Moral Hazard - What It Is and How It Works

What is Moral Hazard?

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Moral hazard is a situation where somebody has the opportunity to take advantage of somebody else by taking risks that the other will pay for. The idea is that people might ignore the moral implications of their choices: instead of doing what is right, they do what benefits them the most.

The Concept of Moral Hazard

The concept of moral hazard comes from the insurance industry. Insurance is a way to transfer risk to somebody else.

For example, an insurance company will pay up if you damage a rental car (and you have the proper insurance in place). In exchange, you pay a price that seems fair, and everybody wins.

The assumption is that neither you nor your insurance company expects any damage to occur. The insurance company uses statistics to estimate how likely the vehicle is to be damaged, and they price their services accordingly. But there are times when you might have more information than your insurance company.

For example, you might know that you’re going to drive into the mountains on rough, narrow roads. So you get the most generous insurance coverage possible, and you don’t worry about bouncing over rocks or scratching the paint in thick brush along the side of the road. In fact, you have a perfectly good car at home, but there’s no way you’re going to drive your car up that road.

Moral hazard says that you have an incentive to take risks that somebody else will pay for: you get to go where you want, and you don’t suffer the consequences.

The more insulated you are from risk, the more temptation you face.

Moral Hazard and Loans

Moral hazard became an important consideration (in some cases after the fact) during the financial crisis around 2008. There are two ways to think about moral hazard and loans.

Lenders were very eager to approve loans prior to the mortgage crisis.

Some mortgage brokers encouraged “subprime” borrowers to lie, or they altered documents to make it appear as if borrowers were able to afford loans that they really couldn’t afford. For example, sometimes inaccurate income numbers were reported, or no documentation was required to prove claims about ability to repay.

Why would lenders hand out money when they don’t really know if they’ll get repaid – especially if they have to lie to get the loans approved? In many cases, the lenders were only originating (or selling) the loans. After the loan was approved and funded, lenders would sell the loans to investors – who later lost money. In other words, the lender took little or no risk (but the lender had an incentive to put risk on somebody else, because originators get paid for making loans).

What’s more, lawmakers and the public became scared. They worried that if major banks collapsed (some of them were loan originators, while others held risky assets), they would bring down the US economy – not to mention the global economy. Because these banks were considered “too big to fail,” the US government helped some of them weather the economic storm: if those banks suffered large losses, the government promised to protect deposits (in some cases through the FDIC).

Of course, the US government is funded by taxpayers, so the taxpayers were ultimately bailing out the banks. In other words, lenders and investment banks took risks that were borne by taxpayers.

Moral hazard also became an issue for borrowers. As millions of homeowners struggled to pay their mortgages and defaults skyrocketed, government programs offered relief. People could avoid foreclosure thanks to funds and guarantees from the US government. Some worried that borrowers would actually have an incentive to walk away from their mortgages: they were underwater on home loans, and some might be tempted to get government aid that they didn’t need. In some cases, their credit might suffer, but in other cases borrowers would come out unscathed (in some ways at least –struggling borrowers almost certainly experienced financial hardship and emotional stress).