Question

Discuss for me the concept of moral hazard, particularly as it relates to the financial crisis of 2008. How was that an important component that ultimately lead to the breakdown of financial markets? You may want to provide examples of the market participants at the time and how moral hazard impacted their decision making.

Answer 1

Moral Hazard - It is the situation in which one party who is entering into the contract is not in good faith. Sometimes one party enters into the contract knowing the fact that the same is protected against the risk and the consequences of risk will be borne by other party.

Moral hazard in 2008 financial crisis- In the early 2008 and late 2007, some banks including Lehman brothers and Merrill Lynch lent money to the borrowers without properly checking their back ground and documents. Loans were given for buying property and investing into real estate. Many people made the property by taking loan and suddenly the properties got unsold and real estate prices came down. Banks could not get the repayment of loan and banks got bankrupt.

Financial institutions expected that Government and regulatory authority would not let them fail in any situation. They were under impression that if any crisis comes, the Government will provide full support and special protection. This is called moral hazard.