Complacency and Moral Hazard

Time are tough now
Just getting tougher
This old world is rough
Just getting rougher
Cover me
--Bruce Springsteen

NYU professor Nouriel Roubini discusses complacency of investors in the midst of risky market environments. He concludes that market participants have generally never been adept at pricing in low probability but high impact events (a.k.a. 'tail risk).

He's correct. We're not all that great at risk management for low probability events.

However, Professor Roubini ignores the influence of moral hazard in today's markets. Investors have learned that governments tend to come to their rescue when prices significantly decline.

If you believe that someone has your back and will cover your losses in the event of a decline, then you will take more risk than you otherwise would. And you would skimp on purchasing insurance to cover downside risk. After all, why self-insure when someone else is willing to insure you?

The problem, of course, is that the other entity may not have the capacity to cover your losses in the event of decline.

Moral hazard invites excessive risk taking followed by excessing loss taking.

position in SPX