Moral Hazard: Mastering the Art of Finance, Understanding Moral Hazard for Informed Decision-Making

By Fouad Sabry

What is Moral Hazard

The term "moral hazard" refers to a circumstance that occurs in the field of economics and describes a situation in which an economic actor has an incentive to expand its exposure to risk because it does not face the full costs of that risk. As an illustration, when a company is insured, it may be willing to take on additional risk since it is aware that its insurance will cover the costs connected with the risk. It is possible for a moral hazard to take place when, after a financial transaction has taken place, the actions of the party that is taking the risk change in a way that is detrimental to the party that is suffering the costs.

How you will benefit

(I) Insights, and validations about the following topics:

Chapter 1: Moral hazard

Chapter 2: Economic bubble

Chapter 3: Debt

Chapter 4: Contract theory

Chapter 5: Adverse selection

Chapter 6: Information asymmetry

Chapter 7: Savings and loan crisis

Chapter 8: Asset-backed security

Chapter 9: Mortgage loan

Chapter 10: Subprime mortgage crisis

Chapter 11: Flight-to-quality

Chapter 12: Subordinated debt

Chapter 13: Subprime crisis impact timeline

Chapter 14: Credit crunch

Chapter 15: Subprime crisis background information

Chapter 16: Interbank lending market

Chapter 17: Government policies and the subprime mortgage crisis

Chapter 18: Subprime mortgage crisis solutions debate

Chapter 19: Securitization

Chapter 20: Financial fragility

Chapter 21: 2007-2008 financial crisis

(II) Answering the public top questions about moral hazard.

(III) Real world examples for the usage of moral hazard in many fields.

Who this book is for

Professionals, undergraduate and graduate students, enthusiasts, hobbyists, and those who want to go beyond basic knowledge or information for any kind of Moral Hazard.

• Language: English
• Publisher: One Billion Knowledgeable
• Release date: Feb 3, 2024

Book preview

Chapter 1: Moral hazard

A moral hazard is a situation in economics in which an economic actor has an incentive to increase its risk exposure because it does not bear the full costs of that risk. When a company is insured, for instance, it can take on greater risk knowing that its insurance will cover the associated costs. After a financial transaction, moral hazard may occur if the actions of the risk-taking party change to the detriment of the cost-bearing party.

Moral hazard can occur under a type of information asymmetry in which the risk-taking party to a transaction knows more about its intentions than the party paying the consequences of the risk and has a propensity or incentive to take on too much risk from the standpoint of the party with less information. A principal–agent approach (also known as agency theory) is one example, in which one party, known as the agent, acts on behalf of another, known as the principal. However, a principal-agent problem can arise when the agent and principal have competing interests. If the agent has more information than the principal about his or her actions or intentions, the agent may have an incentive to act too riskily (from the principal's perspective) if the agent's and principal's interests are not aligned.

Dembe and Boden's research indicates that the term dates back to the 17th century and was widely employed by English insurance companies by the late 19th century. Originally, the term had negative connotations, suggesting deceit or immorality (usually on the part of an insured party). Dembe and Boden note, however, that prominent 18th-century mathematicians who studied decision-making used moral to mean subjective, which may obscure the term's true ethical significance. In the 1960s, economists reexamined the concept of moral hazard, which did not imply unethical or fraudulent behavior. Rather than a description of the ethics or morals of the involved parties, economists use this term to describe inefficiencies that can arise when risks are displaced or cannot be fully evaluated.

Rowell and Connelly provide a comprehensive history of the term moral hazard, by identifying salient changes in economic thought, which are mentioned in medieval theological and probability writings.

Due to the different approaches taken by economics and philosophy in interpreting the concept of moral hazard, there are significant differences in their understanding of its underlying causes.

In economics, moral hazard is often attributed to the malignant development of utilitarianism.

In contrast, philosophy and ethics view moral hazard from a broader perspective that includes the moral behaviour of individuals and society as a whole.

The root cause of moral hazard is due to the immoral behaviour of economic agents from a social perspective.

In addition, their paper compares and contrasts the predominately normative conception of moral hazard found in insurance industry literature with the predominately positive interpretations found in economic literature.

Frequently, what is referred to as moral hazard in the insurance literature is, upon closer inspection, not so, a description of the concept that is closely related, adverse selection.

William J. McDonough, the head of the New York Federal Reserve in 1998, assisted the counterparties of Long-Term Capital Management in avoiding losses by acquiring the company. Former Fed Chair Paul Volcker and others criticized this action as increasing moral hazard. By utilizing the Greenspan put, Greenspan was accused of expanding moral hazard in financial markets.

Paul Krugman, an economist, defined moral hazard as any situation in which one person decides how much risk to take while another person bears the cost if things go wrong. Financial bailouts of lending institutions by governments, central banks, or other institutions can encourage risky lending in the future if those who take the risks believe they will not bear the full weight of potential losses. Lending institutions must take risks in order to make loans, and the riskiest loans typically have the highest return potential.

Frequently, taxpayers, depositors, and other creditors must bear at least a portion of the risky financial decisions made by lending institutions.

Numerous individuals have argued that particular types of mortgage securitization contribute to moral hazard. Mortgage securitization permits mortgage originators to pass on the risk that the mortgages they originate may default, rather than holding the mortgages on their balance sheets and assuming the risk. In one type of mortgage securitization known as agency securitizations, the securitizing agency that purchases mortgages from originators retains default risk. Consequently, these agencies have an incentive to monitor loan originators and evaluate loan quality. Agency securitizations refers to securitizations issued by either Ginnie Mae, a government agency, or Fannie Mae and Freddie Mac, both government-sponsored enterprises with a profit motive. Similar to covered bonds commonly used in Western Europe, the securitizing agency retains default risk for these securities. Under both models, investors are only exposed to interest-rate risk and not to default risk.

In another type of securitization known as private label securitization, the securitizing entity typically does not retain default risk. Instead, the entity that securitizes transfers default risk to investors. Therefore, the entity that securitizes loans has little incentive to monitor originators and preserve loan quality. Private label securitizations are structured by financial institutions such as investment banks, commercial banks, and non-bank mortgage lenders.

Private label securitizations increased as a proportion of total mortgage securitization in the years leading up to the subprime mortgage crisis by purchasing and securitizing low-quality, high-risk mortgages. Although Agency Securitizations appear to have somewhat lowered their standards, Agency mortgages remained significantly safer than private-label mortgages and performed far better in terms of default rates.

Moody's Analytics economist Mark Zandi identified moral hazard as a root cause of the subprime mortgage crisis. He authored that The risks inherent in mortgage lending became so widely dispersed that nobody was required to be concerned about the quality of any individual loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive to be accountable was diminished. Also, he wrote, Banks were not subject to the same regulatory oversight as finance companies. Prior to the financial crisis, only their shareholders and other creditors were liable if they failed. Thus, there was little to prevent finance companies from expanding as aggressively as possible, even if it meant lowering or ignoring traditional lending standards.

Moral hazard is also possible for borrowers. When borrowers invest or spend funds irresponsibly, they may not act prudently (in the lender's opinion). For instance, credit card companies limit the amount borrowers can spend on their cards because, absent such restrictions, borrowers may recklessly spend borrowed funds, resulting in default.

Mortgage securitization in the United States began in 1983 at Salomon Brothers, where the risk of each mortgage was transferred to the subsequent purchaser rather than remaining with the original mortgage institution. These mortgages and other debt instruments were combined into a large pool of debt, and then the pool's shares were sold to numerous creditors.

Thus, there is no one responsible for verifying that a particular loan is sound, that the assets securing that loan are worth what they're supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language in which the loan documents were written, or even that the paperwork exists and is in good order. It has been hypothesized that this contributed to the subprime mortgage crisis.

Brokers, who did not invest their own capital, shifted risk to the lenders. When lenders sold mortgages shortly after underwriting them, they transferred risk to investors. Investment banks acquired mortgages and sliced mortgage-backed securities into varying degrees of risk. Investors purchased securities to hedge against the risk of default and prepayment, delaying the occurrence of these risks. In a purely capitalist scenario, the person who holds the risk the longest (as in a game of musical chairs) is the one who bears the potential losses. During the subprime crisis, national credit authorities (the Federal Reserve in the United States) assumed the ultimate risk on behalf of the general public.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior because there is no assurance that a bailout will take place. A decrease in a corporation's valuation prior to any bailout would discourage executives who fail to conduct adequate due diligence from making risky, speculative business decisions. Lehman Brothers, which did not receive a bailout, and other financial institutions and mortgage companies such as Citibank and Countrywide Financial Corporation, whose valuations plummeted during the subprime mortgage crisis, became aware of the risk and burdens of loss.

The Basel Committee on Banking Supervision, an international banking regulator, noted in a 2017 report that the accounting rules (IFRS # 9 and 13 in particular) leave entities with significant discretion in determining the fair value of financial instruments and identified this discretion as a potential source of moral hazard: The evidence that accounting discretion contributes to moral hazard suggests that (additional) prudential valuation requirements may be justified.

Banking regulators have taken steps to limit discretion and reduce valuation risk, i.e. the risk to banks' balance sheets due to valuation uncertainties of financial instruments. A series of regulatory documents containing detailed prudential requirements that have multiple points of contact with accounting rules and have the indirect effect of reducing moral hazard incentives by limiting the discretion banks have in valuing financial instruments have been issued.

Numerous academics and journalists contend that moral hazard contributed to the 2008 financial crisis, as numerous market participants may have had an incentive to increase their exposure to risk. In general, moral hazard may have manifested itself in three ways in the run-up to the financial crisis.

Especially if they were compensated as a percentage of the fund's profits, asset managers may have had an incentive to take on more risk when managing other people's money. Due to the fact that they were spending other people's money, they were somewhat protected from loss if they assumed a greater degree of risk. Therefore, asset managers may have been in a moral hazard situation in which they took on more risk than was suitable for a given client because they did not bear the cost of failure.

Because mortgage loan originators, such as Washington Mutual, frequently sold the loans they originated to mortgage pools, they may have had an incentive to understate the risk of the loans they originated (see mortgage-backed securities). Because loan originators were compensated per mortgage, they had an incentive to originate as many risky mortgages as possible. As they did not bear the costs of the risky mortgages they were underwriting, mortgage loan originators may have been in a situation of moral hazard.

Third, it is possible that large banks believed they were too big to fail. Because these banks were so integral to the U.S. economy, the federal government would not have permitted them to fail in order to avert a catastrophic economic collapse. This perception may have been influenced by Long-Term Capital Management's 1998 bailout.

The study of moral hazard by insurers

The origin of the name is in the insurance industry. Insurance companies were concerned that protecting their clients from dangers (such as fire or automobile accidents) might encourage those clients to engage in riskier behavior (like smoking in bed or not wearing seatbelts). This issue may ineffectively discourage those companies from protecting their clients to the extent the clients desire.

Economists contend that the inefficiency is due to informational asymmetry. If insurance companies could observe their clients' actions perfectly, they could deny coverage to those who engage in risky behavior (such as smoking in bed or not wearing seat belts), allowing them to provide comprehensive protection against risk (fire or accidents) without encouraging risky behavior. However, because insurance companies cannot observe their clients' actions perfectly, they are discouraged from providing the level of coverage that would be offered in a world with perfect information.

Economists differentiate moral hazard from adverse selection, another problem that arises in the insurance industry that is caused by concealed information rather than concealed actions.

In addition to the insurance industry, the same underlying problem of unobservable actions affects other contexts as well. It also occurs in banking and finance: if a financial institution knows it is protected by a lender of last resort, it may make riskier investments than it otherwise would.

In insurance markets, moral hazard occurs when the insured party's behavior changes in a way that raises costs for the insurer because the insured party no longer bears the full costs associated with that behavior. Because individuals are no longer responsible for the cost of medical services, they have a greater incentive to request costly and unnecessary medical services. In such situations, individuals have an incentive to overconsume because they are no longer responsible for the total cost of medical services.

Two types of behavior are susceptible to change. One type is the risky behavior itself, which creates a moral hazard before the event. The insured parties then behave in a more risky manner, resulting in a greater number of negative outcomes for which the insurer must pay. For instance, after purchasing automobile insurance, some may be less careful about locking their vehicle or drive more frequently, thereby increasing the insurer's risk of theft or accident. After purchasing fire insurance, some individuals may become less vigilant about preventing fires (say, by smoking in bed or neglecting to replace the batteries in fire alarms). In the context of flood risk management, it has been suggested that the possession of insurance undermines efforts to encourage people to integrate flood protection and resilience measures in flood-prone properties.

The second type of behavior that may change is the response to the negative effects of risk after they have occurred and insurance has been purchased to cover their costs. This is known as ex post (after the fact) moral hazard. As insurance coverage increases, insured parties do not act in a manner that is more risky and results in more negative consequences; rather, they ask insurers to pay for a greater proportion of these negative consequences. Without medical insurance, for instance, some individuals may forego medical treatment due to its expense and settle for substandard health. However, after the availability of medical insurance, some may ask an insurer to cover the cost of medical care that would not have occurred otherwise.

Sometimes the severity of moral hazard renders insurance policies impossible. Coinsurance, copayments, and deductibles reduce the risk of moral hazard by increasing consumers' out-of-pocket expenses, thereby reducing their incentive to consume. These methods function by increasing consumers' out-of-pocket expenses, thereby reducing the insured's incentive to engage in excessive consumption. By requiring individuals to pay a portion of their health care costs through coinsurance, copayment, or deductibles, for instance, insurance providers can provide individuals with an incentive to consume less health care and avoid filing unnecessary claims. This can reduce moral hazard by aligning the insured's and insurer's interests.

A graphical representation of moral hazard in health insurance. The graph plots price against quantity of health care. Without health insurance, an individual would consume less health care than with health insurance, potentially leading to moral hazard.

The blue line represents the downward sloping marginal benefit curve.

The orange line illustrates the constant $10 marginal cost without insurance curve.

The green star represents the equilibrium of the market.

When the person is insured, The marginal cost curve declines to zero, resulting in a new balance at the yellow star.

Consider a potential instance of moral hazard resulting from the purchase of health insurance on the health care market. Assume that the marginal cost of health care is $10 per unit and that the individual demand is given by Q = 20 P. Assuming a perfectly competitive market, the equilibrium price per unit of health care will be $10, and the individual will consume 10 units. Consider the same person with health insurance now. Assume this health insurance provides the individual with free health care. In this case, the individual will receive health care at no cost and will consume 20 units. The price will remain $10, but the insurance company will bear the expenses.

This numerical example illustrates the possibility of moral hazard in health insurance. Because they do not bear the cost of the additional care, the individual consumes more health care than the equilibrium amount.

In economic theory, moral hazard refers to a situation in which one party's behavior can change to the detriment of another party after a transaction has occurred. A person with automobile theft insurance, for instance, may be less cautious about locking their vehicle because the insurance company is now (partially) responsible for the negative consequences of vehicle theft. A party decides how much risk to take, while another party bears the costs if things go wrong; the risk-free party behaves differently than it would if it were fully exposed to the risk.

In microeconomics, agency theory examines the relationship between the principal, the party to whom decision-making authority is delegated, and the agent, the party who carries out the service. This theory is a central concept used to investigate and resolve issues pertaining to the principal-agent problem, also known as the relationship between agents and principals. In the adverse selection model (which encompasses agency theory), the agent holds private information before the contract is established with the principal, whereas in the moral hazard model, the agent is privately informed of the withheld information after the contract is established with the principal.

According to contract theory, moral hazard results when a concealed action takes place.

Bengt Holmström said this:

It has been acknowledged for a long time that moral hazard can arise when individuals engage in risk sharing under conditions in which their private actions influence the probability distribution of the outcome.

When it involves asymmetric information (or lack of verifiability) about the outcome of a random event, there are two types of moral hazard. Ex ante moral hazard refers to a change in behavior that occurs prior to the outcome of a random event, whereas ex post refers to behavior that occurs after the outcome. In the case of a health insurance company insuring an individual during a specific time period, for instance, the outcome can be thought of as the individual's final state of health. Ex-ante moral hazard refers to the individual taking greater risks during the period, whereas ex-post moral hazard refers to the individual lying about a fictitious health problem to defraud the insurance company. A second instance is a bank lending money to an entrepreneur for a high-risk business venture. Ex ante moral hazard would be the entrepreneur becoming excessively risky, while ex post moral hazard would be willful default (falsely claiming the venture failed when it was profitable).

According to Hart and Holmström (1987), Models of moral hazard can be subdivided into models with concealed action and models with concealed information.

In the first instance,, After the contract is signed, the agent chooses an action (such as an effort level) that the principal cannot observe.

In the last instance,, The agent's type is determined by a random draw by nature after the contract has been signed (such as his valuation for a good or his costs of effort).

In the writings, There are two reasons why moral hazard may imply that the first-best solution (the solution that would be attained with complete information) is not attained.

First, the agent may be risk-averse; therefore, there is a trade-off between providing incentives and insuring the agent. There is a trade-off between providing incentives and minimizing the agent's limited-liability rent if the agent is wealth-constrained but risk-neutral.

In managerial economics, moral hazard refers to a situation in which an individual or organization engages in risky behavior with the knowledge that the associated costs will be borne by a third party. When one party possesses more information than the other, this phenomenon frequently occurs. For instance, in the context of an employment relationship, an employee may engage in risky behavior with the understanding that their employer will bear any negative consequences. To mitigate moral hazard, companies may implement various mechanisms, such as performance-based incentives, monitoring, and screening, to align the interests of both parties and reduce the probability of risky behavior.

{End Chapter 1}

Chapter 2: Economic bubble

An economic bubble (also known as a speculative bubble or a financial bubble) is a time in which current asset values substantially exceed their intrinsic valuation, which is the valuation that long-term fundamentals support. Bubbles may be produced by excessively optimistic growth expectations (e.g., the dot-com boom) and/or the idea that fundamental value is no longer important when making an investment decision (e.g. Tulip mania). They have occurred in most asset types, including stocks (e.g., the Roaring Twenties), commodities (e.g., the Uranium bubble), real estate (e.g., the US housing bubble of the 2000s), and even obscure assets (e.g. Cryptocurrency bubble). Typically, bubbles emerge from either excessive market liquidity or a shift in investor mentality. Large multi-asset bubbles (such as the Japanese asset bubble of the 1980s and the Everything bubble of 2020–21) are ascribed to central bank liquidity (e.g. overuse of the Fed put).

In the first phases of a bubble, many investors fail to recognize it for what it is. People see that costs are increasing and often believe it is justifiable. Consequently, bubbles are sometimes discovered clearly only in hindsight, after the bubble has already burst and prices have plummeted.

Jan Brueghel the Younger's A Satire of Tulip Mania (ca.

1640)

A card from the South Sea Bubble

During the British South Sea Bubble of 1711–1720, the word bubble refers to the firms themselves and their inflated shares, as opposed to the crisis itself. This was one of the first contemporary financial crises; other instances, such as the Dutch tulip frenzy, were described to as manias. The metaphor implied that the stock values were bloated and unstable - inflated on nothing but air and susceptible to a violent burst, as really transpired.

Some subsequent critics have expanded the metaphor to highlight the abruptness, proposing that economic bubbles end All at once, with nothing preceding / Just as bubbles do when they burst.

There are several forms of bubbles, with economists focusing mostly on two primary categories:

A stock market bubble is characterized by actual investments and an unsustainable ambition to meet the high demand of a genuine market. These bubbles are characterized by easy liquidity, tangible and real assets, and a confidence-boosting innovation. Tulip Mania, Bitcoin, and the dot-com boom are three examples of stock bubbles.

A debt bubble is characterized by intangible or credit-based investments that are unable to meet rising demand in a market that does not exist. These bubbles are not supported by actual assets and are founded on speculative lending in the expectation of a profit or security. When the government can no longer support the fiat currency, these bubbles often end in debt deflation, which causes bank runs or a currency crisis. Examples include the stock market bubble of the Roaring Twenties (which precipitated the Great Depression) and the housing bubble in the United States (which caused the Great Recession).

The effect of economic bubbles is discussed within and across schools of economic thought; they are not usually seen as advantageous, but the extent to which their construction and bursting are destructive is a matter of contention.

Within mainstream economics, many believe that bubbles cannot be identified in advance, cannot be prevented from forming, that attempts to prick the bubble may cause a financial crisis, and that authorities should instead wait for bubbles to burst on their own, dealing with the aftermath through monetary and fiscal policy.

Robert E. Wright, a political economist, contends that bubbles may be recognized with high certainty prior to their occurrence.

In addition, the collapse that often accompanies an economic bubble may destroy a great deal of wealth and lead to persistent economic malaise; this perspective is notably related with Irving Fisher's debt-deflation hypothesis and extended within Post-Keynesian economics.

As was the case during the Great Depression in the 1930s for the majority of the globe and the 1990s for Japan, a prolonged period of low risk premiums may merely extend the deflation of asset prices. Not only can the aftermath of a catastrophe harm a nation's economy, but its consequences may also ripple beyond international boundaries.

Another significant component of economic bubbles is their effect on consumer spending. Market participants with overpriced assets are more likely to spend since they feel wealthier (the wealth effect). Recent property markets in the United Kingdom, Australia, New Zealand, Spain, and portions of the United States are cited by several analysts as an illustration of this impact. When the bubble ultimately collapses, people who hang onto these inflated assets often face a loss of wealth and tend to restrict discretionary expenditure, so impeding economic development or, worse, intensifying the economic downturn.

In an economy with a central bank, the bank may thus strive to monitor asset price appreciation and take steps to limit excessive speculative behavior in financial assets. Typically, this is accomplished by raising the interest rate (that is, the cost of borrowing money). Historically, this is hardly the only strategy central banks have used. It has been suggested that they should remain neutral and let the bubble, if there is one, to run its