Question

Explain moral hazard and give at least two examples. Discuss its implications as an informational asymmetry problem for financial crises

Answer 1

It shall be noted that moral hazard an economics terminology that suggests that there is a risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity and has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles, without having to suffer consequences, but negatively affect the other party.

For example:

1) When a property owner obtains insurance on a property, the contract is based on the idea that the property owner will avoid situations that may damage the property. The moral hazard exists that the property owner, because of the availability of the insurance, may be less inclined to protect the property, since the payment from an insurance company lessens the burden on the property owner in the case of a disaster.

2) Moral hazard can exist in employer-employee relationships, as well. If an employee has a company car for which he does not have to pay for repairs or maintenance, the employee might be less likely to be careful and more likely to take risks with the vehicle.

The implication of moral hazard as an informational asymmetry problem for financial crises can be discussed in light of the financial crisis of 2008.

Prior to the financial crisis of 2008, when the housing bubble burst, certain actions on the parts of lenders could qualify as moral hazard. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions, to originate as many loans as possible regardless of the financial means of the borrower. Since the loans were intended to be sold to investors, shifting the risk away from the lending institution, the mortgage broker and originating lender experienced financial gains from the increased risk while the burden of the aforementioned risk would ultimately fall on the investors. Borrowers who began struggling to make their mortgage payments also experienced moral hazards when determining whether to attempt to meet the financial obligation or walk away from loans that were becoming more difficult to repay. As property values decreased, borrowers were ending up deeper underwater on their loans. The homes were worth less than the amount owed on the associated mortgages. Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning a property.