How did moral hazard impact the financial crisis of 2007-08?

Many economists, financial analysts and policy pundits believe that the U.S. Federal Reserve System and the U.S. Treasury Department created an environment that encouraged excessive risk-taking in the years leading up to the financial crisis of 2007-08. Others argue that the Fed should have allowed major investment banks, such as Bear Stearns and AIG, to fail and go into bankruptcy after their investments collapsed. These are held up as examples of moral hazard: creating precedents where large, politically connected financial institutions can make investments on bad faith with the implicit assumption that they will be bailed out.

The combined support of the Federal Reserve, the Federal Housing Authority, Fannie Mae and Freddie Mac helped to subsidize the risk in home mortgages. Starting in the early 21st century, it became official policy of the U.S. to promote home ownership, and laws were enacted that discouraged banks from denying home loans to less-than-creditworthy borrowers.

Fannie Mae, Freddie Mac and Ginnie Mae are government-sponsored enterprises. These GSEs have been promoting artificially cheap mortgages since FDR's New Deal, but their influence expanded significantly during the 1990s. The Fair Housing Act, Community Reinvestment Act, National Affordable Housing Act and the American Dream Down Payment Act (among others) each promoted the removal of risk from the mortgage market prior to the collapse of the housing market.

The Federal Reserve itself distributed a booklet to mortgage lenders titled "Closing the Gap: A Guide to Equal Opportunity Lending." This booklet reminded lenders that those found to be discriminating too much against less-than-creditworthy borrowers would be subject to fines or jail terms. Then-chairman of the Fed Alan Greenspan said in 2004, "Many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed rate mortgage." He encouraged lenders to issue ARMs at the same time that short-term interest rates were lowered from 6% in 2001 to a mere 1% in 2004. Thousands of families defaulted on their mortgages when their ARMs adjusted upward before and during the crisis.

Capitalism is often described as a for-profit system, but it is more accurately described as a profit-and-loss system. Financiers who make poor loans tend to go out of business, and those who make good loans tend to grow. The markets need losses, but many huge investment banks were saved from this mechanism during the months after the financial crisis began. More than $500 billion of taxpayer funds was used to nationalize a large portion of the banking sector – often against the will of the senior management. By March 2009, the federal government owned nearly 45% of the stock of America's 10 largest banks.

Investment backers further removed themselves from the mortgage risk by packaging and reselling pools of derivative contracts. This provided a form of insurance against non-payment on top of the reduced default risk created by years of low interest rates and government support. This is on top of traditional FDIC insurance, which covered more than 70% of bank checking deposits by 2013. While many on Wall Street made malinvestments that came home to roost in the crisis, the moral hazards created by the federal government and the central bank encouraged them along that road.