Too embarrassed to ask: what is moral hazard?

The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?

The term “moral hazard” was first widely used in the insurance industry in the 18th century. Put simply, it refers to a situation in which a person or institution engaged in a risky activity does not bear the full negative consequences of their decisions. This lack of consequences encourages them to behave more recklessly than if they were fully responsible for their actions.

Here’s an easy example. Let’s say you’ve insured your mobile phone. As a result, you don’t bother to buy a protective case for it. After all, if it drops on the floor and breaks, the insurer will pay. That’s moral hazard.

For a much more dramatic real-life example, consider the role moral hazard played in the financial crisis of 2008. In the early 2000s, the US housing market was booming. Investors lined up to buy bundles of US mortgages, which they saw as a low-risk way to get higher interest payments than they could get from US government bonds. They bought these mortgage bundles from the banks. The banks, in turn, made the bundles out of individual mortgages they’d bought from mortgage lenders.

Because there was so much demand, mortgage lenders paid their salespeople big bonuses to sell as many mortgages as they could. But because they were immediately selling the mortgages on to the banks, the mortgage lenders didn’t worry about how creditworthy the borrowers were. They just cared about their commissions. And because the banks were selling the mortgage bundles on to investors, they didn’t worry about the quality of the loans. They just cared about their fees.

In short, the people who issued the mortgages made a profit, and thought they had offloaded the risks to someone else. Then house prices fell, some homeowners stopped paying their loans, and the entire financial system nearly collapsed.

That’s moral hazard, too – when profits go to one group of individuals or companies, but losses are borne by the taxpayer as a group.

And moral hazard is still rife in the financial system. For example, central banks constantly step in and print money to prevent economic shocks from spreading. But that encourages investors to take more risk than they otherwise would. 

Which just sets us up for a worse crash in the future.

On that cheery note, may I suggest you subscribe to MoneyWeek magazine.

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