Editing Moral hazard (section)

==Finance==
In 1998, [[William J. McDonough]], head of the New York Federal Reserve, helped the counterparties of [[Long-Term Capital Management]] avoid losses by taking over the firm. This move was criticized by former Fed Chair Paul Volcker and others as increasing moral hazard.<ref name="nyt080907">{{cite news|first=Roger|last=Lowenstein|author-link=Roger Lowenstein|url=https://www.nytimes.com/2008/09/07/business/07ltcm.html|title=Long-Term Capital: It's a Short-Term Memory|date=September 6, 2008|work=The New York Times|url-status=bot: unknown|archive-url=https://web.archive.org/web/20181120015201/https://www.nytimes.com/2008/09/07/business/07ltcm.html|archive-date=November 20, 2018|access-date=November 19, 2018}}</ref><ref name=nr081229/><ref>{{cite news|url=https://www.ft.com/content/aced684c-834e-11dd-907e-000077b07658 |archive-url=https://ghostarchive.org/archive/20221210/https://www.ft.com/content/aced684c-834e-11dd-907e-000077b07658 |archive-date=December 10, 2022 |url-access=subscription|title=The Short View: Moral hazard|author=John Authors|work=Financial Times|date=September 15, 2008}}</ref><ref>[http://www.gao.gov/archive/2000/gg00067r.pdf GAO/GGD-00-67R Questions Concerning LTCM and Our Responses] {{Webarchive|url=https://web.archive.org/web/20120419060858/http://www.gao.gov/archive/2000/gg00067r.pdf |date=April 19, 2012 }} General Accounting Office, February 23, 2000</ref> [[Tyler Cowen]] concludes that "creditors came to believe that their loans to unsound financial institutions would be made good by the Fed – as long as the collapse of those institutions would threaten the global credit system."<ref name=nr081229>{{cite magazine|url=https://newrepublic.com/article/46760/long-term-capital-blame-todays-crisis|title=Is Long-term Capital To Blame For Today's Crisis?|date=December 29, 2008|author=Noam Scheiber|author-link=Noam Scheiber|magazine=The New Republic}}</ref> Fed Chair, [[Alan Greenspan]], while conceding the risk of moral hazard, defended the policy to orderly unwind Long-Term Capital by saying the world economy is at stake.<ref>{{cite web|url=https://mises.org/library/mr-moral-hazard|title=Mr. Moral Hazard|author=Jeffrey Tucker|date=December 1, 1998|author-link=Jeffrey Tucker}}</ref><ref name="nyt080907" /> Greenspan had himself been accused of creating wider moral hazard in markets by using the [[Greenspan put]].

Economist [[Paul Krugman]] described moral hazard as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly."<ref name="Krugman 2009">{{cite book
| last = Krugman
| first = Paul
|author-link=Paul Krugman
| year = 2009
| title = The Return of Depression Economics and the Crisis of 2008 | publisher = W.W. Norton Company Limited
| isbn = 978-0-393-07101-6| title-link = The Return of Depression Economics and the Crisis of 2008
}}</ref> Financial [[bailouts]] of lending institutions by governments, central banks or other institutions can encourage risky lending in the future if those that take the risks come to believe that they will not have to carry the full burden of potential losses. Lending institutions need to take risks by making loans, and the riskiest loans usually have the potential for making the highest return.

Taxpayers, depositors and other creditors often have to shoulder at least part of the burden of risky financial decisions made by lending institutions.<ref>{{cite news |url=http://www.ft.com/cms/s/0/5ffd2606-69e8-11dc-a571-0000779fd2ac.html |archive-url=https://ghostarchive.org/archive/20221210/http://www.ft.com/cms/s/0/5ffd2606-69e8-11dc-a571-0000779fd2ac.html |archive-date=December 10, 2022 |url-access=subscription |url-status=live |last=Summers |first=Lawrence |title=Beware moral hazard fundamentalists |newspaper=[[Financial Times]] |date=2007-09-23 |access-date=2008-01-15}}</ref><ref>{{cite web |url=http://www.marketwatch.com/news/story/story.aspx?guid={9F4C2252-8BA7-459C-B34E-407DB32921C1}&siteid=rss |last=Brown |first=Bill |title=Uncle Sam as sugar daddy |website=MarketWatch |date=2008-11-19 |access-date=2008-11-30}}</ref><ref>{{cite journal|ssrn=1321666 |title=Common (Stock) Sense about Risk-Shifting and Bank Bailouts|publisher=SSRN.com |date=December 29, 2009|last1=Wu|first1=Yan Wendy|last2=Wilson|first2=Linus|journal=Financial Markets and Portfolio Management|doi=10.1007/s11408-009-0125-y|volume=24|issue=1|pages=3–29}}</ref><ref>{{cite journal|ssrn=1336288 |title=Debt Overhang and Bank Bailouts|publisher=SSRN.com |date=2 Feb 2009|last1=Wilson|first1=Linus|journal=International Journal of Monetary Economics and Finance|volume=5|issue=4}}</ref>

Many have argued that certain types of mortgage [[securitization]] contribute to moral hazard.<ref>{{Cite journal|title=Mortgage Securitization, Structuring and Moral Hazard: Some Evidence and Lessons from the Great Crash|last=Van Order|first=Robert|journal=International Real Estate Review|year=2018|volume=21|issue=4|pages=521–547|doi=10.2139/ssrn.3306945|doi-broken-date=April 14, 2025 }}</ref> Mortgage securitization enables mortgage originators to pass on the risk that the mortgages they originate might default and not hold the mortgages on their balance sheets and assume the risk. In one kind of mortgage securitization, known as "agency securitizations," default risk is retained by the securitizing agency that buys the mortgages from originators. These agencies thus have an incentive to monitor originators and check loan quality. "Agency securitizations" refer to securitizations by either [[Ginnie Mae]], a government agency, or by [[Fannie Mae]] and [[Freddie Mac]], both for-profit [[government-sponsored enterprise]]s. They are similar to the "covered bonds" that are commonly used in [[Western Europe]] in that the securitizing agency retains default risk. Under both models, investors take on only interest-rate risk, not default risk.

In another type of securitization, known as "private label" securitization, default risk is generally not retained by the securitizing entity. Instead, the securitizing entity passes on default risk to investors. The securitizing entity, therefore, has relatively little incentive to monitor originators and maintain loan quality. "Private label" securitization refers to securitizations structured by financial institutions such as investment banks, commercial banks, and non-bank mortgage lenders.

During the years leading up to the [[subprime mortgage crisis]], private label securitizations grew as a share of overall mortgage securitization by purchasing and securitizing low-quality, high-risk mortgages. Agency Securitizations appear to have somewhat lowered their standards, but Agency mortgages remained considerably safer than mortgages in private-label securitizations and performed far better in terms of default rates.

Economist [[Mark Zandi]] of [[Moody's Analytics]] described moral hazard as a root cause of the subprime mortgage crisis. He wrote that "the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined." He also wrote, "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards."<ref>{{cite book
| last = Zandi
| first = Mark
| year = 2009
| title = Financial Shock
| publisher = FT Press
| isbn = 978-0-13-701663-1
| url-access = registration
| url = https://archive.org/details/financialshockgl00zand
}}</ref>

Moral hazard can also occur with borrowers. Borrowers may not act prudently (in the view of the lender) when they invest or spend funds recklessly. For example, [[credit card]] companies often limit the amount borrowers can spend with their cards because without such limits, borrowers may spend borrowed funds recklessly, leading to default.

Securitization of mortgages in America started in 1983 at [[Salomon Brothers]] and where the risk of each mortgage passed to the next purchaser instead of remaining with the original mortgaging institution. These mortgages and other debt instruments were put into a large pool of debt, and then shares in the pool were sold to many creditors.

Thus, there is no one person responsible for verifying that any one particular loan is sound, that the assets securing that one particular loan are worth what they are supposed to be worth, that the borrower responsible for making payments on the loan can read and write the language in which the papers that he/she signed were written, or even that the paperwork exists and is in good order. It has been suggested that this may have caused the subprime mortgage crisis.<ref>{{cite web |title='Moral hazard' helps shape mortgage mess |author=Holden Lewis |publisher=Bankrate.com |url=http://www.bankrate.com/brm/news/mortgages/20070418_subprime_mortgage_morality_a1.asp?caret=3c |date=2007-04-18 |access-date=2007-12-09}}</ref>

Brokers, who were not lending their own money, pushed risk onto the lenders. Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors. Investment banks bought mortgages and chopped up mortgage-backed securities into slices, some riskier than others. Investors bought securities and hedged against the risk of default and prepayment, pushing those risks further along. In a purely capitalist scenario, the last one holding the risk (like a game of [[musical chairs]]) is the one who faces the potential losses. In the sub-prime crisis, however, national credit authorities (the [[Federal Reserve]] in the US) assumed the ultimate risk on behalf of the citizenry at large.

Others believe that financial bailouts of lending institutions do not encourage risky lending behavior since there is no guarantee to lending institutions that a bailout will occur. Decreased valuation of a corporation before any bailout would prevent risky, speculative business decisions by executives who fail to conduct proper due diligence in their business transactions. The risk and the burdens of loss became apparent to [[Lehman Brothers]], which did not benefit from a bailout, and other financial institutions and mortgage companies such as [[Citibank]] and [[Countrywide Financial Corporation]], whose valuation plunged during the subprime mortgage crisis.<ref>{{cite news |title=Paulson bailout: seizing moral high ground can be hazardous |author=David Wighton |newspaper=[[The Times]] |url=http://business.timesonline.co.uk/tol/business/columnists/article4813975.ece |date=2008-09-24 |access-date=2009-03-17 |archive-date=June 12, 2011 |archive-url=https://web.archive.org/web/20110612121444/http://business.timesonline.co.uk/tol/business/columnists/article4813975.ece}}</ref><ref>{{cite web |title=The SEC Makes Wall Street More Fraudulent |author=HFM |publisher=Justput.com Post # 17-26 |url=http://www.justput.com/forum/showthread.php?t=6820 |date=2009-03-16 |access-date=2009-03-17 |archive-date=April 29, 2011 |archive-url=https://web.archive.org/web/20110429201141/http://www.justput.com/forum/showthread.php?t=6820 |url-status=dead }}</ref><ref>{{cite news |title='Moral Hazard': Why Risk Is Good |author=Frank Ahrens |newspaper=The Washington Post |url=https://www.washingtonpost.com/wp-dyn/content/article/2008/03/18/AR2008031802873.html |date=2008-03-19 |access-date=2009-03-17}}</ref>

=== Incentives to moral hazard in accounting rules ===
A 2017 report by the [[Basel Committee on Banking Supervision]],<ref>{{cite web|url=https://www.bis.org/bcbs/publ/wp31.pdf|title=BCBS, The interplay of accounting and regulation and its impact on bank behaviour, 2017|work=Basel Committee on Banking Supervision}}</ref> an international regulator for the banking sector, noted that the accounting rules ([[IFRS]] # 9 and 13 in particular) leave entities significant discretion in determining financial instrument fair value and identified this discretion as a potential source of moral hazard: "The evidence consistent with accounting discretion as contributing to moral hazard behavior indicates that (additional) prudential valuation requirements may be justified."

Banking regulators have taken actions to limit discretion and reduce [[valuation risk]], i.e. the risk to banks' balance sheets arising from financial instrument valuation uncertainties. A row of regulatory documents has been issued, providing detailed prudential requirements that have many points of contact with the accounting rules and have the indirect effect of curbing the incentives for moral hazard by limiting the discretion left to banks in valuating financial instruments.<ref>{{cite web|url= https://www.bis.org/publ/bcbs189.pdf|title=BCBS, Basel III: A global regulatory framework for more resilient banks and banking systems, 2010|work=Basel Committee on Banking Supervision}}</ref><ref>{{cite web|url=https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32013R0575&from=en|title=Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012|work=Capital Requirements Regulation (CRR)}}</ref><ref>{{cite web|url=https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R0876|title=Regulation (EU) 2019/876 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 575/2013 as regards the leverage ratio, the net stable funding ratio, requirements for own funds and eligible liabilities, counterparty credit|work=Capital Requirements Regulation 2 (CRR2)}}</ref><ref>{{cite web|url=https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R0101&from=EN|title=Commission Delegated Regulation (EU) 2016/101 of 26 October 2015 supplementing Regulation (EU) No 575/2013 of the European Parliament and of the Council with regard to regulatory technical standards for prudent valuation under Article 105(14)|work=EU Commission Regulation}}</ref><ref>{{cite web|url=https://eba.europa.eu/sites/default/documents/files/documents/10180/642449/1d93ef17-d7c5-47a6-bdbc-cfdb2cf1d072/EBA-RTS-2014-06%20RTS%20on%20Prudent%20Valuation.pdf|title=EBA final draft Regulatory Technical Standards on prudent valuation under Article 105(14) of Regulation (EU) No 575/2013 (Capital Requirements Regulation — CRR)|work=European Banking Authority}}</ref><ref>{{cite web|url=https://eba.europa.eu/regulation-and-policy/market-risk/draft-technical-standards-on-the-ima-under-the-frtb|title=EBA final draft Regulatory Technical Standards on criteria for assessing the modellability of risk factors under the Internal Model Approach (IMA) under Article 325be(3) of Regulation (EU) No 575/2013 (revised Capital Requirements Regulation – CRR2|work=European Banking Authority|date=June 27, 2019}}</ref><ref>{{cite web|url=https://eba.europa.eu/sites/default/documents/files/document_library/EBA-RTS-2020-02%20Final%20draft%20RTS%20on%20Backtesting%20and%20PLA%20requirements.pdf|title=EBA final draft Regulatory Technical Standards on Back-testing requirements and Profit and Loss attribution requirements under Article 325 bf(9) and 325bg (4) of Regulation(EU) No575/2013(revised Capital Requirements Regulation - CRR2|work=European Banking Authority}}</ref>

===Connection to the 2008 financial crisis===
{{Main|2008 financial crisis}}

Many scholars and journalists have argued that moral hazard played a role in the [[2008 financial crisis]], since numerous actors in the financial market may have had an incentive to increase their exposure to risk.<ref name=":1">{{Cite journal|last=Okamoto|first=Karl|date=2009|title=After the Bailout: Regulating Systemic Moral Hazard|url=https://www.uclalawreview.org/pdf/57-1-4.pdf|journal=UCLA Law Review|pages=183–236|url-status=live|access-date=2021-06-01|archive-url=https://web.archive.org/web/20201130100922/https://www.uclalawreview.org/pdf/57-1-4.pdf|archive-date=2020-11-30}}</ref><ref name=":2">{{Cite web|url=https://www.investopedia.com/ask/answers/050515/how-did-moral-hazard-contribute-financial-crisis-2008.asp|title=How did moral hazard contribute to the 2008 financial crisis?|last=Investopedia|website=Investopedia|language=en|access-date=2020-03-02|date=2019-06-25|url-status=bot: unknown|archive-date=March 2, 2020|archive-url=https://web.archive.org/web/20200302061627/https://www.investopedia.com/ask/answers/050515/how-did-moral-hazard-contribute-financial-crisis-2008.asp}}</ref> In general, there are three ways in which moral hazard may have manifested itself in the lead up to the financial crisis:

* Asset managers may have had an incentive to take on more risk when managing other people's money, particularly if they were paid as a percentage of the fund's profits. If they took on more risk, they could expect higher payoff for themselves and were somewhat shielded from losses because they were spending other people's money.<ref name=":1" /> Therefore, asset managers may have been in a situation of moral hazard, where they would take on more risk than appropriate for a given client because they did not bear the cost of failure.
* Mortgage loan originators, such as [[Washington Mutual]], may have had an incentive to understate the risk of loans they originated because the loans were often sold to mortgage pools (see [[Mortgage-backed security|mortgage-backed securities]]). Because loan originators were paid on a per-mortgage basis, they had an incentive to produce as many mortgages as possible, even if they were risky.<ref name=":1" /> Because these institutions did not expect to hold on to the loans until maturity, they could pass on the risk to the buyer of the loans.<ref name=":2" /> Therefore, mortgage loan originators may have been in a situation of moral hazard, because they did not bear the costs of the risky mortgages they were underwriting.
* Third, large banks may have believed they were "[[too big to fail]]." That is, because these banks were so ingrained in the US economy, the federal government would not have allowed them to fail in order to prevent a full-scale economic crash. This belief may have been shaped by the 1998 bailout of [[Long-Term Capital Management]].<ref name="nyt080907" /> "Too big to fail" banks may have believed they were essentially invincible to failure, thus putting them in a position of moral hazard: they could take on big risks&nbsp;– thus increasing their expected payoff&nbsp;– thinking that the federal government would bail them out in the event of a major failure. Therefore, large banks may have been in a situation of moral hazard, because they did not bear the costs of a catastrophic collapse.

Notably, the [[Financial Crisis Inquiry Commission]] (FCIC), tasked by Congress with investigating the causes of the financial crisis, cited moral hazard as a component of the crisis, arguing that many factors, including deregulation in the derivatives market in 2000, reduced federal oversight, and the potential for government bailout of "too big to fail" institutions all played a role in increasing moral hazard in the years leading up to the collapse.<ref name=":5">{{Cite report|url=https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf|title=The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States|author=National Commission on the Causes of the Financial and Economic Crisis in the United States|date=February 25, 2011|url-status=live|archive-url=https://web.archive.org/web/20181216095833/https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf|archive-date=2018-12-16}}</ref>

Others have argued that moral hazard could not have played a role in the financial crisis for three main reasons. First, in the event of a catastrophic failure, a government bailout would only come after major losses for the company.<ref name=":3">{{Cite magazine|url=https://www.newyorker.com/business/james-surowiecki/moral-hazard-and-the-crisis|title=Moral Hazard and the Crisis|last=Surowiecki|first=James|magazine=The New Yorker|date=January 14, 2010|language=en|access-date=2020-03-02|url-status=bot: unknown|archive-date=October 24, 2020|archive-url=https://web.archive.org/web/20201024072130/https://www.newyorker.com/business/james-surowiecki/moral-hazard-and-the-crisis}}</ref> So even if a bailout was expected it would not prevent the firm from taking losses. Second, there is some evidence that big banks were not expecting the crisis and thus were not expecting government bailouts, though the FCIC tried hard to contest this idea.<ref name=":3" /> Third, some have argued that negative [[Externality|externalities]] from corporate governance were a more important cause, since some risky investments may have had positive expected payoff for the firm but negative expected payoff to society.<ref name=":4">{{Cite journal|last=Schwarcz|first=Steven L.|date=December 2017|title=Too Big to Fool: Moral Hazard, Bailouts, and Corporate Responsibility|url=https://scholarship.law.umn.edu/cgi/viewcontent.cgi?article=1093&context=mlr|format=PDF|archive-format=PDF|journal=Minnesota Law Review|volume=102|pages=761–802|access-date=2021-06-01|archive-url=https://web.archive.org/web/20200318122717/https://scholarship.law.umn.edu/cgi/viewcontent.cgi?article=1093&context=mlr|archive-date=2020-03-18|url-status=live}}</ref>