The financial crisis of 2008 resulted from numerous market inefficiencies, bad practices, and a lack of transparency in the financial sector. Market participants were engaging in behavior that put the financial system on the brink of collapse. Historians will cite products such as CDOs or subprime mortgages as the root of the problem; however, it’s one thing to create such a product, but knowingly selling and trading these products requires moral hazard.
Key Takeaways
- The 2007-2008 financial crisis was caused by a confluence of many factors, including the Dotcom bubble burst, a low interest rate environment, financial products such as mortgage-backed securities (MBS), poor borrower due diligence, and moral hazard.
- Moral hazard exists when a party enters into risky behavior based on the fact that the cost of any negative outcome will be borne by another party.
- One moral hazard that led to the financial crisis was banks believing they were too important to fail and that if they were in trouble, they would be rescued, leading to them taking on more risks.
- A second moral hazard that led to the crisis was banks selling off their mortgages to third parties for collateralization, which incentivized them to make as many mortgages as possible without thorough risk analysis or standards.
What Is a Moral Hazard?
A moral hazard exists when a person or entity engages in risk-taking behavior based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavorable outcome.
A simple example of a moral hazard is drivers relying on auto insurance. It is rational to assume that fully insured drivers take more risks than those without insurance because, in an accident, insured drivers only bear a small portion of the full cost of a collision.
Moral Hazards Leading to the 2008 Financial Crisis
Before the financial crisis, financial institutions expected that regulating authorities would not allow them to fail due to the systemic risk that could spread to the rest of the economy. The institutions holding the loans that eventually contributed to the downfall were some of the largest and most important banks to businesses and consumers.
There was the expectation that if a confluence of negative factors led to a crisis, the owners and management of the financial institution would receive special protection or support from the government. Otherwise known as moral hazard.
The presumption was that some banks were so vital to the economy they were considered “too big to fail.” Given this assumption, stakeholders in the financial institutions faced a set of outcomes where they would not likely bear the full costs of the risks they were taking at the time.
The stock market capitalization to GDP for the U.S. was 138% in 2007 and dropped to 79% in 2008.
Another moral hazard that contributed to the financial crisis was the collateralization of questionable assets. In the years leading up to the crisis, it was assumed lenders underwrote mortgages to borrowers using languid standards. Under normal circumstances, it was in banks’ best interest to lend money after thoughtful and rigorous analysis.
However, given the liquidity provided by the collateralized debt market, lenders could relax their standards. Lenders made risky lending decisions under the assumption they would likely be able to avoid holding the debt through its entire maturity.
Banks were offered the opportunity to offload a bad loan, bundled with good loans, in a secondary market through collateralized loans, thus passing on the risk of default to the buyer. Essentially, banks underwrote loans with the expectation that another party would likely bear the risk of default, creating a moral hazard and eventually contributing to the mortgage crisis.
What Ended the Financial Crisis of 2008?
The financial crisis of 2008 ended due to a variety of measures taken by the federal government under President Barack Obama. One of the main contributors to ending the crisis was the passing of the American Recovery and Reinvestment Act. It provided over $760 billion in support for the economy, which came through tax cuts for families and businesses, and investments in education, transportation, and clean energy.
How Do You Reduce Moral Hazard?
Some ways to reduce moral hazard include providing incentives and enacting policies to make moral hazard practices punishable. An example of incentives could be that an insured driver will receive a reduction in their insurance premiums every year if they have no accidents or speeding tickets. This may entice risky drivers to drive more carefully.
What Is a Mortgage-Backed Security (MBS)?
A mortgage-backed security (MBS) is a type of asset-backed security that functions like a bond. Banks make mortgages to homeowners and then sell these mortgages to third-party financial institutions. These institutions take these mortgages and package them into a financial product known as a mortgage-backed security (MBS). Each MBS consists of tiers, with the top tiers consisting of less risky mortgages and the bottom tiers consisting of riskier mortgages. Investors buy MBSs, specifically a tier, and receive investment income as their return. The investment income is the monthly payments that homeowners make on their mortgages.
The Bottom Line
The financial crisis of 2008 was partly due to unrealistic expectations of financial institutions. By accident or design—or a combination of the two—large institutions engaged in behavior where they assumed the outcome had no downside for them.
By assuming the government would opt as a backstop, the bank’s actions were a good example of moral hazard and the behavior of people and institutions who think they are given a free option.
Quasi-government agencies such as Fannie Mae and Freddie Mac implicitly supported lenders underwriting real estate loans. These assurances influenced lenders to make risky decisions as they expected the quasi-government institutions to bear the costs of an unfavorable outcome in the event of default.
