Question

Describe the moral hazard problem that facilitated the financial crash of 2007–2009.

Answer 1

The 2008 financial crisis was the product of multiple market inefficiencies, unethical practices and a lack of financial sector transparency. Market participants engaged in behavior which placed the financial system on the brink of collapse. Historians would cite goods as the root of the problem, such as CDOs or subprime mortgages. Yet producing such a product is one thing, but knowingly selling and trading such goods involves moral hazard.

Before the financial crisis , financial firms expected regulators not to allow them to fail because of the systemic risk that could spread to the rest of the economy. Some of the largest and most important banks for companies and customers were the institutions holding 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. Also named moral hazard.

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