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In the context of the U.S. Treasury Department's TARP, according to Barofsky, "moral hazard" refers to the danger that private-sector executives/investors/lenders may behave more recklessly if the government has insulated them from consequences.

Barofsky released his report to Congress Jan. 30, 2010. I reviewed it and the 11-page executive summary is well worth the read.

Much of the report focuses on the government's effective "takeover" of the residential mortgage industry. "The government has done more than simply support the mortgage market, in many ways it has become the mortgage market, with the taxpayer shouldering the risk that had once been borne by the private investor," Barofsky writes.

Over the past year, the feds have spent billions bolstering the housing market. Approximately 90 percent of home loans are backed by entities such as Fannie Mae and Freddie Mac. The question is, What behavior does this kind of government support incent going forward? What moral hazard is being created?

According to Barofsky, the banks still have an incentive to take on risk because they know the government will save them. In essence, banks are in the driver's seat of this fast-moving car. "To the extent that institutions were previously incentivized to take reckless risks through a "heads, I win; tails, the government will bail me out" mentality, the market is more convinced than ever that the government will step in as necessary to save systemically significant institutions."

If U.S. taxpayers are bearing the brunt of these risks, they have the right to make all the rules. Clearly, harsher limits on the risk-taking behavior of financial institutions must be set and governed by an independent agency whose sole mission is to protect the consumer.

And what role does the U.S. taxpayer play in all this going forward? What should he or she try to encourage? To start, maybe there is value in trying to shift government attitudes when it comes to owning or renting a home. Maybe it makes sense to curb the zeal for making home ownership a national goal.

And maybe it's time for a gradual phaseout of tax incentives that encourage Americans to take on too much debt. Can the United States afford to sustain a policy that encourages homeowners to act materialistically and puts the financial system at risk?

If we agree moral hazard is driven by the presence of distorted incentives, curbing its threat begins with the incentives that are reinflating the bubble. It is a simple matter of supply and demand--if taxpayers can't over-borrow, banks can't over-lend.

JOANNA MAKOMASKI, the former risk manager for an energy delivery company, is a specialist in innovative enterprise risk management methods and implementation techniques with V3 Advisory Group.

May 1, 2010

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