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 is an economic terminology to suggest 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 affects the other party negatively.

For example:

1) Consider a house that is not insured for events such as fire or burglary. The home-owners would take extra care and remain attentive as any loss due to fire or burglary will be completely borne by the homeowner at the time of a mishappening like fire or burglary. The homeowner will install high tech burglar alarms and hire watchmen to avoid any unforeseen event.
But if the house is insured for its full value, then if anything happens the homeowner does not really lose anything. Therefore, the homeowner has less incentive to protect against any mishappening. In this case, the insurance firm bears the losses and the problem of moral hazard arises.

2) 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.

The implications of moral hazard as an informational asymmetry problem for financial crises can be understood in the context 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.