Question

Moral Hazard and the Subprime Mortgage Crisis

Identify and describe each of them. (Provide concrete examples in some detail. ) And what's the relationship between them. (Explain in details)

Punctuation concerns

考虑在此标点符号的前面加一个空格。

Answer 1

Answer

What is Moral Hazard?

The concept of Moral Hazard is prevalent in many disciplines. However, in economics, moral hazard takes place when someone is insured and thereafter augments exposure to risk. It occurs more in those circumstances when a person takes more risks because other person or entity would bear the value of repercussions of those risks. A moral hazard occurs in those facts and circumstances wherein one party makes a decision about how much risk to take, while another party bears the cost of risk if the situation becomes adverse/ go badly. Moreover, the party that is isolated from risk behaves differently from how it would if he would have to bear the value of repercussions of taking risk.

When moral hazard occurs?
Moral hazard occurs in case of information asymmetry i.e. when the party bearing the risk to a transaction is more self-aware about its intentions as compared to the party paying the cost of consequences of the risk.

Example

Given the situation that you have not insured your car from any future damages due to the accident. Consequently in case of any mishappening/accident loss will be completely borne by you. Hence you will more sensitive and would show extra care and attentiveness. You might install high tech burglar alarms and other systems in your car to be on the safer side.

But if your car is insured for its full value, then if anything wrong happens to your car, you do not really lose anything because insurance company would pay the amount. As you know this fact, you will have less incentive to protect your car against any mishappening as you know that you would not have to bear value of repercussions in case of burglary or accident . And you would become insincere and would not care for your car. Here, in this particular case, the insurance firm bears the value of repurcussions and the problem of moral hazard has arisen.

Subprime Mortgage Crisis in the United States is another example of moral hazard.

In the early-to-mid 2000s, Federal Reserve's decided to significantly lower the Federal funds rate to spur growth. Consequently, more and more people with low credibility were allotted subprime mortgages with manageable rates. As a result home ownership rose to a great extent in the United States of America.

Secondly, investors who suffered from the dot com bubble of the early 2000s started investing in real estate.

As a result, Housing prices were accelerating rapidly, and rate of subprime mortgages given out was rising at a high rate. However, by the year 2005, some people began to fear that this was a housing bubble. The bubble burst in 2005 and 2006 and prices of housing market crash back down to earth. As a result, Subprime mortgage lenders lay off thousands of employees. Others filed for bankruptcy and others shut down entirely.