typical means of offsetting the moral hazard is via insurance limit, deductible, and coinsurance. Suppose if the deposit insurance in the U.S. is set up similarly to what’s in the UK, the first $4,000 is covered in full, and the next $66,000 is covered for 90%, people would be much more careful about where they place their money. If they used a bad bank, they’d lose 10% of their money over $4,000. Therefore they’d choose carefully who they bank with and not jump on whoever offers 0.1% higher interest rate. FDIC estimated that the NetBank shutdown would cost it $110 million. If the FDIC insurance had a coinsurance component, NetBank would not have been able to attract as much asset, and its closure wouldn’t have cost as much. I think the deposit insurance system in the UK is designed much better than that in the U.S.

Fast forward 20 years to our recent residential real estate market. People with poor credit bought houses using zero down, interest only loans with teaser rates. They were gambling that the house prices would continue going up 15%, 20% a year. If they won, they’d profit handsomely. If they lost, well, the lender can  take the house back. Here the moral hazard plays out again. Because there is no downside risk, people took on more risk than they should.

Now we hear President Bush and some senators talking about helping the homeowners who cannot pay their mortgages. That will exacerbate the moral hazard problem. If people get to profit if they win, and receive federal subsidy if they lose, they will take on even more risk. People taking on more risk than they should’ve is exactly what got us into the current situation. What should be done is the opposite of what Bush and some senators proposed — discourage the moral hazard. For example,

  • Require a 10% down payment on all mortgages. If people can’t pay their mortgages, they’d lose their down payment. This way they will not bid up the house prices wildly.
  • Require recourse and loss recovery. If a mortgage is foreclosed, the borrower should be required to make up the difference through other assets or future income. If people know that they’d also have their paychecks garnished if they defaulted on their mortgage, they will not take on risky mortgages as easily as they did. If they sell a different property in the future, some of the gains should go to the lender they previously defaulted on.

These measures will put the risks back into buying a house. Buying a house is a huge undertaking and it should be. In the last few years responsible savers couldn’t compete with no-risk gamblers. While the responsible savers were diligently saving for their down payment and shopping for houses within their means, they were priced out of the market. If the speculators are driven out, house prices should fall back to more rational levels. The interest rate will be lower too because lenders would become more comfortable with a large down payment and loss recovery. Both lower prices and lower interest rates will benefit the responsible buyers. Our markets should reward the qualified responsible buyers, not the speculators.

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  1. Ted says

    I agree with your sentiments. The risk should equal the potential reward.

    However, I take issue with one statement: “They were gambling that the house prices would continue going up 15%, 20% a year. If they won, they’d profit handsomely.”

    There is no “profit” per se here because all houses have gone up. The only gain made is buyers that “get in” in an escalating market establish a basis. To move up there has to be either an extra contribution from the buyer or an increase in the risk assumed or a drop in the interest rate. And usually you need 2 of the 3 after selling and buying costs are included.

    Also, I’m pretty sure that banks do go after buyers that walk away from houses. Thankfully I don’t have experience here, but my understanding is that it usually takes a couple years for the bank to start collection. Also, it is my understanding that any forgiven debt is required to reported as income and taxes are due.

    Aside from the mental pain of foreclosure there is some financial suffering as well. Perhaps not enough, however, to keep this from happening again.

  2. Harry Sit says

    I forgot where I read which said people who purchased homes with zero down and teaser rates effectively negotiated a lower than market rent for 2-3 years. If prices go up, they sell, take the profit, and can go back to renting if necessary. When the house prices were going up like crazy, the market rent was down because people who rented went on buying.

    By the way a bill removing the tax on forgiven debt passed in the House 386-27. Bush wanted the relief temporarily. Democrats went even further and made it permanent. Isn’t that great? Remove those inhibition for gambling. Everybody should gamble away without fear. It’s a free country after all.

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