Northern Rock: morally hazardous

First we heard about ‘sub-prime mortgages’; then it was ‘collateralised debt obligations’; now it’s the turn of ‘moral hazard’ to appear on the Ten O’Clock News.

Jolted out of prosperous complacency by market turmoil, the public has started to care about economics: strange jargon and obscure concepts previously familiar only to investment bankers are going mainstream.

The best way to understand moral hazard is to reflect on how taking out insurance changes our behaviour, encouraging us to take greater risks and less care of our possessions. A holidaymaker without travel insurance is more likely to keep an eye on his baggage than one who can claim compensation if it’s lost or stolen. The threat of moral hazard is in fact a central concept in modern life.

Thus if bank deposits are always protected by the state, depositors will cease bothering to check on the creditworthiness of banks and will simply choose the highest-yielding account, regardless of whether or not the institution in question can actually afford the deals it offers.

All of which brings me to the disgracefully botched bail-out of Northern Rock, the former building society which has so far been Britain’s biggest victim of the credit crunch. Northern Rock had done very well for itself by expanding its lending at breakneck speed, gaining many plaudits in the City of London. To attract deposits and thereby increase the funds it had available to lend, it offered high-interest internet accounts, some paying 6.3 per cent. It raised additional funds by securitising, or selling off, its existing mortgage portfolio. The final leg of its strategy was to tap the money markets, borrowing billions at low rates from other banks to lend at higher rates to homeowners. These money-market loans typically lasted three months, and were rolled over each time they expired.