Baker’s Moral Hazard
Shortly after hurricane Katrina, U.S. Representative Richard Baker (R-Baton Rouge) introduced a bill that would allow the Federal government to step in and buy homes damaged by Katrina. The actual buying would be done by the Louisiana Recovery Corporation (LRC), a new federal agency created by the Baker Bill (latest version here).
Congress did not vote on the bill before its Christmas recess, so the bill died. Actually, it’s probably more accurate to say it was put on life support. After Congress adjourned, Baker quickly announced “No matter the circumstances, we must try again.†And, shortly thereafter, U.S. Senator Mary Landrieu (D-LA) introduced a Senate version of the bill. The Bush administration – in an apparent attempt at fiscal restraint ?? – has refused to support the bill from the very beginning. You can find their latest position on the bill here, via the Washington Post.
One reason the White House gives for opposing the Baker bill is that they do not want to create another government agency. After reading just the first two pages of Baker’s bill, it’s easy to see what will happen if the bill is signed into law. For instance:
The principal office of the Corporation shall be located in the State of Louisiana, but there may be established agencies or branch offices in the District of Columbia and in any municipality or parish in Louisiana to the extent provided for in the by-laws of the Corporation.
Multiple offices….And, multiple divisions:
(d) CORPORATE DIVISIONS.— (1) IN GENERAL.—At a minimum, the Corporation shall establish and maintain separate divisions for the following subjects:
(A) Environment and Land Use Management.
(B) Economic Development.
(C) Property Acquisition.
(D) Property Management.
(E) Property Disposition.
(F) Urban Homesteading and Community and Faith-Based Organizations.
Just what we need. I would certainly prefer to save the money it would cost to run this new agency – oh, sorry, corporation – but I dislike the bill because of the unhealthy incentives it creates.
The newly created (LRC) would pay owners of damaged homes no less than 60 percent of their pre-hurricane equity. And the “corporation†would give lenders up to 60 percent of the money they were owed. Then, to “cover some of its expenses,†the LRC would sell the homes (or giant tracts of land ?) to private developers.
So, homeowners that did not have flood insurance (or insufficient flood insurance) can get most of their equity back from the taxpayers, many of whom did actually pay for sufficient flood insurance. And it’s these taxpayers that will be forced to bail out the lenders of the uninsured/underinsured. Why, exactly, have I been paying for flood insurance?
It certainly is difficult to not feel sympathy for those most affected by the storm (I lost a house too), but that doesn’t change the fact that Baker’s bill produces perverse incentives. In general, this phenomenon is referred to as a moral hazard – homeowners will no longer want to pay for flood insurance because they expect to be compensated for their losses. And lenders will not perform due diligence to ensure that homeowners in low-lying areas purchase flood insurance (which, by the way, they were required to do by law).
I would not be too surprised to learn that some of the homeowners in LA fully expected to receive some compensation from the government in the event of a disaster such as Katrina. And I would even argue that one reason many lenders did not require sufficient flood insurance is because they fully expected the same thing.
Historically, moral hazard and flood insurance go together so well that many economists have used homeowners’ lack of flood insurance to explain “moral hazard.†One example is in Mankiw’s popular Principles of Economics (1st edition, page 581):
A family lives near a river with a high risk of flooding. The reason it continues to live here is that the family enjoys the scenic views, and the government will bear part of the cost when it provides disaster relief after a flood.
I guess Mankiw can include a Katrina/Rita analogy in his next edition.
For discussion:
What impact could the moral hazard associated with the Baker bill have on future flood insurance rates?
Could this type of moral hazard have caused over-building in flood prone areas?
Baker’s bill passed the House Financial Services Committee 50-9. Could this be a sign of rent seeking?
Norbert Michel
February 12th, 2006 at 11:09 pm
Baker’s Moral Hazard
The moral hazard associated with the Baker bill would have a huge impact on future insurance rates. According to the bill, those who suffer from devastation are reimbursed for their loss. Even if they owe on their house they do not take the loss because the bill would reimburse the lender and the company would take the loss. This means that it pays to not carry insurance. Those who do not carry insurance will be compensated and not pay the insurance premiums. Those who have insurance do not get as high of a pay-out when they loose their property and also had to pay the premiums throughout the year. They come out behind. So why does it pay to have insurance? It doesn’t. Those who do not carry it will come out ahead anyway because they will be paid each time the home is destroyed. However, the people with insurance will not get 60% of the value of their house. They will only get a percentage of the damage. So, where will the government get the money to pay for such reimbursements? It comes from the taxpayers of course. They are trying to run the agency like an insurance company. However, there is a major flaw in this idea. In an insurance company everyone pays their premiums but not everyone makes a claim. This leaves money to pay for the claims. With the new agency, if none of these people pay into the system then there is no money to pay out. This means that the taxpayers that carry insurance take the brunt of the cost again. Not only do they pay their premiums they also pay the increased taxes to pay for the reimbursement of those who choose not to. This means that it doesn’t pay to carry insurance. With fewer people carrying insurance this means that the cost will skyrocket. If no one is paying into the insurance system then those who do will again face the brunt of the cost and pay very high premiums to cover the loss of money from people dropping their insurance.
This idea of reimbursement will defiantly cause over-building in flood prone areas! Why would anyone leave? If you don’t have to pay insurance premiums and you will be compensated every time your home is destroyed, why move? This means you get to live where you want and you will never have to worry about the cost of repairing your home. You come out ahead. Also, if your house has been destroyed and fixed multiple times is it really worth the amount you get compensated? You come out ahead again. So, of course, if people are compensated for their loss then technically they gain by living in a flood prone area.
CT (not Chad Turner, though)
February 13th, 2006 at 2:27 pm
Maybe that’s why Washington is against this bailout proposal and now public opposition by the White House, dramatically handicaps the bill’s prospects.
February 13th, 2006 at 4:55 pm
Someone has brought it to my attention that we are not dealing with a true case of moral hazard with respect to Katrina disaster relief. The problem is not if homeowners would be willing to purchase flood insurance, it is that they will continue to build in flood plains. A good metaphor the same person suggested to me is when one has fire insurance does his propensity to juggle flaming torches indoors increase; does he partake in the risky behaviors because he does not internalize the full cost?
Whether or not flood victims are bailed out by the federal government is not itself an economically inefficient prospect. It is a matter of the federal government substituting private for public insurance. The efficiency aspect would come in with the mis-pricing of the service and the associated, generally inefficient, bureaucracy of implementation.
Still another issue is who demands flood insurance. I heard an argument concerning federally mandated catastrophic health insurance with a $10,000 deductible, for everyone. Lenders make the same demand of borrowers who borrow against the value of an asset they intend to purchase, like a car. They made the point that lenders are the ones who demand insurance for the value of the asset, as well as the athletes, race car drivers, and other daring doers. Lenders want to hedge against default in the event of the destruction of the asset, and the daring doers against obvious and substantial risks. We know that individuals are poor evaluators of small risks. Floods are small risks in any given period, even though they seem common. If lenders demand borrowers have flood insurance, then it is another cost of borrowing in flood prone areas. A cost of living on the beach I guess. Do the lenders expect the federal government to bail out homeowners for the full value of their homes? I doubt it, and it looks like they may for only 60% of the equity; a correct guess. I believe that lenders will still demand borrowers have flood insurance as a condition of lending to protect themselves, regardless of what the goverment is going to do for those who owned their homes outright and failed to get flood insurance.
February 13th, 2006 at 6:13 pm
I think there may be some confusion in this discussion due to the degree of moral hazard involved. Norbert wrote:
“In general, this phenomenon is referred to as a moral hazard – homeowners will no longer want to pay for flood insurance because they expect to be compensated for their losses.”
Moral hazard refers to the fact that when people are insured, they respond by engaging in riskier behavior as they no longer bear the full cost of their risk. Likewise, they engage is less risk-reducing activity. As Earl points out, when people get fire insurance, they may start juggling flaming torches, and may spend less on smoke alarms and fire extinguishers. In the case of someone who pays for private insurance, the insurance policy is provided by the private company. I think the way to think about the government bailout is as an insurance policy that is provided by the government.
Here is my main point, which I believe echoes Earl’s comment. It is not that the person does not pay for insurance that is the big moral hazard problem; it is that the person has insurance. The undesirable outcome is that the house is built in an overly risky area, and would not have been built in the absence of some form of insurance. The “who pays part” is of secondary importance – a transfer of wealth. I definitely agree with Norbert that if otherwise equal insurance policies are provided to everyone “free of charge”, there will be a larger moral hazard problem than if people are required to pay premiums. If people pay no part of their risk (no premiums), we have a huge moral hazard. But, with only 60% of equity being paid back, this is not the case for the proposed bailout.
And while we all know what is meant by “private” insurance, let us not forget that these policies are not, in fact, private. They are subsidized by Uncle Sam; the prices are not set by markets, and are not actuarially fair.
How do insurance companies generally attempt to reduce the moral hazard problem? Deductibles and co-payments are two ways. I would say 40% of your equity is a substantial deductible, and is the answer to Norbert’s question about why has he been wisely paying for “private” flood insurance.
Let me take the moral hazard / bailout story one step further. With an important caveat, I think people correctly anticipating a partial bailout may be a positive thing for society as a whole.
Suppose people did not anticipate this bailout (or future bailouts). If they had no clue it was on the way, then the bailout does not cause a moral hazard problem – people do not juggle torches if they do not know they have fire insurance. The bailout just transfers around wealth from party to party, but did not change anyone’s behavior. Society’s resources will be wasted by the administering the bureaucracy to shift around the money. This is one of Norbert main points, and is very important.
Suppose people did anticipate this bailout (or future bailouts), but also anticipated it would not be a full 100% bailout. Suppose Norbert is right in that there was a reduction in the number of people who bought private flood insurance and lenders did less due diligence activity as result of the expected future bailout. Then as a result, don’t people effectively have less insurance overall? Isn’t there less of a moral hazard problem? Does this mean there will be less building in flood prone areas? It is at least possible that the good that comes here would overcome the waste associated with the bureaucracy?
Don’t get me wrong – I certainly agree that this wealth transfer mechanism will be a disaster as it looks like it would be administered. Insurance companies, homeowners without flood insurance, and lenders to those without flood insurance are the sure winners.
By the way, I cam imagine readers being curious about my home ownership status when reading this comment. As someone with about $25 equity in my house, whose residence is 12 feet above sea leve, and who did not have flood insurance, the only thing on the line for me during Katrina was my credit score. I was sweating, but my lender was sweating more.
February 14th, 2006 at 12:04 pm
The only thing I want to revisit deals with one of the points Chad brought out:
How do insurance companies generally attempt to reduce the moral hazard problem? Deductibles and co-payments are two ways. I would say 40% of your equity is a substantial deductible, and is the answer to Norbert’s question about why has he been wisely paying for “private†flood insurance.
Chad is correct, 40% is a substantial deductible. I’ll just add two things here. First, the Baker bill is vague – homeowners are supposed to be eligible for at least 60% of their equity. Second, New Orleans Mayor Ray Nagin is now fighting for his own version – one that will automatically give homeowners 100% of the equity. Stay tuned.
March 19th, 2006 at 10:19 am
[...] In our February 9th post, Baker’s Moral Hazard, I noted that Baker’s bill had passed the House Financial Services Committee 50-9. I then asked (sort of rhetorically): [...]