Analysis: Moral hazard and the case for privatizing the CMHC

A rash of self amputations in Florida, and a call for change at the Canadian Mortgage and Housing Corporation. They might seem worlds apart, but these two stories are bound by an ages-old economic problem: moral hazard.

When Conservative Party Leadership candidate Michael Chong promised to privatize the Canadian Mortgage and Housing Corporation, he argued the move would protect taxpayers from risk and help make housing more affordable. He cited evidence from the International Monetary Fund that show countries with government securitization of mortgage risk suffer from greater housing market inflation. 

Moral hazard is "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly."- Economist Paul Krugman

Even though he never used the phrase, the economic problem that Chong identified is known as moral hazard.

In the words of Nobel Prize-winning economist Paul Krugman, moral hazard is "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly."

And the concern raised by the IMF is that the CMHC bears the cost, while the banks, and by extension, borrowers decide on the risk.

A 2014 IMF report advised that "action to further limit exposure of taxpayers to the housing market and encourage appropriate risk retention by the private sector would be desirable."

One claimant lost two limbs in a strange incident involving a rifle and a tractor. Another shot off his foot while aiming at a squirrel.

They continued the theme in a 2015 report.

"Limiting the federal backstop would increase private sector risk sharing and can further encourage prudence."

In other words, the banks will be a lot more careful with their lending if the government weren't there to catch them when they fall.

The further logic in Chong's announcement is this: banks are overly liberal with lending because the risk is borne by taxpayers. As long as interest rates are at historic lows, consumers are willing to take on big debt, because it's comparatively cheap. That in turn drives up housing prices to unsustainable levels. It's the cascading effect of moral hazard.

Moral hazard is often associated with the insurance industry, because insurers are in the business of taking on risk for people and firms. For the price of a premium, the insurer promises to pay you if something goes wrong car accident, fire, death, etc.

And for the most part, that arrangement works. Insurers calculate risk and set the premiums accordingly, so they can cover people's losses and still turn a profit. And the insured get peace of mind from knowing that if worse comes to worst, they will not be ruined by misfortune.

The problem for insurers here is that people can behave differently when they know they don't bear the full risk. The knowledge that someone else will bear the cost of their behaviour can lead people to be less careful, even if it's only in small ways.

There's long been concern that you might lose your moral compass because of incentives built into an economic agreement. In the 19th century, when life insurance started to become common, pastors and priests sermonized about the evils of insurance. They recognized that the terms of an insurance policy could put their parishioners in moral peril.

By and large, insurers find ways to deal with the problem by building stipulations into policies and contracts. So for example, fire insurance policies might be contingent on proper maintenance of safety equipment. Car insurance in nullified if the driver is impaired. Premiums go up if you get speeding tickets. And, of course by and large people DON'T want their house or business to burn down.

But there's plenty of evidence that the combination of moral hazard and a sprinkle of human desperation can turn ugly.

Consider the town of Vernon, Florida. It had once been a prosperous centre for shipping. But by the 1950s the good times were over and Vernon was an economic backwater. Some townsfolk found a gruesome solution to their financial straits. They started "accidentally" losing limbs in order to make dismemberment claims on their insurance policies. In a town of just 500 people insurance companies reported 50 cases of dismemberment claims over 10 years. 

That earned Vernon the nickname "Nub City" among insurance adjusters.

An insurance claims inspector at the time told a Florida newspaper about some of his cases. They included a man who shot off his foot in a valiant defence of his chickens. One claimant lost two limbs in a strange incident involving a rifle and a tractor. Another shot off his foot while aiming at a squirrel.

It was just 12 hours after he took out the policy.

It's difficult to know just how many of those cases were truly accidents and how many were outright fraud. But the rash of claims suggest that the promise of pay out tilted the moral balance for some folks in desperate times.

The Canadian Mortgage and Housing Corporation is not 'Nub City,' but moral hazard is still a concern, according to real estate finance expert Tom Davidoff, of the UBC Sauder School of Business.

"Any time there's insurance, be it explicit insurance, like CMHC or implicit insurance, that the banking system will be bailed out in a major downturn...there are moral hazard issues."

Davidoff also points out that the tricky business of managing who bears risk and who gets the reward is a permanent feature of finance.

"Almost any banking or financial system is going to involve some moral hazard where lenders are going to have incentives to take risks, because their downside is going to be limited."