Question

Discussing moral hazard, identify the theories discussed in the unit’s required reading and how they applied to the global financial collapse of 2008.

Answer 1

A moral hazard occurs when a person or entity participates in risk-taking actions based on a set of expected outcomes where the risks are borne by another person or entity in case of an adverse result. Drivers dependent on auto insurance are a simple example of a moral hazard. It is fair to believe that fully insured drivers take more risks than non-insurance drivers because, in the event

Before the financial crisis, financial institutions wanted regulators not to encourage them to collapse because of the systemic risk that could spread to the rest of the economy. Some of the biggest and most important banks for businesses and consumers were the institutions carrying the loans that ultimately led to the downfall. There was the expectation that if a confluence of negative factors led to a crisis, the financial institution's owners and management would be given special protection or support from the government. Otherwise called moral hazard.

The collateralisation of risky assets was another moral hazard that led to the financial crisis. In the years leading up to the recession, lenders were believed to have borrowers underwritten mortgages using languid criteria. It was in the best interest of the banks, in normal circumstances, to lend money after thorough and rigorous study. However, given the liquidity the collateralized debt market provided, lenders have been able to relax their standards. Lenders made aggressive lending decisions on the premise that they could potentially stop keeping the debt throughout its entire maturity.

Banks were offered the opportunity to offload a bad loan, combined with good loans, by collateralized loans in a secondary market, thereby moving the risk of default on to the borrower. In fact, banks underwrote loans expecting another party to bear the risk of default, generating a moral hazard and subsequently leading to the mortgage crisis.