"Until Debt Tear Us Apart" stenciled on a brick wall.
Moral Hazard and Financial Crises: The 2008 Bailouts of US Financial Institutions
Moral hazard is a tendency of people to increase their risk exposure when insured or protected. This is especially pronounced when someone else bears the cost of that risk. The insurance or protection emboldens people to take risks they would otherwise not consider, knowing that if things go wrong, somebody else will bear the brunt of their actions. During the 2008 financial crisis, mortgage holders walked away from their debts, knowing that insurance would cover any losses. Some argue that the 2008 bailouts of US (and UK) financial institutions continued to send false signals to the marketplace, resulting in misplaced lending confidence.
Moral Hazard Occurs When People Are Protected from Their Actions
The term moral hazard does not refer to a particular person’s ethics. Instead, it relates to their economic decision-making; in particular, the decisions they make when the consequences of making a “bad” decision are minimised in some way by an external party.
Technically, most of us encounter moral hazard every day. For example, insured drivers often take more risks than uninsured drivers, who know they have no fallback if they damage or destroy their car. Tradesmen potentially take more risks in their customers’ homes, if they carry public liability insurance. Employees often take less care of their work laptops and other equipment, than if they provided such equipment themselves, knowing that their employer will cover any damage.
A moral hazard is like a child pushing the limits… (Robinhood)
The 2008 Financial Crisis
We have previously written in detail about the 2008 financial crisis. Since the 1970s, US and UK banks started selling their own credit risk to third parties, increasingly becoming reliant on computer-based systems for assessing risk. The 1980s saw widespread deregulation of financial markets and banking mergers. Increasingly complex financial products were developed and traded, e.g. derivatives, options, and swaps.
During the late 1980s banks diversified through increased securitisation, i.e. creating asset-backed debt. The most common type was through mortgages, which gave the banks a regular flow of income.
By the late 2000s, many insurers offered products to other financial institutions, enabling them to insure against credit defaults. One such system provided for investors to buy credit default swaps (CDSs) to protect against mortgage defaults. CDSs can be bought and resold and end up on the balance sheets of many financial institutions.
From mid-2007 to early-2009, there was extreme stress in global financial markets and banking systems. The Global Financial Crisis (GFC) began with a downturn in the US housing market and spread across the world thanks to linkages in the global financial system. House prices fell and more borrowers were required to repay their loans. Many borrowers found themselves unable to repay their loans.
This had a flow-on effect, with many mortgage lenders finding themselves over-extended, repossessing many houses for non-payment, and not being able to resell them for a profitable price.
Many lenders had previously purchased CDSs to protect against mortgage defaults. This affected their scrutiny of mortgage loan requests, and they had made loans to people who previously would not have qualified for finance. It had not been uncommon for financial institutions to make loans that covered the entire value of a house on the expectation that house prices would continue to rise.
With the unthinkable happening, house prices falling and people defaulting on their mortgages, investors became less willing to invest in CDSs and started to actively try and sell their CDS holdings. As a result, the value of CDSs fell rapidly, and this flowed through to the financial institutions’ balance sheets. Those who had bought CDSs with short-term loans found they were unable to settle their debts.
Financial stresses peaked in September 2008, with the failure of the US financial firm Lehman Brothers. On top of everything else, this triggered a panic on financial markets, that spread across the globe. Investors pulled their money from banks and other financial institutions, which in turn exposed these organisations to more subprime loans. Households stopped spending, businesses stopped investing, and much of the world fell into a deep recession.
Perhaps the most visible sign of the financial crisis in the UK was Northern Rock. They experienced a bank run in 2008 (the first in the UK since the 19th century) and ultimately were nationalised and bailed out by the UK government.
Aftermath of the Global Financial Crisis
The US federal government enacted the Dodd-Frank Financial Reform Act because of the crisis. The purpose of the act is “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” The act tried to reduce the level of moral hazard in the US economy.
One way the Dodd-Frank Financial Reform Act tries to reduce moral hazard is by limiting the size of deposits that banks can insure with the Federal Deposit Insurance Corporation (FDIC), currently a maximum of $250,000.
Events of 2023, make you wonder whether the act has done enough to reduce moral hazard, however. Silicon Valley Bank failed that year, yet the FDIC enabled all its depositors to get access to their funds, even those well over the $250,000 limit. The government made an exception to the rules, deeming Silicon Valley Bank too big to fail.
It can be argued that the very existence of the FDIC, providing compulsory deposit insurance, distorts the market and sends the wrong message to investors. As long as they invest less than $250,000 (or deposit their money in any “too-big-to-fail”-sized bank), they have no incentive to consider how safe their money will be. This takes the incentive off bad bankers, who can be riskier with their lending/investing to increase the funds they earn.
The UK government’s intervention in Northern Rock was controversial at the time, leading to questions about just how much governments should bail out banks. They weren’t alone, of course. The US government also intervened with a $700 billion Troubled Assets Relief Program (TARP), enabling the US Treasury to buy or insure CDSs and other toxic assets from banks. The government's actions appeared to highlight the moral hazard of investing, and in the process, minimised investor risk, and distorted the investment marketplace.
The 2008 Financial Crisis
We have previously written in detail about the 2008 financial crisis. Since the 1970s, US and UK banks have started selling their own credit risk to third parties, increasingly becoming reliant on computer-based systems for assessing risk. The 1980s saw widespread deregulation of financial markets and banking mergers. Increasingly complex financial products, such as derivatives, options, and swaps, were developed and traded.
During the late 1980s, banks diversified through increased securitisation, i.e., creating asset-backed debt. The most common type was mortgages, which gave the banks a regular flow of income.
By the late 2000s, many insurers offered products to other financial institutions, enabling them to insure against credit defaults. One such system provided for investors to buy credit default swaps (CDSs) to protect against mortgage defaults. CDSs can be bought and resold and end up on the balance sheets of many financial institutions.
From mid-2007 to early-2009, global financial markets and banking systems experienced extreme stress. The Global Financial Crisis (GFC) began with a downturn in the US housing market and spread worldwide thanks to linkages in the global financial system. House prices fell, and more borrowers were required to repay their loans. Many borrowers found themselves unable to make these unexpected early repayments.
This had a flow-on effect, with many mortgage lenders finding themselves over-extended, repossessing many houses for non-payment, and being unable to resell them for a profitable price.
Many lenders had previously purchased CDSs to protect against mortgage defaults. This affected their scrutiny of mortgage loan requests, and they had made loans to people who previously would not have qualified for finance. It had not been uncommon for financial institutions to make loans that covered the entire value of a house on the expectation that house prices would continue to rise.
With the unthinkable happening, house prices falling and people defaulting on their mortgages, investors became less willing to invest in CDSs and started to actively try and sell their CDS holdings. As a result, the value of CDSs fell rapidly, and this flowed through to the financial institutions’ balance sheets. Those who had bought CDSs with short-term loans found they were unable to settle their debts.
Financial stresses peaked in September 2008, with the failure of the US financial firm Lehman Brothers. On top of everything else, this triggered a panic on financial markets, that spread across the globe. Investors pulled their money from banks and other financial institutions, which in turn exposed these organisations to more subprime loans. Households stopped spending, businesses stopped investing, and much of the world fell into a deep recession.
Perhaps the most visible sign of the financial crisis in the UK was Northern Rock. In 2008, they experienced a bank run (the first in the UK since the 19th century) and ultimately were nationalised and bailed out by the UK government.
Aftermath of the Global Financial Crisis
The US federal government enacted the Dodd-Frank Financial Reform Act because of the crisis. The act's purpose is “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail”, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” The act tries to reduce the level of moral hazard in the US economy.
One way the Dodd-Frank Financial Reform Act tries to reduce moral hazard is by limiting the size of deposits that banks can insure with the Federal Deposit Insurance Corporation (FDIC), currently a maximum of $250,000.
Events of 2023, make you wonder whether the act has done enough to reduce moral hazard, however. Silicon Valley Bank failed that year, yet the FDIC enabled all its depositors to access their funds, even those well over the $250,000 limit. The government made an exception to the rules, deeming Silicon Valley Bank too big to fail.
It can be argued that the very existence of the FDIC, providing compulsory deposit insurance, distorts the market and sends the wrong message to investors. As long as they are investing less than $250,000 (or are depositing their money in any “too-big-to-fail”-sized bank), they have no incentive to consider how safe their money will be. This takes the incentive off bad bankers, who can be riskier with their lending/investing to increase the funds they earn.
The UK government’s intervention in Northern Rock was controversial at the time, leading to questions being asked about just how much governments should bail out banks. They weren’t alone, of course. The US government also intervened with a $700 billion Troubled Assets Relief Program (TARP), enabling the US Treasury would buy or insure CDSs and other toxic assets from banks. The government's actions appeared to highlight the moral hazard of investing, and in the process, minimised investor risk, and distorted the investment marketplace.
