Home > Economics - General > Moral hazard, meet adverse selection

Moral hazard, meet adverse selection

September 20th, 2008

At a time when anyone on the cutting edge is talking quadrillions, it seems a bit petty to worry about a $50 billion component of the latest bailout (only $500 per US household!). Modest as it is, the insurance scheme offered to money market funds by the US Treasury provides the opportunity to explain a little bit more about the theory of insurance.

By now, everyone has heard about moral hazard, that is the encouragement to take risky or reckless action that arises when your losses are insured by someone else. Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.

For example, if you have a money market fund with assets now worth 97 cents in the dollar, and someone offers you the chance to insure against ‘breaking the buck’ you’re going to take it, since it’s a sure thing that you can collect. (It doesn’t matter much what the premium is, since your loss will increase by an amount equal to the premium paid). As far as I can tell, that’s exactly what’s on offer from the US Treasury right now. (I’d be pretty annoyed if, like Legg Mason, I’d just tipped in $630 million of company money to protect customers against this eventuality, but I guess they can probably claw it back, and take the Treasury deal instead).

By contrast, if I have kept my customers’ money in safe assets like government bonds,it would be silly to take out insurance against a risk to which I’m not exposed. That means that the premiums have to be high, which in turn means that even moderately risky firms will find the deal unattractive, unless the public subsidy keeps increasing.

The current holdings of money market funds are around $3.4 trillion. Let’s suppose half of them are in some kind of trouble, amounting to an average loss of 3 cents in the dollar (the same as the Putnam fund that just put up the shutters). If all these funds sign up for the scheme, while the other half stay out, the losses will almost exactly wipe out the Treasury’s stake.

An interesting sidelight is that this scheme is being funded by cashing in the assets of the Exchange Stabilization Fund, established in the 1930s to intervene in foreign exchange markets. I guess they’ll never need any of those Depression era relics again.

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  1. Ian Gould
    September 20th, 2008 at 11:27 | #1

    “By contrast, if I have kept my customers’ money in safe assets like government bonds,it would be silly to take out insurance against a risk to which I’m not exposed.”

    with official interest rates at 2% and inflation at 4%+. government bonds are really only “safe” in the sense that the amount of money you’re going to lose is quantiified up front.

  2. September 20th, 2008 at 11:31 | #2

    i thought ‘moral hazard’ was allowing people to dispose of opm without supervision. the hazard being, without supervision, they’re going to steal. the moral part comes from imaging children in an unintended lollyshop won’t help themselves, because nana said “don’t”, silly old lady.

    your definition is a subset, predicated on financial mandarins meaning well initially, but drifting into turpitude from repeated temptation.

    the enron case should have educated the whole world that in fact people who like to make money without getting dirty and sweaty are not initially virtuous. hardly the first lesson, of course.

  3. Ernestine Gross
    September 20th, 2008 at 20:37 | #3

    Re #1. There is a difference between the discount rate (2%) and the yield for Govt issued bills and bonds with varying maturities.

  4. Ernestine Gross
    September 20th, 2008 at 21:03 | #4

    1. It seems to me moral hazard-adverse selection type problems are of interest only if one assumes that the regulatory framework will not change. However, it has already changed (banning of naked shorts, then banning of shorts for a period of time, then .. we are waiting what next).

    Furthermore, not all people who make their living in the financial market have ideological blinkers. There are many voices which say ‘back to basics’, stricter enforcement of existing laws and regulations and a rethink.

    2. There is another hypothesis that was promoted during the ‘financialisation of the economy’ (I like this term): The hypothesis that there is a ‘market for corporate control’(take-overs) and it is a ‘good thing’. I can’t remember whether the word ‘competitive’ was also in the phrase but I remember clearly that the ‘theory’ was that this market would increase ‘efficiency’ defined as increasing the ‘value of the firm’ (share market + debt market value).

    I propose, this hypothesis is being more or less continuously tested (case study method) for quite some time. What would you conclude from the evidence todate?

  5. SJ
    September 20th, 2008 at 21:04 | #5

    Ernestine,

    I’m quite sure that Ian understands the difference between discount, coupon and yield, and the difference between bills and bonds. So what? What’s your point, and if there is one, are you able to state it clearly?

  6. TerjeP
    September 20th, 2008 at 21:06 | #6

    Now it’s time meet moral hazard’s evil twin, adverse selection. That’s what happens when the people you are offering to insure already have a pretty good idea whether they are going to collect or not.

    The evil cousin (twice removed) is when you know insurance is a bad deal and somebody forces you to buy it anyway.

  7. SJ
    September 20th, 2008 at 21:17 | #7

    Terje, those kinds of insurance stop you from landing the bill with someone else. Ain’t the same thing at all, except from the completely, utterly self centered Terje perspective.

  8. SJ
    September 20th, 2008 at 21:52 | #8

    Ernestine, your post #4 must have been held up in moderation or something, so that I hadn’t seen it before my post #5.

    But I take it that your answer to my question is “no”.

  9. Ernestine Gross
    September 20th, 2008 at 23:11 | #9

    Re #5: SJ, I don’t want to know why you make an assumption about assumptions I make about other people and then ask: ‘So what’?

    Re #8: I can find a question to which my answer is NO. The question is: Is SJ’s assumption about the assumption I make about Ian’s knowledge true? The answer is NO.

    (Hint: There is a distinction between what a person knows and what a person may write at an instance in time in a comment on a blog-site. … Oh, you know that. Well then it supports my point.)

  10. Ernestine Gross
    September 20th, 2008 at 23:30 | #10

    Re #6: SJ, stop playing the player rather than the ball. Obviously, Terje is referring to something like compulsory superannuation. This does not imply that I agree with Terje’s point of view.

    However, I happen to have reached the conclusion, rightly or wrongly, that you, SJ, are so self-centred that unless you understand something, it must be the fault of the person who said or wrote it

    May I suggest you answer the question in #52 in the preceedig thread.

  11. Ian Gould
    September 21st, 2008 at 12:40 | #11

    Ernestine is correct that the bond yield on Treasury bills differs from the discount rate.

    However the recent yields of Treasury bonds and notes have varied between 2.375 and 4.5%.

    So real rates on offer have been negative or extremely low.

  12. Ian Gould
    September 21st, 2008 at 12:50 | #12
  13. TerjeP
    September 21st, 2008 at 13:48 | #13

    #10. Actually compulsory superannuation is not insurance in my book. However something like the medicare tax surcharge is designed to compel insurance and is annoying. By all means cut of my access to medicare but don’t force me to buy crap products.

  14. SJ
    September 21st, 2008 at 20:52 | #14

    Alas, Terje, we don’t live in a country where the three little Terjes will be allowed to die simply because big Terje didn’t want to be forced to buy insurance, and can’t pay the medical bills.

    You may be confident that you can afford anything on your own, but you’re probably wrong. Hence you’re going to intentionally or otherwise land the bill on someone else.

    I’d agree that the requirement for private insurance is useless on top of medicare, but your position that you don’t need either the private insurance or medicare is ludicrous.

  15. SJ
    September 21st, 2008 at 21:07 | #15

    However, I happen to have reached the conclusion, rightly or wrongly, that you, SJ, are so self-centred that unless you understand something, it must be the fault of the person who said or wrote it.

    Ernestine, when people qualified in you own field can’t understand what you mean, and you refuse to explain, there are two possible explanations:

    a) you don’t really understand what you are talking about, or,

    b) your communication skills are poor.

    You’re like a high-end version of the poster who calls himself “observa”.

  16. TerjeP
    September 21st, 2008 at 23:30 | #16

    SJ – I’m not confident that I could afford any medical bill on my own. However a $500 excess is frankly ridiculous. I could certainly handle a $20,000 excess. Which is the type of insurance product I would buy if we did actually have a free market in health care.

    I haven’t advocated that we move to a completely free market in health care next month. If you want a taste of what I would advocate then the following link explains.

    http://alsblog.wordpress.com/2008/04/04/medicare-should-be-like-hecs/

  17. Ernestine Gross
    September 21st, 2008 at 23:59 | #17

    SJ, you like playing the player rather than the ball.

    For option c), see #11 above. It contradicts your options a) and b).

    Could we please return to the topic of the thread.

  18. O6
    September 22nd, 2008 at 13:07 | #18

    I’d be grateful if one of you economists could reassure me that the USA, while running a deficit of $500 milliard and now spending at least as much on ‘rescues’ and ‘bailouts’, is not going to generate massive inflation everywhere. It looks like printing money to me, but probably I’m wrong?

  19. Ian Gould
    September 22nd, 2008 at 13:19 | #19

    O6 – there are two realistic responses – print more money or raise taxes.

    An additional $1.5 trillion debt can be paid off over a decade at roughly $200 billion per year.

    (That figure for the final cost has two big caveats. The first is that it assumes the money from the current bail outs isn’t recovered. The second is that there are no further bail-outs. I assume for the moment that those two risks cancel each other out.)

    $200 billion per year is roughly 1.5% of GDP.

    Allowing the Bush tax cuts to lapse for people in the top tax bracket would recover most of that.

    My personal preference would be that the US Federal government cut spending by say $100 billion (starting with a wind-down of the Iraq spending). But politically that’s highly unlikely.

  20. SJ
    September 22nd, 2008 at 22:12 | #20

    Ernestine Gross Says:

    SJ, you like playing the player rather than the ball.

    Unfortunately, sometimes this is necessary to elicit information from uncooperative players.

    Ernestine Gross Says:

    For option c), see #11 above. It contradicts your options a) and b).

    And this tells me what I wanted to know, that the answer was actually option (a), which I was previously leaning against, rather than option (b), which I had favored.

    A good outcome for most of us here, I’d say. :)

  21. jquiggin
    September 22nd, 2008 at 22:19 | #21

    Can we stop being rude to each other please?

  22. SJ
    September 22nd, 2008 at 22:35 | #22

    Terje Says:

    I could certainly handle a $20,000 excess. Which is the type of insurance product I would buy if we did actually have a free market in health care. I haven’t advocated that we move to a completely free market in health care next month.

    Terje Says at the link in his earlier post:

    Medicare should be reformed so it is more like HECS. When you front up to the doctor or hospital for medical services then in order to pay the medical bill you should have the option of whipping out some cash, whipping out the MASTERCARD or whipping out the Medicare card. Medicare should be a credit fascility much like MASTERCARD or VISA. The only difference should be that the Medicare debt should be repaid via the tax system in the same way that HECS debts are repaid. In fact the debt could be administered by the same bureaucracy.

    Such a reform would ensure that medical consumers seek value for money. However it would still provide access for those with financial difficulties. Medicare should be regarded as a payment system not an insurance system. Insurance should be entirely optional.

    OK, so you want the system where the three little Terje’s die because big Terje can’t pay the bills.

  23. SJ
    September 22nd, 2008 at 22:44 | #23

    John Says:

    Can we stop being rude to each other please?

    Apparently not. ;)

    More seriously, though, your comment wasn’t visible before I posted my last. :)

  24. Bingo Bango Boingo
    September 22nd, 2008 at 23:15 | #24

    16 minutes is a long time to write about 30 words, SJ.

    Anyway, isn’t Terje’s plan one that clearly does not entail letting people die, or remain ill or whatever, for lack of money? They front, with no cash, and take the ‘HECS’ option, repaying the costs later (ie. by way of a HECS-like system: over time at a fairly low rate and only so long as their income is sufficiently high). Why would any little Terje’s die under this scheme?

    BBB

  25. TerjeP
    September 23rd, 2008 at 00:13 | #25

    Nobody would die due to moving from the current system to the one I propose via the link above. The system provides many of the benefits of a free market whilst also addressing concerns about universal access. It also does away with attempts at making private insurance compulsory. And with less queuing in the system we should expect fewer people dieing whilst they wait.

    Medical care is also less of a public good with fewer positive externalities than higher education (except perhaps in containing contageous illnesses). The case for HECS style funding in health services would seem to be more easily justified than in education services.

  26. Ian Gould
    September 23rd, 2008 at 11:04 | #26

    The problem with the HECS/Medicare analogy is two-fold.

    1. Firstly, education expenditure is volitional and is assumed to increase one’s debt repayment capacity.

    2. Some of the highest returns from health investment come from the low-cost preventative health measures which a high-deductible system wouldn’t cover, Personally I’d rather spend $10 for folate tablets for every pregnant woman rather than pay out the excess over $20,000 on the medical costs for kids born with Spina Bifida.

  27. Jim Birch
    September 23rd, 2008 at 11:13 | #27

    I don’t quite get you Terje. Is your objection to a compulsory system personal/ideological or evidence-based? You seem (to me) to swap arguments at will.

    What is the *evidence* against a compulsory system? AFAIK the Australian system performs quite well. And the pure private unregulated systems perform the worst, in both in terms of cost and failure rates.

  28. Ian Gould
    September 23rd, 2008 at 11:56 | #28

    Jim, the US system is not a private unregulated system. Hong Kong comes a lot closer to such a system. so did the Australian system prior to the 1950′s.

    The American system is a mish-mash of public and private which seems designed specifically for the purposes of transferring vast amounts of public money to private pockets.

    Because it was.

  29. jquiggin
    September 23rd, 2008 at 12:51 | #29

    The Hong Kong market was the beneficiary of a massive bailout in 1997, IIRC.

  30. Ian Gould
    September 23rd, 2008 at 13:49 | #30

    John – I was referring to the Hong Kong health system.

  31. TerjeP
    September 23rd, 2008 at 21:01 | #31

    Is your objection to a compulsory system personal/ideological or evidence-based?

    All of the above.

  32. Bingo Bango Boingo
    September 23rd, 2008 at 21:34 | #32

    The key thing is to get price signals in there, not to end the policy of state-funding of healthcare. Think Singapore, not USA.

    BBB

  33. Ian Gould
    September 23rd, 2008 at 21:46 | #33

    Yeah, that National Provident Fund is a model of free enterprise.

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