Moral Hazard: Definition and Examples

What is Moral Hazard?

Temptation
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Moral hazard happens when somebody has the opportunity to take advantage of a situation by taking risks that others will pay for. In those cases, the consequences of risk-taking don’t fall on the risk-taker, but the benefits do. The situation creates a temptation to ignore the moral implications of a choice: Instead of doing what is right, you can do what benefits you most.

The Concept of Moral Hazard

Moral hazard comes from the insurance industry. Insurance is a way to transfer risk to somebody else, but insurance works best when moral hazard is not at work.

For example, if you damage a rental car (and you have the proper insurance in place), the insurance company will pay for repairs or a new car. In exchange for that coverage, you pay a price that seems fair, and everybody is satisfied.

Information advantage: Insurance works best when neither you nor your insurance company expects any damage to occur. The insurance company uses statistics to estimate how likely the vehicle is to suffer damage, and they price their services accordingly. You pay much less than it costs to repair a car, and in most cases, the insurance company doesn’t have to pay for any repairs. But there are times when you might have an unfair information advantage over your insurance company.

Example: For example, you might plan 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. You might even have a perfectly good car available at home, but there’s no way you’re going to drive your vehicle up that road—so you rent a car and buy insurance.

Moral hazard is when you have an incentive to take risks that somebody else will pay for: You get to do whatever brings you the greatest potential benefit, 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 factor leading up to (and after) the financial crisis that began in 2007. There are two ways to think about moral hazard and loans.

Lenders: Lenders were eager to approve loans before the mortgage crisis. Some mortgage brokers encouraged “subprime” borrowers to lie on loan applications, 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 a borrower’s 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 commit fraud to get the loans approved? In many cases, the lenders were only originating (or selling) the loans. After approving and funding loans, lenders would sell the loans to investors, who eventually lost money. In other words, the lender took little or no risk. But lenders had an incentive to keep making new loans because that​'s how originators get paid.

When things turned sour, lawmakers and the public got scared. They worried that if major banks collapsed (some of them were loan originators, while others held risky investments), they would bring down the U.S. economy—not to mention the global economy. Because these banks were considered “too big to fail,” the U.S. government helped some of them weather the economic storm. If those banks suffered significant losses, the government promised to protect deposits (in some cases through the FDIC). Of course, taxpayers fund the U.S. government, so the taxpayers were ultimately bailing out the banks.

In other words, lenders and investment banks took risks that were borne by taxpayers.

Borrowers: Moral hazard also appeared with borrowers. As millions of homeowners struggled to pay their mortgages and defaults skyrocketed, government programs offered relief. People could avoid foreclosure thanks to money and guarantees from the U.S. 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” (although struggling borrowers almost certainly experienced financial hardship and emotional stress).