Moral Hazard

Moral Hazard

---

The decision is based not on what is considered right, but what provides the highest level of benefit, hence the reference to morality. This can apply to activities within the financial industry, such as with the contract between a borrower or lender, as well as the insurance industry. For example, when a property owner obtains insurance on a property, the contract is based on the idea that the property owner will avoid situations that may damage the property. The moral hazard exists that the property owner, because of the availability of the insurance, may be less inclined to protect the property, since the payment from an insurance company lessens the burden on the property owner in the case of a disaster.

Prior to the financial crisis of , certain actions on the parts of lenders could qualify as moral hazard. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions , to originate as many loans as possible regardless of the financial means of the borrower.

Since the loans were intended to be sold to investors, shifting the risk away from the lending institution, the mortgage broker and originating lender experienced financial gains from the increased risk while the burden of the aforementioned risk would ultimately fall on the investor. Borrowers who began struggling to pay their mortgage payments also experienced moral hazards when determining whether to attempt to meet the financial obligation or walk away from loans that were difficult to repay.

As property values decreased, borrowers were ending up underwater on their loans. The homes were worth less than the amount owed on the associated mortgage.

Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning the property. Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private label securitizations, and performed far better in terms of default rates.

Economist Mark Zandi of Moody's Analytics described moral hazard as a root cause of the subprime mortgage crisis. He wrote that "the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan.

What is moral hazard?

As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards. Moral hazard can also occur with borrowers.

BREAKING DOWN 'Moral Hazard'

Borrowers may not act prudently in the view of the lender when they invest or spend funds recklessly. For example, credit card companies often limit the amount borrowers can spend with their cards because without such limits borrowers may spend borrowed funds recklessly, leading to default. Securitization of mortgages in America started in at Salomon Brothers and where the risk of each mortgage passed to the next purchaser instead of remaining with the original mortgaging institution.

DOWNLOAD THE APP NOW

These mortgages and other debt instruments were put into a large pool of debt, and then shares in the pool were sold to many creditors. It has been suggested that this may have caused subprime mortgage crisis. Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along.

In a purely capitalist scenario, the last one holding the risk like a game of musical chairs is the one who faces the potential losses. In the sub-prime crisis, however, national credit authorities the Federal Reserve in the US assumed the ultimate risk on behalf of the citizenry at large.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout would prevent risky, speculative business decisions by executives who conduct due diligence in their business transactions. The risk and the burdens of loss became apparent to Lehman Brothers who did not benefit from a bailout and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation , whose valuation plunged during the subprime mortgage crisis.

Moral hazard has been studied by insurers [16] and academics; such as in the work of Kenneth Arrow , [2] [17] [18] Tom Baker, [19] and John Nyman. The name comes originally from the insurance industry.

MORAL HAZARD (Encyclopedia)

Insurance companies worried that protecting their clients from risks like fire, or car accidents might encourage those clients to behave in riskier ways like smoking in bed or not wearing seat belts. This problem may inefficiently discourage those companies from protecting their clients as much as the clients would like to be protected.

Economists argue that this inefficiency results from information asymmetry. If insurance companies could perfectly observe the actions of their clients, they could deny coverage to clients choosing risky actions like smoking in bed or not wearing seat belts , allowing them to provide thorough protection against risk fire, accidents without encouraging risky behavior.

However, since insurance companies cannot perfectly observe their clients' actions, they are discouraged from providing the amount of protection that would be provided in a world with perfect information. Economists distinguish moral hazard from adverse selection, another problem that arises in the insurance industry, which is caused by hidden information rather than by hidden actions. The same underlying problem of non-observable actions also affects other contexts besides the insurance industry.

It also arises in banking and finance: In insurance markets, moral hazard occurs when the behavior of the insured party changes in a way that raises costs for the insurer, since the insured party no longer bears the full costs of that behavior. Because individuals no longer bear the cost of medical services, they have an added incentive to ask for pricier and more elaborate medical service, which would otherwise not be necessary.

In these instances, individuals have an incentive to over consume, simply because they no longer bear the full cost of medical services. Two types of behavior can change. One type is the risky behavior itself, resulting in a before the event moral hazard.

In this case, insured parties behave in a more risky manner, resulting in more negative consequences that the insurer must pay for. For example, after purchasing automobile insurance, some may tend to be less careful about locking the automobile or choose to drive more, thereby increasing the risk of theft or an accident for the insurer. After purchasing fire insurance, some may tend to be less careful about preventing fires say, by smoking in bed or neglecting to replace the batteries in fire alarms.

A further example has been identified in flood risk management where it is proposed that the possession of insurance undermines efforts to encourage people to integrate flood protection and resilience measures in properties exposed to flooding. A second type of behavior that may change is the reaction to the negative consequences of risk, once they have occurred and once insurance is provided to cover their costs.

This may be called ex post after the event moral hazard. In this case, insured parties do not behave in a more risky manner that results in more negative consequences, but they do ask an insurer to pay for more of the negative consequences from risk as insurance coverage increases. For example, without medical insurance, some may forgo medical treatment due to its costs and simply deal with substandard health.

You will lock it carefully. However, if it becomes insured for its full value then if it gets stolen you do not really lose out. Therefore, you have less incentive to protect against theft. This becomes a situation of asymmetric information. In the case of the sub-prime mortgage market ; lenders faced a situation of moral hazard. They were able to sell on mortgage bundles to other financial institutions.

Because there was strong demand from other people, and because other banks were taking on all the risk, the mortgage companies had less incentive to check the mortgages could be repaid. Therefore, there was a big growth in sub-prime mortgage lending with inadequate checks made. It is argued that membership of the Euro can cause a type of moral hazard.

A country in the Euro may assume that if it gets into difficulties, other countries will bail it out. Therefore, they may allow their debt to grow. For example, when Greece joined the Euro, it benefited from low-interest rates because it was in the Euro. This encouraged them to keep increasing public sector debt — until markets realised too late that they actually had high, unsustainable debts.

If managers or civil servants have a guaranteed job for life, this may alter their work incentives.

If they are protected from making bad decisions, they have a greater willingness to make self-serving decisions or help out friends. This is more of a problem if it is difficult to evaluate who is accountable for the decision. It is related to the principle-agent problem and can lead to outcomes such as profit satisficing. Doctors will take on risky treatment because the cost is borne by others the insurance companies.

Free market economists have argued that IMF intervention for countries experiencing crisis, encourages risky behaviour by countries. To avoid moral hazard in insurance, the insurance firm will design a contract to give you an incentive to make you insure your bike. This is why they will not insure for the full amount. Insurance firms also make the process of getting money difficult.

What Causes Moral Hazard?

This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place. The government could bail out banks, but penalise those responsible for making the reckless decisions. In the case of Greece, bailout funds are being given very reluctantly and with conditions to reform and pursue austerity.

• Red Carpet Ready: Secrets for Making the Most of Any Moment Youre in the Spotlight
• Wine Marketing & Sales, 2nd Edition
• No Other Help I Know
• Benjamin Harrison - A Short Biography
• Be Sincere, Not Serious (Spirituality, Meditation & Self Help Guaranteed Solutions Series Book 6)
• Forest Management and Planning