“Moral hazard” are two words that used to be thrown around a lot. When the global financial crisis hit in 2008, the US government was busy bailing out banks and other financial institutions. But it was only the really big ones, deemed “too big to fail”, that were lucky enough to receive taxpayer aid.
This taught corporate America a valuable lesson: if you are going to engage in risky behaviour, do it at such an enormous scale that the government will have no choice but to protect you. This is moral hazard: those benefiting from taking the risk (the shareholder) are implicitly protected by those who are not (the taxpayer).
Ten years on and we hear little about moral hazard these days. Does this mean moral hazards have generally reduced in the global economy? It sure does not seem that way.
Take global pension assets, for example. Since 2009, around $4 trillion has been withdrawn from fixed income assets and allocated to higher-yielding (and higher-risk) real estate and equity assets. This behaviour is rational in such a low interest rate environment. But when taken to the extreme, there are now very real social consequences of interest rates normalising. Pension assets could become impaired resulting in significant unfunded pension obligations. And the burden of unfunded pensions would ultimately fall to the taxpayer.
In China, the wealth management sector has ballooned over recent years and has been estimated to be as large as US$15 trillion today. Short duration wealth management products (WMPs) that fund long duration assets, such as real estate investments, are inherently risky. The reason? New WMPs need to be continually sold to repay the principal on maturing WMPs. Should demand for new WMPs suddenly dry up, it could trigger a funding freeze analogous to a run on a bank. Yet, the prevailing wisdom has been such that the Chinese government would not allow material defaults in this space – thereby ensuring continual liquidity in the WMP market. And this wisdom is probably right. The market has grown so large now, the government would not have much choice if a problem did materialise.
Finally, Australia is not immune to moral hazard either. The most notable moral hazard in recent years related to the implicit government guarantee enjoyed by Australia’s major four banks. David Murray’s Financial System Inquiry of late 2014 spotted this immediately: “To avoid moral hazard, regulatory settings should reduce the likelihood of Government support being required.” Sensibly, capital requirements for the major banks have since been increasing. Yet perhaps the largest moral hazard in the Australian economy relates to the country’s residential property market. It is no secret that property price metrics in certain Australian cities such as Sydney and Melbourne have risen to become some of the most expensive in the world. And these asset prices have supported a significant run up in household borrowings (with the causal effect likely going the opposite way).
But here is the problem: the significance of Australia’s housing market has now become so great that, arguably, policymakers cannot let prices fall. From an economic perspective, a meaningful decline in asset prices would likely result in significantly reduced home equity values and a substantial haircut to discretionary consumption. And from a political perspective, a very large voting cohort have benefited materially from this dynamic and will certainly vote against any policies that could see it end. But if prices can never fall, then the rational investor response is to borrow and buy as much as possible – putting the taxpayer at even greater risk. While moral hazards no longer make the headlines, it seems they remain alive and well, all around the world.
Andrew Macken is Chief Investment Officer with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.