Question

essay about The Financial crises of 2008-09

Answer 1

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First, let's understand what is moral hazard.

Moral hazard means a lack of initiative to safeguard against the risk when one knows they are protected from that risk. For example protection by insurance or guarantee.

In 2008 crisis. There was a huge moral hazard. It made way for the structural failure of the system. In which "Too big to fail companies," were made target's and did actions according to it, with the thought that they will never fail. Banks wrote Loans, imitated OCD, thinking that the counterparty would bear all the risk of default. Unreasonable loans were given to people who don't deserve to get loans. Banks, insurance companies thought that eventually, the government will bail them out if they fail (deep somewhere they had that confidence), because if they were not bailed out then entire USA economy would turn around to crisis. It would affect the whole world due to systematic risk and structural failure.

It created a moral hazard. Which eventually lead to the subprime mortgage crisis of 2008.

While many investors are trained to expect some risk, the huge and dramatic swings we have seen in recent years have been unnerving to many.

We need to understand the components of risk.

Total risk = systematic risk+unsystematic risk.

Majority of investor are trained to expect a higher degree of failure due to unsystematic risk and a lower degree of failure due to systematic risk.

The recent dramatic swings like the financial crisis of 2008 and Bernie Madoff scandal of 2009. Has decreased the confidence of the investor because:

1. It was a systematic failure of the system. Majority of investor are unable to bear such type of risk as they don't think it's possible in the first place. It happens when "too big to fail companies fail".

When such a failure happens it creates a very negative sentiment in the market. When Too big to fail companies fail then investors can't trust mid and small-cap companies at all- that's the psychology at that time.

This classic cases of systematic risk failure and Trust breach has let the retail investors lose confidence in the market.

From the 2007-08 financial crisis and aftershocks of it, we learn to take a risk appetite for the systematic failure of the system.

You also learn to have a diversified portfolio in different asset classes and not only primarily equity.