Decision Quality Blog

I think the people of King County, that’s where Seattle is, have Boston envy. Boston has the Big Dig, the most expensive public works project since the great pyramids, and now we have Brightwater, the most expensive sewage treatment plant in the history of the world. Not that the two have anything to do with each other. I make the connection because Seattle also has an elevated arterial that some of the locals want to bury in a tunnel behind a sea wall right along the waterfront. Now you get it.

So, sewage treatment. Amateur comedians insert your favorite jokes here. I’m not up on all the issues involved, but I get the general idea and why it’s important: we generate the stuff regularly, some of us more regularly than others, and just pumping it out to sea no longer cuts it. The stuff needs to be processed to a standard that exceeds the quality of the ingredients that go into our toothpaste and heparin before the harmless leftovers are released to recycle themselves. The big deal is where to put the facilities. And that’s where the story gets muddy according to the Seattle Times.

In all, it will take 35 to 40 years of principal and interest payments to retire the $3 billion debt burden on Brightwater, scheduled to open in 2011 in Snohomish County north of Woodinville.

How did Brightwater get so pricey?

There are many reasons: engineering changes, technology that exceeds state and federal environmental requirements, and construction-industry inflation among them.

But above all was the simple truth that almost nobody wants a sewer plant near his home or business or beach.

That reality pushed the plant so far inland that a 13-mile, $735 million pipeline is being built to take treated waste to Puget Sound. It also meant installing the nation’s most advanced odor-control system and paying for parks and other goodies to win at least grudging acceptance from jurisdictions near the plant and pipeline.

A 43-acre habitat-restoration area overlooks the site, where massive concrete structures are rising from the hillside. Sewer bills will also pay $4 million for artwork and $8 million for an education center.

When it opens, the plant will serve 189,000 residents, 109,000 of them in Snohomish County, which for decades has sent some of its wastewater to King County.

These stories have a certain sameness to them. Decisions are all about trade-offs. People want to build bigger and bigger houses further and further out. They expect water when they get there. They also expect to be able to run their disposals and flush their toilets without having to keep an eye on a drain field (which is nothing but an on-site sewage treatment facility). But they also don’t want the ignominy of living near a pumping plant. Or a power plant. Or an airport. Or a major road. Or a factory. It’s called NIMBYism . . . not in my backyard.

So now the piper is presenting the big bill. No surprise here: Dealing with those kinds of large scale trade-offs is expensive, as the Taj Mahal price tag for Brightwater shows.

Tags: Brightwater, Big Dig, sewage, King County, Snohomish County, Decision Making, Decision Quality, NIMBY, Not in my Backyard

One of the bedrock truths of investing is that we should “take the long view”. I suppose that means many things, not the least of which might be . . .

• Don’t try to time the markets
• Don’t panic when things turn ugly
• Buy and hold
• Wait long enough and “the markets” and particularly the stock market will be good to you

All good advice, particularly if you’re an endowment fund that pays no taxes, has huge amounts of capital, and is built with “perpetuity” as a guiding principle. But what about you and me? As Peter Bernstein points out in a piece in the New York Times . . .

In the long run, we often hear, everything turns out well, so just hang in there. In the long run, the bumps will even out; main trends are identifiable; main trends dominate.

Yet, what use are these notes of hope when so many of us are struggling to survive in the short run? As John Maynard Keynes put it way back in 1923: “In the long run we are all dead. Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that when the storm is long past the ocean is flat again.”

Keynes touched on a profound truth that will always dilute easy reassurances about the long run. Since the beginning of time, human beings have had to make decisions whose outcomes are clouded by uncertainty. We never know what the future holds. It’s just that simple.

The problem with the long view forward begins with the long view backwards. Blur your vision and look back at the history of the US Stock market, and it looks pretty darned appealing. Lost in that blurred view are significant deviations from the mean. Look at global markets and you see even more. Meaning? If you don’t need your money, no worries. If you do, and you need it when the market is on the wrong side of the mean, and you’re not going to be happy.

Making matters worse, a significant piece of those historic returns has been fueled by handsome dividend rates. Don’t look now, but those days are largely gone, making the historic 7% total return even harder to come by without taking a whole lot of risk.

I’m no financial planner, but looking at this purely as a matter of good decision making, a couple of thoughts come to mind . . .

You should look at scenarios that consider both lower overall returns and you needing to sell assets during a declining market. Given the depressing regularity with which the big boys of global finance regularly crater the markets (every five years or so), that scenario seems more, not less likely.

There is a lot of friction in the financial system. Housing is one example. The relatively simple idea of taking out a loan to buy a house masks the fact that there are a host of seen and unseen players with their hands in your pocket from the time you sign the offer to the time you sell the house and retire the mortgage. They’re all getting paid. They all cost you money.

The same is true of nearly any other type of financial product you buy. Fees, like taxes, tend to eviscerate your total returns. It’s these kind of costs and drags that many people fail to consider when making a decision.

Tags: LongRun, Historic Returns, Stock Market, Financial Planning, Mortgages, Investments, Decision Making, Decision Quality

As if there isn’t enough to worry about, the New York Times reports that a couple of guys are bringing a law suit to stop CERN from lighting up their cool new toy, the Large Hadron Collider. Why? It might destroy the universe.

More fighting in Iraq. Somalia in chaos. People in this country can’t afford their mortgages and in some places now they can’t even afford rice.

Scientists say that is very unlikely — though they have done some checking just to make sure.

The world’s physicists have spent 14 years and $8 billion building the Large Hadron Collider, in which the colliding protons will recreate energies and conditions last seen a trillionth of a second after the Big Bang. Researchers will sift the debris from these primordial recreations for clues to the nature of mass and new forces and symmetries of nature.

In the world of decision making, we call that an "uncertainty." The way you explore it mathematically is by doing something called a sensitivity analysis. Basically you ask the smartest people you can find, what’s the outcome if you’re wrong on the bad side? What about on the good side? What’s your base expectation?

So if you were thinking about buying a vacation home, you might ask yourself what you think the value of the home might be in ten years time: low side, high side, base expectation. The idea is to be 90% confident that the answer is in that range. So you make the range big. Most people don’t make it big enough, but that’s another discussion.

In the case of the the super collider . . . we’ll I’m not even sure where to start. Apparently the "down side" is total obliteration of the earth, or maybe even the universe. Bummer. That sounds bad. The upside is that we may or may not get some cool new insights into the nature of matter. Hmmmm. Well I guess that sounds useful. The good news is that apparently, and I say that guardedly, the probability that CERN will destroy the universe is pretty small. Too, as my wife points out, if they do that, why do we care? It’s not like we’ll be around to see what it’s like.

I have no additional insights to offer to this debate. Doomsday predictions have a long and lustrous history of not working out, at least not yet. Of deeper interest is the ongoing debate, currently being engaged in by 17 people, as to how much big science is enough. Or, better stated, who gets to decide when chasing after something just because it appears scientifically possible is okay, and when is it not? Ever see Terminator?

Tags: CERN, end of world, LHC, Large Hadron Collider, Terminator, decision making, ethics, sensitivity analysis

This video should be required viewing by every tax paying American. It’s also massively depressing. I’m tempted to not summarize what it says becuase then you might not look at it. But here goes anyway . . . The video features David Walker . . .

David M. Walker became the seventh Comptroller General of the United States and began his 15-year term when he took his oath of office on November 9, 1998. As Comptroller General, Mr. Walker is the nation’s chief accountability officer and head of the U.S. Government Accountability Office (GAO)

So Mr. Walker took office before the current administration rode into town. He’s got what I think anyone would agree are "impeccable credentials." And nobody who counts disagrees with him. In other words, what he has to say isn’t the equivalent of global warming. It’s probably worse, except without the "controversy." The problem in a nutshell comes down to these three dynamics . . .

Dynamic 1: Entitlements. At least since the 1960s, our elected officials have had periodic spasms that have resulted in further expansion of various "entitlement programs". Medicare is an example. While both sides of the aisle have contributed mightily to the larding on of promises and costs, the party of fiscal prudence has been especially imprudent. Exhibit A is the new Medicare Drug benefit that managed a rare trifecta of: Promising to bankrupt the federal government, while guaranteeing massive profits to drug companies already operating under the monopolistic protection of our patent laws, while thoroughly confusing the populace.

Dynamic 2: Boomers. This is nobody’s fault, but there are a whole lot of us heading towards retirement and beyond. This has two serious implications. The first is that our health care costs will go up and up as we get older. That’s just what happens. The second is that traditional sources of funding for those costs, companies and insurance companies, don’t want the costs. That means we’re collectively dumping ourselves onto each other. And there are fewer wage earners to pay for the mess.

Dynamic 3: Spending. Reckless spending. Baffling to "fiscal conservatives," their party of choice has presided over the biggest increase in every category of federal spending in modern history. It’s not just entitlements. It’s not just defense. It’s everything. Again, both parties play a role in this, but the blame sits squarely with the GOP. Add it all up, and the loan we’ve taken out for our kids and grandchildren to pay is stunningly large. And this is important: we can’t grow our way out of the problem.

Embedded Video

So, what do we do? If you’re young, a couple of choices come to mind.

1. Think about emigrating. Leave the problem to someone else to clean up.
2. Do everything you can to stay healthy.
3. Have a really serious talk with your parents about "advanced directives."
4. Don’t plan on having any disposable income when mom and dad get old. Your fellow former tax payers will be needing it all.

If those seem like grim choices, can someone please offer me some others? At a governmental level, the choices are actually quite clear. It’s just that none of them will be taken any time soon.

1. Get rid of the Medicare drug benefit
2. Get serious about a radical federalization of healthcare ala the UK, Sweden, Canada etc.
3. Impose other radical changes that will force, or perhaps enable, true entrepreneurial behavior not just at the fringes of medicine, like plastic surgery or laser eye surgery, but at the center of the plate where all the costs are.

Tags: DavidWalker, Comptroller General of the United States, GAO, Health Care, Medicare, Part D, Bankrupt the country, Decision Making, Decision Quality, Morality, Ethics

For years, all the hand wringing about the poor rate at which America saves–a statistic that struggles under the weight of the federal deficit thumb on the scale–has been offset by high rates of home ownership and home equity. Here’s the dirty little secret.

For the past couple of decades Americans have used their homes as ATM machines and banks have used home equity loans as one of their primary engines of financial growth. Worse, the mighty US economy has been buoyed along all these years on a wave of consumer spending that has as its source, not rising wages, but rising use of credit to buy all those marvels of the consumer age.  That hissing sound you hear is the next bubble getting ready to go flat.

Little by little, millions of Americans surrendered equity in their homes in recent years. Lulled by good times, they borrowed — sometimes heavily — against the roofs over their heads.

Now the bill is coming due. As the housing market spirals downward, home equity loans, which turn home sweet home into cash sweet cash, are becoming the next flash point in the mortgage crisis.

Americans owe a staggering $1.1 trillion on home equity loans — and banks are increasingly worried they may not get some of that money back.

To get it, many lenders are taking the extraordinary step of preventing some people from selling their homes or refinancing their mortgages unless they pay off all or part of their home equity loans first. In the past, when home prices were not falling, lenders did not resort to these measures.

Such tactics are impeding efforts by policy makers to help struggling homeowners get easier terms on their mortgages and stem the rising tide of foreclosures. But at a time when each day seems to bring more bad news for the financial industry, lenders defend the hard-nosed maneuvers as a way to keep their own losses from deepening.

Like all the other macro chickens coming home to roost, there really isn’t anyone to blame. It wasn’t a plot. The pickle is the result of millions of people making decisions to advance their self interest as they understood it at the time. But a couple of factors did contribute . . .

The hard-scrabble debt-aversion so characteristic of the children of the depression didn’t get passed down to their children

The vast and superbly effective media-fed consumer engine got going after the last great war and has never stopped. Almost none of us are immune to the siren call of the latest new, new thing.

The ongoing tug of war between regulation and “free markets” has never been truly two-sided. Little by little the regulatory fences put in place as a result of the big D have been cast aside, making it easier and easier for regular folks to paddle in the same pool with financial sharks.

As an individual, the choices aren’t that tough to figure out. Spend less than you make. Save more. Don’t take on a lot of debt. Stuff your grand parents said. As a society, there’s more pain ahead.

Tags: HomeEquity, Bubble, Mortgages, home equity loans, depression, recession, decision making, decision quality

There is a long piece at www.midliferider.com on buying a motorcycle helmet. Tucked in there is a bit about using a standard decision quality tool called a decision table to help you sort out your choices.

How to decide for yourself

Before we go any further, and by all means skip ahead if you want, a word or three about making YOUR OWN decision about what helmet to buy.

There isn’t a right answer. There is a right answer for you. You can make your decision any way you want. You can throw darts, pull names from a can, buy what your buddy uses, or let a sales person tell you what to buy. Up to you.

There is a way to make this decision in a high-quality way, even if you know nothing about helmets. To do that, make a grid. On one axis, put your values. On the other your choices.

Values are what you want. Make a list of no more than five. Consider these: Quality, price, fit, noise/quiet, weight, graphics. That’s six. Think about throwing one overboard or making a bigger table. Or try: shock, fit, noise, weight, and fogging.

Choices are what you can choose. In this case, that’s the actual helmets. Again, no more than five.

What you’re going to do is use a scale to grade each choice by each value. The scale can be A, B, C, D, or 1—10, or anything that pleases you. Head to the internet and do some research. Talk to people. Read some reviews. Then grade each helmet by each criteria. Do the math and pick the helmet that’s best for you.

There are lots of subtleties and wrinkles to this. For example, you can weight different values as more or less important. Do that if you need to, but for now, just make the grid. It will help a lot. 

Tags: MotorcycleHelmet, Decision Quality, Decision Making, Midlife Rider, Values, Choices

We’re going to see more and more stories like this one about how the checks and balances built into the mortgage business got roundly ignored.

They could see the meltdown coming.

Freelance financial watchdogs who examined the paperwork on subprime home loans being sold to Wall Street had an inside view of the boom in easy-money lending this decade.

The reviewers say they raised plenty of red flags about flaws so serious that mortgages should have been rejected outright — such as borrowers’ incomes that seemed inflated or documents that looked fake — but the problems were glossed over, ignored or stricken from reports.

The reviewers’ role was just one of several safeguards — including home appraisals, lending standards and ratings on mortgage-backed bonds — that were built into the country’s mortgage-financing system.

But in the chain of brokers, lenders and investment banks that transformed mortgages into securities sold worldwide, no one seemed to care about loans that looked bad from the start. Yet profit abounded until defaults spawned hundreds of billions of dollars in losses on mortgage-backed securities.

There are so many "larger lessons" in here it’s hard to know where to start. Focusing on the decision-making lessons here, one obvious one is the importance of looking for "dis-confirming" information. Nobody is immune to falling in love with an idea. We do it for all sorts of reasons. And in the rush and flush of excitement about this person, or that option, or this idea, we tend to be particularly unreceptive to information that might suggest a flaw, a pause, or a concern.

This dynamic goes geometric when two other factors are introduced.

The first is the presence of a "champion," someone who passionately believes in and advocates in favor of an alternative. It’s hard not to get swept up in the enthusiasm. It’s harder still to point out flaws in something someone else has identified him or herself with. Now the divergent thinking feels a lot like personal criticism. To not love the idea is to not love the idea’s champion.

The second is the madness of the crowd, otherwise known as peer pressure. Everyone else is doing it, so why not me or us?

Add to these two factors a third, the presence of massive amounts of money being shoveled towards the idea, in this case securitized mortgages, and you have a toxic brew: Powerful champions, a brain-dead heard, and greed born on the wheels of pots of money. Is it any wonder that the pencil pushers who kept turning up signs of bad news at the loan level were going to get ignored? After all, it’s just one loan out of a zillion. Exactly.

So add this to the ever growing list of potential lessons learned: go looking for information that runs counter to the crowd, the champions, and the money. At least consider the possibility that there is more uncertainty here than you think. At least ponder the other options.

Tags: Mortgage, Sub-Prime, Mortgage-backed-securities, meltdown, due diligence, disconfirming evidence, greed, decision making, decision quality

A few weeks ago I took a poke at Harvard University for its apparent decision to invest in its basketball program, a decision which has had at least one unintended consequence, which is to draw the attention of the NCAA. I put it down to Stanford envy.

For slightly less than forever, colleges, universities, and their alum have been pouring money into their athletic programs. I’m sure there are lots of reasons why that’s so, but the leading reason surely must fall under the general category of marketing and brand building. It’s a way of getting the name out. And presumably success on the field translates elsewhere. “We won our conference last year, so enroll here and you can be a winner too (at finding a mate, learning about post-modernism, finding a job, whatever).”

Since 1984, there’s actually been a term for this seeming relationship between athletics and academics. It’s called the “Flutie Effect”, and it’s now been studied by a couple of academics . . .

Until recently, evidence about the “Flutie Effect” — coined when applications to Boston College jumped about 30 percent in the two years after quarterback Doug Flutie’s Hail Mary pass beat Miami in 1984 — had been mostly anecdotal.

So two researchers set out to quantify it, concluding after a broad study that winning the NCAA football or men’s basketball title means a bump of about 8 percent.

“Certainly college administrators have known about this for a while, but I think this study helps to pin down what the average effects are,” said Jaren Pope, an assistant professor in applied economics at Virginia Tech who conducted the study with his brother Devin, an assistant professor at the University of Pennsylvania’s Wharton School.

Getting down to specifics . . .

For George Mason University, just outside Washington D.C., the positive effects of its unlikely Final Four appearance two years ago were wide-reaching.

In addition to increases in fundraising and other benefits, freshman applications increased 22 percent the year after the team made its run. The percentage of out-of-state freshmen jumped from 17 percent to 25 percent, and admissions inquiries rose 350 percent, said Robert Baker, director of George Mason’s Center for Sport Management who conducted a study called “The Business of Being Cinderella.”

Baker also found that SAT scores went up by 25 points in the freshman class, and retention rates as freshmen moved into their sophomore year increased more than 2 percentage points.

I must confess I find this a fascinating study in decision making.

From the standpoint of the college or university, this surely puts the sword to the tiresome debate about the role of athletics in institutes of higher learning. If you want to get your inquiries and SAT scores up, offer more scholarships to better athletes. Or, to call the ball, get more people who are less like the people you want to educate to come work for your sports program. The operative word here is “work.”

The brilliance of this strategy is that, while there is certainly some uncertainty involved with “investing” in sports, elsewhere it’s called gambling, here in the hallowed halls of academia it’s a simple cost/benefit analysis. Hit up some alumni for a new field house or weight room, buy yourself a new coach, and go find some young men (and it’s not Title 9 athletes we’re talking about here) who are willing to work for room and board. It’s not like the sticker price of the scholarship means anything; it’s funny money anyway. And the best part about it? You don’t even have to win. You just have to show up in the polls or the big tournament for the benefits to roll in.

From the standpoint of the prospective student, following the sports page now takes the mystery out of the otherwise hard work of weighing all those pesky criteria like costs, majors, graduation rates, and whatever else it is the US News college guide says you should pay attention to. Just buy the winning brand baby! It will be good training later in life when you go to buy your next cup of coffee, toothpaste, car, television, vacation destination, pre-school for your kids . . .

kah

Tags: FlutieEffect, Harvard, Stamford, Gonzaga, George Mason University, NCAA, Virginia Tech, The Business of Being Cinderella, Decision Making, Decision Quality

Some years ago I coined the term, "Customer 6.0". Here’s what I said . . .

The idea behind Customer 6.0 is that the information asymmetry that had existed in most buyer/seller transactions, certainly over the past 60 years, were beginning to invert in favor of the customer (a notable exception is the complete lack of transparency in the world of exotic financial transactions).

Whether this is good or bad, it is, and the tools of this inversion were built by large enterprises, and now those same tools were and are being used "against" them. In other cultures, bargaining is just part of going to the market. Here in the big PX, that type of transaction typically does not happen, particularly in large-footprint retailers, the kind that increasingly dominate retail sales of nearly everything everywhere. Instead of bargaining, many of us just went someplace else . . . like the internet. At least according to the NYT, the historic dynamics of the bazaar are finally visiting even big-box retailers.

A bargaining culture once confined largely to car showrooms and jewelry stores is taking root in major stores like Best Buy, Circuit City and Home Depot, as well as mom-and-pop operations.

Savvy consumers, empowered by the Internet and encouraged by a slowing economy, are finding that they can dicker on prices, not just on clearance items or big-ticket products like televisions but also on lower-cost goods like cameras, audio speakers, couches, rugs and even clothing.

The change is not particularly overt, and most store policies on bargaining are informal. Some major retailers, however, are quietly telling their salespeople that negotiating is acceptable.

Good to know.

kah

Tags: Customer6.0, bargaining, big box retailer, megastore, haggling, bazzar, Best Buy, Cicuit City, Home Depot

The drums are beating louder about the ongoing financial sector melt-down, and the seemingly unequal treatment received by "we the people," citizens, tax-payers, shareholders, and mortgage holders, and the captains of industry. Yes, it’s true: A couple of them missed their bonuses last year. And true, some have seen huge piles of paper net worth go up in smoke, built as it turns on on what look like ill-gotten gains.

But the truth is, there has been a massive shift in financial risk from the government and large corporate entities, all of whom presumably have available the absolute latest and greatest in analytical capabilities, to individuals who do not. Some sightems, first from the NYT Editorial Page on how big financial players have successfully socialized the costs of their bad decision making.

The ongoing bailout of the financial system by the Federal Reserve underscores the extent to which financial barons socialize the costs of private bets gone bad. Not a week goes by that the Fed doesn’t inaugurate a new way to provide liquidity — meaning money — to the financial system. Bear Stearns isn’t enormous. It doesn’t take deposits from the public. Yet the Fed believed that letting it implode could unleash a domino effect among other banks, and the Fed provided a $30 billion guarantee for JPMorgan to snap it up.

Compared to the cold shoulder given to struggling homeowners, the cash and attention lavished by the government on the nation’s financial titans provides telling insight into the priorities of the Bush administration. It’s not simply a matter of fairness, though. The Fed is probably right to be doing all it can think of to avoid worse damage than the economy is already suffering. But if the objective is to encourage prudent banking and keep Wall Street’s wizards from periodically driving financial markets over the cliff, it is imperative to devise a remuneration system for bankers that puts more of their skin in the game.

Financiers, of course, dispute that they are being insufficiently penalized. “I received no bonus for 2007, no severance pay, no golden parachute,” E. Stanley O’Neal, the former chief executive of Merrill Lynch, told a House committee recently. That doesn’t seem like much of a blow to Mr. O’Neal, who was removed earlier this year following gargantuan subprime-related losses.

Indeed, the pain that is being inflicted on financial-industry executives as a result of their own actions and decisions is not proving much of an encouragement. Rather, the knuckle-rapping seems only to encourage bankers to make up for any losses they may suffer by finding another way to navigate their companies, the financial system and the economy into the next maelstrom — from Internet stocks to what the industry calls zero-down, negative amortization, no-doc, adjustable-rate mortgages.

I’ve been struggling to capture this notion in previous blogs. It turns out there’s a juicy academic term for what I was trying to express: "Moral Hazard." Ellen Goodman, columnist for the Boston Globe, shines the light on this one as used by various right-leaning economists.

The idea began as an argument against insurance. If you had fire insurance, you would be careless around matches. Zap, more fires. In recent decades, it’s been used as a righteous reason for shredding safety social nets and toughening laws like those against declaring bankruptcy. Such safety nets, it’s argued, only encouraged more sinners, excuse me, welfare mothers and bankrupt families.

The same language of morality has been used by economic fundamentalists who don’t want to help homeowners who got subprime mortgage loans and find themselves in deep foreclosure weeds. Mike Huckabee once said that it "is not the purpose of government to prop people up from every poor decision they make. . . . It creates an enabling co-dependency." And as recently as last weekend, Treasury Secretary Henry Paulson insisted that government actions to prevent foreclosures would "do more harm than they would do good."

I grant you that moral hazard is not a myth. But most of the sermons railing against the harm of helping others are directed at the poorer pews.

We don’t seem to worry about the moral hazard of, say, protecting a CEO from his failings. Need I remind you that Robert Nardelli got $210 million in severance after he hammered Home Depot? Or that he now resides at the top of Chrysler?

This leads us right into the den of Bear Stearns. Last weekend, while its chief executive was off playing bridge, one of the most aggressive cowboy firms in the mortgage securities business collapsed. The government brokered a deal with J.P. Morgan Chase to buy the firm and guarantee its loans with your tax dollars.

None of this is difficult to understand, even if the intellectual dishonesty and all-around hypocrisy reeks. Money talks. Money fills campaign coffers. Money pays for elections. Money makes the world go round. And the "money, mahogany, and Monet" crowd have more of it than the rest of us, and they know how to spend it to smooth the way for their best friend, though occasionally obstreperous Mr. Markets.

All this talk of Moral Hazard got me interested. Who is this guy and why should I care? It turns out the concept figures prominently with the dismal science crowd. The problem is, nobody seems to want to play pin the tail on the donkey and talk about MH in connection with the really-really of how large corporations and the US Government have systematically transfered financial risk to average citizens.

Economist Sam Vaknin defines Moral Hazard like this . . .

Moral hazard is the risk that the behaviour of an economic player will change as a result of the alleviation of real or perceived potential costs.

Basically the idea is that the risks and rewards are not properly arrayed against the choices available. There is more upside than there is downside, and that asymmetry is artificial. This asymmetry is made worse where there is a similar and related imbalance in access to material and useful information.

Moral Hazard makes an appearance as the handmaiden of the foundation of modern economies: The ability to talk about and quantify risk. Says Professor Vaknin . . .

Profits can be easily cast as the premiums a firm charges for the risks it assumes on behalf of its customers – i.e., risk transfer charges. Depositors charge banks and lenders charge borrowers interest, partly to compensate for the hazards of lending – such as the default risk. Shareholders expect above "normal" – that is, risk-free – returns on their investments in stocks. These are supposed to offset trading liquidity, issuer insolvency, and market volatility risks.

The reallocation and transfer of risk are booming industries. Governments, capital markets, banks, and insurance companies have all entered the fray with ever-evolving financial instruments. Pundits praise the virtues of the commodification and trading of risk. It allows entrepreneurs to assume more of it, banks to get rid of it, and traders to hedge against it. Modern risk exchanges liberated Western economies from the tyranny of the uncertain – they enthuse.

But this is precisely the peril of these new developments. They mass manufacture moral hazard. They remove the only immutable incentive to succeed – market discipline and business failure. They undermine the very fundamentals of capitalism: prices as signals, transmission channels, risk and reward, opportunity cost. Risk reallocation, risk transfer, and risk trading create an artificial universe in which synthetic contracts replace real ones and third party and moral hazards replace business risks.

As I’ve already said, herein lies the problem. It’s not Moral Harard writ large. It’s bad enough when the counter parties are roughly equal. For example, in a contest between two governments or two large entities, there is often a back door available. Governments can inflate their way out of their money problems (and do all the time). Large entities can do the equivalent by issuing more stock or engineering a transaction.

But what happens when it’s you and me vs. Enron or Bear Stearns? What happens if you’re one of the millions of baby boomers who entered the work force with one set of assumptions about where your retirement security would come from, only to find out that all the risk has been transfered to you, and all the rewards have been kept by someone else. That seems like something more than mere Moral Hazard.

Tags: MoralHazard, JPMorgan, Bear Stearns, Enron, Markets, Federal Reserve, Fed, Bailout, Bubble, Sam Vaknin, Ellen Goodman, Decision Making, Decision Quality