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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
-
Equity release rates drop – is it worth unlocking cash from your home?News Lifetime mortgage rates are falling from their record highs - is equity release worth another look?
-
Hargreaves Lansdown launches fixed-term cash ISA product
savings/hargreaves-lansdown-fixed-cash-isa-launch Investment platform Hargreaves Lansdown is to offer fixed term cash ISAs via its Active Savings platform paying 4.8%, tax free - but is it any good?
-
What is an investment trust?
Videos “Active” investment funds come in two main varieties, one of which is investment trusts. But what exactly is an investment trust?
-
What is a dividend yield?
Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
-
High earners to pay nearly £2000 more in tax due to fiscal drag
Videos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
-
What is a deficit?
Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
-
Too embarrassed to ask: what is contagion?
Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
-
Too embarrassed to ask: what is a marginal tax rate?
Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
-
Too embarrassed to ask: what is stagflation?
Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
-
What is pension drawdown?
Videos Pension drawdown is a way of taking cash out of your pension pot and funding your lifestyle in retirement. But how does it work and is it the best option for you?
