Moral Hazard – Part 2

From a moral hazard perspective the problem is believed to have been started with brokers transferring risk to lenders, who carried out the underwriting of mortgages. Investment banks purchased these mortgages and turned them into mortgage-backed securities with varying levels of risk, which investors bought and hedged against the inherent risk of either default or prepayment by the borrower holding the mortgage. In simplistic terms, capitalist principles decree that the last one holding the risk is liable for the potential losses. However, in the subprime crisis of 2007-2008, the US Federal Reserve took on the risk by bailing out financial institutions.

Borrowers are also, at times, guilty of the practice of moral hazard by reckless spending of borrowed funds, or misrepresenting their credit-worthiness. Although with the latter, comprehensive checks and balances on behalf of the lender should uncover any undisclosed information regarding a borrower’s credit-worthiness. Credit card companies are well aware of the potential for moral hazard behavior among borrowers, and it is for this reason that credit limits are set at the time the card is applied for, being reviewed upon request from the borrower, with fresh credit-worthiness checks carried out. Most loans are made against a specific asset, such as a house or a vehicle, but credit cards are accepted virtually everywhere making it very tempting to overspend. Recent reports have indicated that there has been a substantial drop in US credit card debt since early 2009, and while this may look as though borrowers are being more responsible, it appears that a fair portion of the drop is due to banks writing off (or ‘charging off’ in banking terms) so-called ‘bad debts’. A report released by Evolution Finance and reported on in the New York Times revealed that it has been calculated that financial institutions charged off around $20 billion each quarter since the beginning of 2009. Borrowers who have had their debt written off in this manner, will find it extremely difficult to secure a loan in the future.