Moral hazard noun
môr’əl, hāz’ərd
1: The tendency of individuals, firms, and governments, once insured against some contingency, to behave so as to make that contingency more likely. 2: A justification for imposing the negative economic impact of a transaction on the party least responsible for it and least able to bear it.

The basic concept seems sensible enough: If you protect people against the consequences of their acts, some of them will feel freer to do things they shouldn’t. If people know that they will be reimbursed after a flood wipes out their beachfront houses, they will rebuild again and again. If insurance pays off when their cars are stolen with the keys in the ignition, people are more likely to leave their keys in the ignition.

Some think the concept of moral hazard should lead policy makers to refuse to protect defaulting subprime borrowers from losing their homes. “The vast majority of today’s market meltdown is attributable to business decisions that grown-ups entered into voluntarily,” the Washington Post has editorialized, referring presumably to the lenders who loaned money and the people who borrowed it. “The people who made those decisions should have to face the painful consequences, just as they would have profited if the market had worked out differently.”

Come on. We know what was really happening, don’t we? The “business decisions” that really drove the sub-prime market were not between lenders and home-buyers. If they had been, they never would have happened. Basic cable TV would not have been awash in “bad credit, no problem” commercials. Money would not have been loaned to people who, almost by definition, were bad credit risks.

The real “business decisions” were made by the lenders that made the loans and the investors, flush with bull-market cash, that bought packages of these loans. The role of the home-buyer was closer to the role of beef cattle in a livestock deal. The cattleman and the packing house turn a profit. The cattle? Not so much.

What about the transactions between borrowers and lenders? Weren’t they, as the Post says, contracts, entered into voluntarily, between grown-ups who now “should have to face the painful consequences”?

Well, yes, they were contracts of a sort. They were a couple of steps up from the “contracts” between customers and dry cleaners who, by posting a sign, seek to force your consent to their selling your clothes after thirty days. You think that you’ll pick up your clothes in thirty days and, besides, they won’t clean your clothes if you don’t agree, so you drop your shirts and take your claim check.

It might be fairer to compare the sub-prime loans to other agreements you sign when you buy a home. Like termite inspection. It seems reasonable. Why shouldn’t you and the mortgage company want insurance against the possibility that termites might be found and the value of the house would drop precipitously? But have you ever read the agreement you sign with the termite company? (No? Well there’s at least part of the problem.) The one I signed did say that the house was termite-free—on the day of the inspection. And if termites are discovered a few weeks or months later? They must have gotten in after inspection day, so they’re your problem. Oh, and there’s one other small reservation. The termite company is not responsible for termite damage or infestation that was covered up by furniture, rugs, or boxes. Of course. How could they be responsible? Why should they be responsible? But think about it. As a condition of the mortgage and therefore of the sale, the termite inspection is made before the sale—usually while people are still living there. The house is filled with furniture, rugs and boxes. Is there a square inch that’s not covered? So why would you, a grown-up, make the business decision to pay for almost non-existent protection? Because you want the house, you need the loan, and the mortgage company won’t make it unless you sign. So you sign.

Or take another condition of getting a home loan, title insurance. Again, it seems reasonable. A company that is going to lend a few hundred thousand dollars to buy a house wants and needs assurance that the house actually belongs to the sellers and that they are legally entitled to sell it to you—that overlooked heirs of former owners won’t come out of the woodwork and claim that the house really belongs to them, that your deed of sale is worthless. But if you read it—did you?—title insurance actually insures you against no such thing. It only insures you against the possibility that whoever searched the title—whoever followed the record of sellers and buyers that the county register of deeds maintains—didn’t miss something that was on the record. But what happens if the real ownership isn’t reflected on the record? What happens if a long-lost ex-wife appears, claiming that the house is really hers, and that her no-good skunk of an ex-husband had no right to sell it to you? It’s not on the record. So it wouldn’t be the title insurer’s problem. It would be your problem. But you want the house. You’re at closing. You’ve already sold your old house. Refusing to buy title insurance would kill the deal. So you sign.

Lawyers have a name for these kinds of contracts: contracts of adhesion. Contracts in which one party has so much more power than the other that it can dictate the terms of the deal.

For example: Everybody needs a place to live. But for many working low- and moderate-income families, rent has become unaffordable, and a mortgage company will loan the price of a house at payments that are less than rent. The payment will be a stretch—but with a little belt-tightening it will be doable. There’s a lot of fine print and a lot of legal language—which nobody reads. They want the house. They need the house. So people sign.

Think that only the truly desperate or terminally dim would enter into such a deal? A few years ago I was visiting a friend, a mid-thirties teacher, Phi Beta Kappa, a master’s degree, married to an accountant. We took a walk around their neighborhood, and I noticed a lot of homes for sale. What happened, I asked. There had been a local real estate downturn, she said, and a lot of people found themselves with houses they couldn’t afford to keep up payments on and couldn’t sell for what they owed. So they just walked away. She and her husband, said my friend, were paying half their take-home pay for their mortgage payment. She was a good friend, so I wondered aloud how they got into such a situation, as smart as they were. “The real estate agent said we could afford it,” they said. “The VA said we could afford it, and the VA said we could afford it. Who were we to say no?”

What do the equities involved in how we got here tell us about what we should do now?

To start with, not the kind of federal bail-out the Federal Reserve announced in mid-March, loaning investment banks up to $200 billion on the collateral of the high-risk packages of mortgages that got them into trouble in the first place. Many economists will like this solution because it will ease the credit crunch by channeling cash to the investment banks, cash that they can pump back into the market, no doubt more prudently this time. But it offends economic equity by holding harmless the most culpable parties to the enterprise, the investment banks that encouraged the creation of these sub-prime loans as investment vehicles. Talk about moral hazard!

In fact, it’s the investment banks and mortgage lenders that deserve the remedy that the Washington Post prescribes for all the grownups that participated in these business decisions: “fac[ing] the painful consequences, just as they would have profited if the market had worked out differently.”

If the Fed has $200 billion burning a hole in its pocket, why not use it to help the real victims of the sub-prime imbroglio, the families who thought they could afford to buy a house they had thought was out of reach, or who took out sub-prime refinancing so they could pay for college or medical bills? Why not use it to help them make the monthly payments they thought they were agreeing to at the bargain-basement interest rates they were promised. That would allow the holders of the sub-prime paper to bail themselves out on a short leash, one month at a time.

It would also assign to the government the role it should be playing. Not rearranging markets by saving major economic actors from the consequences of their own unwise actions, but protecting victims whose primary mistake was to take those actors’ representations at face value.