Assorted thoughts on moral hazard

I am genuinely conflicted by what we should do about moral hazard in the housing markets and the financial markets. Make things too easy, and people will be encouraged to take more insane risks; make them too hard, and the economic results will force the rest of us to pay for their sins.

Whatever it is we do, however, I'm pretty sure we should take the same approach to the homeowners and the bankers. Most homeowners are not dupes of anyone other than their own speculative mania; they borrowed more money than they should have on the assumption that asset prices would just keep rising forever. The bankers, the same.

One thought I have had is that perhaps we should declare a sort of bank holiday for people whose mortgages are unaffordable. Set a three month period during which people can hand the house back to the bank in exchange for canceling the loan and surrendering whatever extra cash they have in the bank. No expensive and time consuming foreclosure procedures; they voluntarily sign it over. In exchange for their doing this, we wipe the loan off their credit record. They don't get to keep a house they can't afford, but they also don't get crippled for the next ten years by an unwise but somewhat understandable urge to own a nice house.

Meanwhile, this is not correct:

Whether the BS bailout will motivate riskier behavior in the future is impossible to know directly. But the market has spoken in one regard: the stock prices of the investment banks that Wolf refers to jumped about 20% after the bailout. The market, obviously, thinks the bailout has made risky behavior less risky and more profitable than before. As Wolf says, this is "moral hazard made visible."

A put option at $2 a share in the event of catastrophic failure is not worth 20% of the current stock price; it is worth considerably less than $2 a share. Stock prices rose because Bear Stearns had been the counterparty to a really staggering number of trades that markets thought would be uncovered, and because fears of an acute liquidity crisis abated. Not because people suddenly no longer feared losing money on the stock.