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What is 'Moral Hazard'

Moral hazard is the risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity. In addition, moral hazard may also mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles. Moral hazards can be present any time two parties come into agreement with one another. Each party in a contract may have the opportunity to gain from acting contrary to the principles laid out by the agreement.

BREAKING DOWN 'Moral Hazard'

A moral hazard occurs when one party in a transaction has the opportunity to assume additional risks that negatively affect the other party. The decision is based not on what is considered right, but what provides the highest level of benefit, hence the reference to morality. This can apply to activities within the financial industry, such as with the contract between a borrower or lender, as well as the insurance industry. For example, when a property owner obtains insurance on a property, the contract is based on the idea that the property owner will avoid situations that may damage the property. The moral hazard exists that the property owner, because of the availability of the insurance, may be less inclined to protect the property, since the payment from an insurance company lessens the burden on the property owner in the case of a disaster.

Moral Hazard and the 2008 Financial Crisis

Prior to the financial crisis of 2008, certain actions on the parts of lenders could qualify as moral hazard. For example, a mortgage broker working for an originating lender may have been encouraged through the use of incentives, such as commissions, to originate as many loans as possible regardless of the financial means of the borrower. Since the loans were intended to be sold to investors, shifting the risk away from the lending institution, the mortgage broker and originating lender experienced financial gains from the increased risk while the burden of the aforementioned risk would ultimately fall on the investor.

Borrowers who began struggling to pay their mortgage payments also experienced moral hazards when determining whether to attempt to meet the financial obligation or walk away from loans that were difficult to repay. As property values decreased, borrowers were ending up underwater on their loans. The homes were worth less than the amount owed on the associated mortgage. Some homeowners may have seen this as an incentive to walk away, as their financial burden would be lessened by abandoning the property. In walking away, the borrowers assumed a risk where some of the penalty would fall back on the financial institutions holding the loans.

 

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