From Wall Street to Main Street, the pain of the sub-prime debacle is being felt far and wide. Already, write-downs by big banks and brokerage firms like Citigroup and Merrill Lynch collectively top $120 billion and are expected to double in size before the debacle ends.
In recent times, both the stock and real estate markets have been sent reeling from the effects of sub-prime woes, as the economy teeters on the brink of an all out recession. Yet, the root cause of the marketplace's mayhem is greater than sub-prime mortgages simply gone bad. In reality, sub-prime is just the external symptom of the underlying issue concerning moral hazards.
Moral hazards occur when parties who are mostly insulated from risk behave differently from the way they would normally behave if they were fully exposed to the risk. Or put another way, moral hazards often result in sub-par behavior stemming from not having enough skin in the game.
Moral hazards abound these days because individuals and institutions do not bear the full consequences of their actions, thereby leaving other parties to bear the brunt of responsibility for the consequences of those actions. Finance, politics and the marketplace are rift with a variety of moral hazards. Consider the following:
Société Générale trader Jerome Kerviel and his staggering $7.2 billion dollar loss from unauthorized trades. Kerviel, who sought a bonus for himself, continued to bet the farm when in a hole because he was paid only for profits and could simply walk away from losses.
The proposed 2009 government spending plan, which has a deficit of around $400 billion (not including costs of the wars in Iraq and Afghanistan) and spending on entitlement programs like Social Security, Medicare and Medicaid, which are growing far faster than we can afford. Both are prime examples of passing the burden for the bill onto future generations.
The current bailout of our fragile economy through a combination of fiscal (tax rebates) and monetary (lowering of interest rates by the Federal Reserve) policy. Generous bailouts, however, typically help stage the next round of speculative excess because every time we repeat the bailout cycle, we get bigger and riskier bubbles. It should not be forgotten that the tax rebates and the lowering of interest rates earlier this millennium to help bailout the "dot com" bubble, in turn, helped fuel the ensuing housing bubble.
With respect to the aforementioned, each is more than just numbers or dollar signs. Rather, each is a moral statement about how life is lived and what is valued. To some extent, financial decisions are also spiritual ones.
In the case of sub-prime lending, a moral hazard occurred precisely because the players within it all profited by making imprudent loans, without bearing the burden of making good on the loans if they went bad. From mortgage brokers who loaned money that was not theirs, to banks who sought to sell the investment risk on to others in the form of high-yielding mortgage-backed securities, prudent mortgage standards were shirked in exchange for profit as the risk was passed on.
Unfortunately, the use of legislation is often ill-equipped to instill morality in the marketplace. For example, the recent passage of the Sarbanes-Oxley Act to prevent large companies from financial fraud and misleading their stockholders and investors in the wake of Enron and World-Com, failed to prevent today's sub-prime debacle.
Make no mistake, however; free markets need morality to function properly. History repeatedly shows that if the non-economic asset of virtue is removed from the marketplace then the constructive interplay regarding all other economic assets comes to a grinding halt given time.
Perhaps part of the problem today is that there is a growing cultural demarcation between the sacred and the secular. Increasingly, love and faith are reserved for Church on Sundays, while the workplace demands a focused self-interest and a competitive edge to survive.
Yet, as the late Pope John Paul II expressed, "There cannot be two parallel lives in their existence: on the one hand, the so-called spiritual life, with its values and demands, and on the other hand, the so called-secular life, that is life in a family, at work, in social relationships, in the responsibilities of public life and in culture."
Our faith reminds us that the pursuit profit through self-interest is not the sole purpose of business. Here again, Pope John Paul II urges us to understand that "The purpose of a business firm is not simply to make a profit, but it is found in its very existence as a community of persons who in various ways are endeavoring to satisfy their basic needs and who form a particular group at the service of the whole society."
Avoiding future debacles requires us to strive to do the right thing in business each day. It requires us to take into account the interests of other stakeholders in the greater marketplace, well beyond our little corner of it. At some level, all of us as business people are stewards, where as God's trustees, we are called to discharge our fiduciary duties with a spirit of love and concern for others.
In particular, the legitimate pursuit of profit through self-interest must be intertwined with a deeper concern for the spread of solidarity. Only then will we be living in accordance with God's design for business and with enough skin in the game to avoid moral hazards.
