Moral Hazard in Light of 2007-2008 Crisis

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I.Introduction

Financial crises had repeated several times such as the great depression in 1920, saving and loan crisis in 1986 and Asian crisis in 1997 before the 2007-08 financial crisis. There are a considerable number of articles about the causes of financial crises. Based on the traditional view, the causes of the financial crisis are the government budget imbalances, high inflation, low investment, low savings and low growth rate (Esquivel and Larrain, 1998). Specifically, the causes for the 2007-08 financial crisis stemmed from house price bubbles, the failure of risk management at sub-prime mortgage market and the dysfunctional ranking system and the causes are implicit in the relationship with a moral hazard. The definition of moral hazard is based on Leopold’s description (2009, p. 48): “More insurance could lead to lazier bicycle riders – a moral hazard – who enable more bicycle thefts. In finance the bicycle is risk. If I know I will be bailed out if I assume risk and fail, I’ll assume more and more risk and let you bail me out if I fail”. It mainly arises due to information asymmetry; asymmetric information is the situation in which one party in an economic transaction has better information than the other party. Thus, in this essay, we will discuss whether the solution to a moral hazard problem is to eliminate asymmetry in the information that a borrower and a lender had in light of the financial crisis. It is structured with three parts, First we will provide evidence for the relationship between asymmetric information and a moral hazard problem; Second we will discuss other reasons causing moral hazard problems, particularly in the intervention of governments. Finally a brief summary of the discussion and the conclusion will be given.

II.The relationship between asymmetric information and a moral hazard problem

Complete information describes a condition when individuals involved could access all relevant information, and complete information definitively does solve moral hazard problem. We will analyze how moral hazard acts at the financial market and explore instances of moral hazard due to the information asymmetry in the 2007-08 financial crisis. Principal agent problem is a sub-category of the moral hazard problem; the reason is that their short-term incentives outweigh shareholders’ interest based on agents’ views. As a result, the agent or the employees do not act in the best interests of shareholders and they might hide information. Asymmetric information lies in the lack of knowledge of the principals about the consequences of the risks that the agents take to earn their bonuses. Principal-agent problems were present in the financial crisis that started in 2007 known as subprime mortgages crisis. Subprime mortgage crisis resulted from that mortgage borrowers, mortgage lenders and investment bankers who maximized their profits without being accountable for the risks of the mortgages. Their unaccountable actions led to the spread of a large amount of sub-prime mortgages throughout the financial system. For instance, McDonald & Robinson (2009, p.185) provide a conversation with employees of New Century, which was the second-largest subprime mortgage lender, and their salesmen had annual earnings between $300,000 and $600,000. When the salesmen were asked whether they had considered the possibility of widespread default and whether proof or assets were needed before the mortgage in granted to a borrower, the salesmen responded “Not our concern. Our job is to sell mortgage policy. Right after that it’s someone else’s problem”, and “No. They just need to state their income. No docs. That’s why we work here” respectively. This definitely shows there is asymmetry in the information between the borrower and lender because there was no requirement of proof or assets in order to get mortgages. Another example of asymmetric information occurred in the financial crisis is credit rating agencies’...
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