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President Obama said he would announce his plans to attack home foreclosure today just before signing the stimulus bill yesterday. No matter what the plan is, it will undoubtedly shift incentives for homeowners or lenders. Moral hazard is a term used in economics, business, and political science to describe a situation where one party is insulated from risk and that insulation changes their behavior so they behave as if they were not at risk. Moral hazard comes up when an actor is not fully responsible for their actions—which could result in irresponsible behavior.
We run into moral hazard all the time in our daily lives. Auto insurance is one classic example. If you are insured against having to pay for a car accident, then you might drive a little more recklessly. Another example might be FDIC insurance on your bank account. If you have under $100,000 in your account, then the FDIC insures it against bank insolvency. Because of that insurance, consumers are less picky about their selection of who handles their money.
Obama’s wish list for home foreclosure prevention probably includes a subsidy for mortgage companies if they reduce their interest rates on borrowers, forced refinancing, and possibly cram down. Cram down could would give judges the power to change contracts in certain situations for mortgage holders—possibly including reducing the amount of their mortgage. Each of these methods and virtually any others used by government to prevent foreclosures will generate moral hazard. That will lead to even more government-induced risky behavior on either the part of consumers or mortgage lenders that drove the housing crisis in the first place.