What is Moral Hazard?

By Jason Fittler

Moral hazard occurs when a party insulated from risk behaves differently than it would behave if it were fully exposed to the risk.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions.

More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.

The phase Moral Hazard is now a buzzword, made popular by the recent movie Wall Street.

Moral Hazard is in my book a very serious problem in our society and extends well beyond the bounds of just the financial market.

We see it in the media. For example, the attack on Tony Abbott by channel 7 over his comments regarding a killed Australian Soldier. This was a clearly a beat up story by channel 7 to try to improve ratings.

You also see it with the ABC, a government owned media centre. Next time you are listening to their reporter interview a member of the opposition count how many times they mention that the opposition is being negative. This is in line with the Labors parties’ campaign that the opposition is only negative.

The GFC was caused by Moral Hazard, banks lending to homeowners in the US at very low interest rates and very low lending standards. These loans were then bundled up by the investment banks and sold to the poor unsuspecting retail investors. The bankers and investment banks made a bundle and the rest of us paid the price.

Back here in Townsville we had the Storm Financial collapse; here Storm clients were put into high risk gearing strategies to improve up front commissions to Storm. It works like this, Storm charged 6% entry fee, and on $300,000, this would be $18,000.

However, once Stormafide that client now had $1,000,000 to invest of which $700,000 is borrowed, the entry fee is now increased to $60,000. This is an increase of 233% of up front fees to Storm, but a major increase in risk to the investor.

To avoid the risk of Moral Hazard, you need to make sure that your risks are aliened to the risk of your adviser. For this to be the case your adviser’s income should be directly related to the performance of your portfolio.

MINC Townsville is structured in such a way, our income only increases if the value of your portfolio increases.

We share any risks with you, as such we treat your money as if it was our own.

In essence, our future prosperity is in step with your future prosperity.

Like to find out more? Give me a call on (07) 4771 4577.