Moral Hazard Critical Thinking Essay

Everyday people are faced with challenges, obstacles and important decisions. When forced to address these encounters, a system of options are present. When choosing which option to chose or path to follow, people ultimately have two absolute alternatives. First, people can chose to be moral and just in their tactic, or unfortunately, people may choose a more unethical approach. Regrettably, in today’s world the latter has and is occurring. This seemingly unfair, yet also unavoidable interaction is referred to as moral hazard. Moral hazard occurs when two parties are forming some sort of agreement, contract, etc. and there is a possible risk at hand. Although people normally would be cautious of these risks they are protected. Bluntly, moral hazard is when a party is protected in some way from risk and therefore chooses to act in a way that they normally would not if they were not protected from that risk. While moral hazard may seem to only affect the party who is ignorant of the other party’s protection, it can become a much larger issue with regard to financial markets. Therefore, many financial market observers are aware and cautious of this for a few reasons. When dealing with the financial markets, the issue of moral hazard specifically relates to the Federal Reserve. The Federal Reserve creates a “safety net” for companies in large financial markets. There are two opposing stances regarding this. While some argue that if there was not a form of inevitable government assistance, the economy could end up collapsing, others believe that by providing a safety net, the government is enabling companies to engage in riskier activities. Just before the start of the financial crisis of 2007/2008 America’s economy was faced with trouble when housing prices dropped. Homeowners had questionable credit but banks were reselling them in mortgage-backed securities. The Federal Reserve was under the impression that this issue was confined to the housing market. Unfortunately, financial institutions owned them in the form of mutual funds, corporate assets, and pension funds. These purchases of assets were very risky; this is where moral hazard comes into play. They thought that they were protected due to credit default swaps, but they quickly realized all swaps could not be honored. Frenzy broke out in the financial world, and then the Federal Reserve stepped in. The government spent $150 billion just to keep mortgage companies Freddie Mac and Fannie Mae afloat. Although the large amount of money allocated to Fannie Mae and Freddie Mac seem drastic, they are just the tip of the iceberg. The government put money into many different kinds of these institutions. More specifically, they put a certain amount of equity into a number of large banks. While this was meant to help, it caused a mini panic. They thought it would give people confidence that they recapitalized the financial system and that the stock and debt prices would stop falling because there was now more equity to support the system. Ultimately, they forced banks to buy other banks (JP Morgan bought Bear Stern etc.). This only added to the panic, the fed forced the shaky undercapitalized banks to accept equity. Mutual funds, other banks, and other financial institutions were buying all of the debt, making the assumption that the government would bail out all of the banks, rather than putting in the effort and doing the research and realizing that they should not have invested in the debt of these entities. A common phrase coined during this time was “too big too fail”. Institutions that were considered to be “too big to fail” included insurers and banks. Before the recession they had an unjust benefit, they acquired other smaller companies and in turn became larger. Due to moral hazard, some of these institutions were sure that although the investments were beginning to fail, they would be bailed out. They were aware that if they were not ‘bailed out’ the risk of global economic collapse was possible. Federal Reserve Bank of Richmond President, Jeffrey Lacker, stated, “Financial instability is a consequence of the moral hazard effect of expected official intervention.” This statement has a lot of truth behind it. The government is there for security to ensure that the economy remains flourishing, yet they perpetuate risky decision-making that could hurt the economy. However, currently the government is taking steps to try to improve the economy and avoid any future similar situations to the financial crisis of 2008, which I believe is both smart and necessary. Banks need more capital today than they were previously required to maintain. The government is trying to increase the capital cushion that banks and insurance companies may maintain to absorb future losses. For example, when Lehman Brothers went under they had 1 dollar of capital for every 30 or more dollars in liabilities. I think that the capital levels should be significantly higher than it was during the crisis. Also, banks took on a lot of risk for themselves called proprietary trading, which is the purchase of buying risky assets hoping to make returns. This is not the appropriate function of banks; the function should be to service the customer. Regulations over recent have allowed banks to take on more risks that were historically only preformed by unregulated investment banks. Therefore, the government should continue to encourage both the limitations on banks engaging in risky investments and the necessity for a higher capital to liabilities ratio to overcome the negative effects of moral hazard.

Works Cited

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Derby, Michael S. "Fed’s Lacker: Fed Emergency Actions Made Crisis Worse." The Wall Street Journal: Real Time Economics RSS. The Wall Street Journal, 21 Feb. 2014. Web. 02 Mar. 2014. .