What Is a Moral Hazard?

Definition & Examples of a Moral Hazard

Temptation
••• Cristian Baitg/E+/Getty Images

A moral hazard is a circumstance or decision in which one party can take risks because they do not have to endure the consequences of their actions. The term is generally used in economics and the financial industry; moral hazards create win-win situations for the people who find themselves in circumstances where they can take risky actions and pass on the risk to others.

What Is a Moral Hazard?

A moral hazard is a term used in reference to situations in which one entity takes advantage of another when they realize they will not be held responsible for actions that may be illegal or otherwise socially and morally unacceptable. The term originated in the insurance industry and spread to the financial sphere.

Moral hazards are introduced when it becomes easy to ignore unethical behavior.

How Does a Moral Hazard Work?

There are two circumstances that are necessary for a moral hazard to emerge. First: There needs to be more information available to one party than another. Second: Each of the parties in a contract has different incentives for the agreement, which are not communicated.

For example, American Insurance Group (AIG) collapsed after the financial crises of 2008, when they lost vast sums of money on mortgage-backed securities.

It was understood at the time that mortgage-backed securities were virtually risk-free—to the investors—which meant the risk would be taken on by someone else.

The two conditions were met in this instance because AIG began to invest in these securities during the housing bubble of 2006–2007. The risk was assumed by the mortgagor, who took out a loan to have a place to live and was unaware of the risk they were assuming, or taken on by real estate investors getting mortgages to generate real estate income.

Moral Hazards in Lending

Lenders create moral hazards by acting in a manner that is more beneficial for themselves but not borrowers; borrowers create moral hazards in the same way.

Lenders

Before the Great Recession, lenders were eager to approve loans for many borrowers even though they knew there was a high risk of default. Real estate investors were seeing tremendous gains leading up to 2007. As lenders recognized this, more borrowers were approved regardless of their ability to repay the loans.

Some mortgage brokers encouraged subprime borrowers (people with lower credit scores and income) to lie on loan applications, or the brokers altered documents to make it appear that borrowers were able to afford loans that they couldn't.

Subprime loans come with a high risk of default, and investors purchasing housing loan derivatives caused prices to skyrocket. When the financial crises caused borrowers to default on their mortgages, investors and lenders re-assumed the risk they had passed onto the borrowers and lost large sums of money.

Borrowers

Lenders were not the only ones at fault for causing the market to crash—borrowers were more than happy to receive loans they knew they could not pay. Many were approved for mortgages they could simply not afford because lenders and investment banks wanted the income.

The sub-prime mortgage crises and the following financial crises resulted in the Dodd-Frank Wall Street Reform Act, which was passed to ensure transparency and accountability are present in the financial system.

Additionally, during the financial crisis, millions of homeowners struggled to pay their mortgages—loan defaults skyrocketed, and government programs began to offer relief, creating further moral implications.

People who couldn't afford the homes they were in in the first place avoided foreclosure thanks to money and guarantees from the U.S. government.

The moral hazard, in this case, was that borrowers—increasingly underwater on their home loans—would be tempted to walk away from their mortgage rather than work to repay it. Such an action placed risk back onto lenders, who then worked to pass risks back to borrowers in a never-ending circle of moral hazards between borrowers, lenders, and investors.

Key Takeaways

Moral hazards are situations in which people are not held responsible for their decisions and actions when dealing with business, finances, and insurance. Moral hazards exist when:

  • There is asymmetry of information.
  • Different incentives exist for a transaction.
  • There are other circumstances where risk can be passed onto another party.