The Financial Crisis Causes: Moral Hazard and Adverse Selection

NB: We do not resell your papers. Upon ordering, we do an original paper exclusively for you.

NB: All your data is kept safe from the public.

Table of Contents

Introduction
The Financial Crisis
The crisis: Adverse selection and moral hazard
Mitigation measures
Conclusion
Works Cited
Footnotes

Introduction

The recent financial crisis was one of a magnitude only comparable to the Great Depression¹. It saw economies that previously seemed to be doing well spiral downward, thus forcing their respective governments to take drastic measures to prevent them from crumbling. The crisis was experienced in almost every country across the world over owing to globalization, with its origin or trigger thought to be the United States’ economic performance in 2007.

The consequences were similar in most parts of the world with the main indicators being debt crises, high unemployment rates, a reduction in the number of home ownership facilities and the demand for the same, high taxation, a significant reduction in consumer spending, and a drastic increase of the overall cost of living.

Although the effects of the crisis have significantly reduced, they are still being felt across the world, with most countries still cautious about how they interact with other countries. Some countries have thought of taking the approach of developing policies that favor the growth of their economies without necessarily depending on help from other countries.

Even though self-sufficiency may be considered as a good way of avoiding future crises, such economies end up missing out from benefits that come with trade and other interactions with other economies. These benefits include the availability of foreign currency, expansive markets for their goods and services, and assistance in case there is internal conflict, an epidemic, or natural disasters of great magnitudes².

Various causes believed to have caused such an enormous downturn in the American economy. These factors include, but not limited to, lack of proper governance financial institutions, laxity in policy-making, and lack of proper risk management mechanisms³. The crisis led to the closing of some of the major financial institutions, with others requiring help from the government in order to stay afloat⁴.

This paper discusses these causes in detail, particularly with regard to moral hazard and adverse selection. It will also look into the regulatory and monetary tools put in place by the American government to cushion its economy, alleviate the crisis, and bring the economy back to its previous successful state.

The Financial Crisis

In the years preceding 2006, there had been steady growth and availability of credit mainly aided by foreign exchange and growth of investments from Asia and Russia. This move led to a rapid increase in the housing construction business thus increasing competition in the housing sector, which caused a fall in the price of housing to the benefit of consumers wishing to invest in the housing sector.

This boom in the housing sector underscores what came to be known as the “housing bubble”. At the same time, financial institutions were increasingly putting into effect the deregulation policy established in the 1970s, which worked to their advantage⁵. The policy was established to reduce some of the regulations enforced against financial institutions so that they could conduct business more freely and with added flexibility to suit their customers’ needs.

The combined existence of these two aspects simultaneously led to a chain of situations that consequently led to the crisis that brought the entire economy to its knees. A series of choices made by financial institutions had consequences that had a ripple effect throughout every sector of the economy.

As mentioned earlier, the availability of credit was on an all time high, which meant that banks and other financial institutions could afford to lend money to consumers at low rates. Lending rates fell to as little as 1 per cent, which attractively affordable to most individuals, and thus this increased the rate at which people borrowed money as well as the amounts borrowed.

This aspect meant increased clients for the lending institutions, which seemed like a good thing at the time. The deregulation policy on the other hand reduced oversight on financial institutions, which led to laxity in policies made by the institutions, with regard to the requirement for qualification for loans and specifically mortgage loans.

Hedge funds and investment firms willing to provide mortgage loans to individuals without sound financial backing were on the rise, thus taking over a market mainly occupied by commercial banks. These forms of loans are popularly known as subprime mortgages.

The lack of adequate oversight from the relevant authorities led to an increase in scrupulous institutions, which provided loans at attractively low rates, thus providing potential investors in mortgages with bulky and detailed contracts, which saw the interest rates rise after the closing of the contracts.

These types of mortgages are popularly known as Adjustable Rate Mortgages (ARMs). The result of this lending trend is that the actual interest on these mortgages rose periodically, thus requiring the mortgagor to pay well past the amount that he or she thought was agreed. It also led to a laxity in policy making within the lending institution, which overlooked the necessity to put in place measures to cushion them from possible losses owing to the subprime mortgages⁶.

The availability of cheaper housing options also contributed to an increased incentive for foreclosure with the majority of people with houses that were worth less than the mortgage loans they were previously paying, thus opting to agree to foreclosure and applying for the cheaper subprime mortgages that were not previously available to them.

This scenario caused a fall in property value. The lack of adequate security in subprime mortgages led to defaults on payment, which in turn led to the worsening of the foreclosure situation that already existed. This scenario was also similar with adjustable rate mortgages. It also meant that many people lost their homes and investors lost their money.

Due to the losses incurred by investors, many people withdrew money invested in the housing sector thus leading to a debt crisis. For instance, the Wall Street was adversely affected by the withdrawal of investments with stocks falling to unprecedented levels⁷. Some of the major financial institutions had to close down as they were operating on losses and did not even have money to pay their investors back.

The crisis: Adverse selection and moral hazard

Adverse selection is described as a market process whereby a buyer or seller in a transaction has information that the other party is deprived of, which results to a negative outcome in the transaction. The person withholding the additional information usually does so with the intention of getting the best possible result out of the transaction while shouldering as little risk as possible.

The risk burden thus transfers to the person without the additional knowledge, usually of the product or a subject of the transaction service. The one who is adversely selected against is not always the one who lacks additional information about the transaction. The determination of the person affected depends on what happens after the successful conclusion of the transaction.

For instance, in insurance, insurance companies set prices for their cover packages based on the amount of risk involved and the cover offered for such risks. This aspect means that high-risk products and services demand more cover, which translates to a higher price for the package.

Therefore, in a situation involving a life insurance cover where one client is a drug user and the other one not, and because this information is not necessary when applying for cover, the person who does not use drugs is adversely selected against as he or she is required to pay the same amount as the drug user.

The adverse selection in this case occurs because the drug user has a higher mortality rate than the person who does not indulge in drug consumption. The insurance company is also adversely affected by this arrangement for people who are not drug users are less likely to take the cover thus leading to lower income on the company’s part.

Moral hazard is a principle that stipulates that a person who is likely to incur the least loss out of a situation is more likely to take more risk. This scenario usually occurs in cases of agency relationships whereby the agent is likely to take more risk in a given situation than the principle and in investment where the party investing in a product or service is doing so on behalf of someone else.

For instance, an investment firm or bank is likely to make investments in products and services that involve higher risks than the client depositing funds with the institutions does⁸.

In applying these elements to the crisis, the investors, owners of Adjustable Rate Mortgages, financial lending, and the government were adversely selected against in different ways. The lending institutions, in withholding information regarding the types of securities they were investing in, put the investors in a situation where they were adversely selected against by the loss of their money to unsound investments.

Due to the omission of the details in the interest payment plan, some investment firms and hedge funds caused homeowners with Adjustable Rate Mortgages to be adversely selected against by the ultimate loss of their homes to foreclosure.

The withdrawal of money by investors from investment institutions caused these institutions to be adversely selected against by the deficit of funds with which to invest leading to their collapse. The non-disclosure of financial institutions regarding their dealings caused the government to be adversely selected against by the loss of revenue to bailouts and economic stimulus programs.

The environment in the country left financial institutions bare to the risk of moral hazard. The lack of oversight by the relevant government bodies, availability of credit, and provision for disclosure provided the perfect atmosphere for institutions to invest in a developing high-risk commodity. The institutions capitalized on numbers in order to rake in profits by focusing their efforts on attaining quantity instead of quality with regard to clients.

The institutions took a great risk investing in mortgages that did not have sound security backing mainly from low-income earners. This move meant that even in the incidence that there was a foreclosure; these institutions would be unlikely to get buyers for the houses, as there was fear by the public that real estate was not a good investment owing to the lack of disclosure by the same institutions as to the real situation.

People buying subprime mortgages were also at risk, as their knowledge of their financial situation and the fact that the fall of property value meant that even in the event of a foreclosure; they would not really have much to lose as a moral hazard. A large number of consumers also started leading debt-supported lifestyles aware that if they default on payment, the lending institutions would not have much to take repossess as a lien for the remainder of the payments⁹.

Mitigation measures

The United States government, in consultation with European governments, has come up with mitigation measures to arrest the effects of the crisis on its economy. One such measure is the provision of bailouts. A bailout is a capital injection mechanism that comes in several forms. One form of the bailout is the provision of loans by the government to major financial institutions based on their economic contribution to the country in order to ensure that they remain a float.

The American International Group (AIG) and vehicle manufacturer Chrysler are examples of companies that received bailouts. Bailouts also come in the form of purchase of assets from the troubled institution.

Such purchases enable the government to gain some form of control over the institution while allowing the institution the ability to continue running its business. Bailouts can also come in the form of guarantees. The institution in trouble is in a position to borrow loans from other institutions with the backing of the government, as a guarantor to the loan.

Another form of bail out is direct spending whereby the government buys products from the institution, which works to inject capital into the business¹⁰. The government also introduced fiscal stimulus packages. These packages are supposed to inject capital into the economy and prevent the deflation of the country’s currency.

It executed two such packages between the year 2008 and 2009. The American government also provided funds to reduce chances of currency inflation. However, the banks invested this money in emerging markets, thus increasing both revenue and foreign exchange.

The United States government has also expanded regulations on shadow banking institutions such as hedge funds and investment firms, which ensures that these institutions continue to grow the economy while monitored by strict regulations enacted by the government. This measure reduces the risks moral hazard and adverse selection against consumers.

The government has raised the capital requirements of most financial institutions to ensure that they have enough funds to insure them against the risks they undertake on behalf of investors. Lastly, the Federal Reserve has been granted the mandate to overlook important financial institutions and whenever the case may arise, oversee the winding down of these institutions.

This move ensures that the winding-up process is systematic and transparent. These measures prove adequate judging from the significant stability experienced in the economy presently. The measures put in place may cause the recovery process to be seemingly slow, but although gradual, it has proved efficient in getting the economy back on its toes.

Conclusion

The financial crisis, which rippled to the entire globe, started due to the mismanagement of seemingly perfect conditions for economic growth. These conditions include the availability of credit, deregulation of financial institutions, favorable pricing for housing and low interest rates.

This avoidable occurrence was made possible by corporate greed and bad governance of institutions tasked with the development of the economy and entrusted to hold funds in trust for other institutions and individuals with permission to grow it at their own advantage. The institutions made high-risk investments without setting required mechanisms in place to counter the effects of foreseeable losses¹¹.

The government was also to blame for its laxity and lack of diligence in the oversight of such financial institutions and keen observation of the economy of its own country. It was also responsible for lack of a mechanism for the constant its policies to in order to ensure that they match the needs of the people.

However, the government put in place measures to alleviate the situation and carry out consultations with other world leaders to ensure that any future effects of the crisis are mitigated and to ensure that such an event does not happen again and measures are put in place in the event that it does. These measures are working and even though the effect of the crisis is still being felt presently, it will take some more time before things normalize.

The global financial crisis was a gradual process that culminated in the breakdown of economies worldwide. Its effects only became significantly noticeable when it got to an advanced stage. Therefore, it would be premature to assume that it would take a year or two to mitigate its effects throughout an entire country, not to mention the rest of the world.

Works Cited

Bebchuck, Luciana, and Jesse Fried. “Executive compensation as an agency problem.” Journal of Economic Perspectives 17.3 (2003): 71-92. Print.

Bogle, John. The Battle for the Soul of Capitalism, New Haven: Yale UP, 2009. Print.

Conrad, Edward. Unintended Consequences: why everything you have been told about the economy is wrong, New York: Penguin, 2012. Print.

Freid, Joseph. Who Really Drove the Economy to the Ditch? New York: Algora Publishing, 2012. Print.

Healey, Paul, and Krishna Palepu. “The Fall of Enron.” The Journal of Economic Perspectives 17.2 (2003): 138-143. Print.

Leid, Arthur. “Some Hope for the Future after the Failed National Policy for Thrifts.” The Milken Institute Series on Financial Innovation and Economic Growth 5.1 (2004): 31-60. Print.

Salmon, Felix. “Recipe for Disaster: the Formula that Killed Wall Street.” Wired Magazine 17.3 (2009): 14-25. Print.

Simkovic, Michael. “Secret Liens and the financial Crisis of 2008.” American Bankruptcy Journal 83.4 (2009): 253-54. Print.

Soros, George. “The worst market crisis in 60years.” Financial Times 22 Jan. 2008: 36. Print.

Suden, Mark, and Alvin So. War and State Terrorism: The United Sates, Japan and the Asia-Pacific in the Long 20^th Century, Lanham, Maryland: Rowan & Littlefield, 2004. Print.

Footnotes

¹George Soros. “The worst market crisis in 60years.” Financial Times, 22 Jan. 2008: p.36

²Mark Suden and Alvin So. War and State Terrorism: The United Sates, Japan and the Asia-Pacific in the Long 20^th Century, Lanham, Maryland: Rowan & Littlefield, 2004. p.80.

³Joseph Freid. Who Really Drove the Economy to the Ditch? New York: Algora Publishing, 2012. p.36.

⁴Paul Healey and Krishna Palepu. “The Fall of Enron.” The Journal of Economic Perspectives 17.2 (2003): p.138.

⁵Edward Conrad. Unintended Consequences: why everything you have been told about the economy is wrong, New York: Penguin, 2012: p.155.

⁶Felix, Salmon. “Recipe for Disaster: the Formula that Killed Wall Street.” Wired Magazine 17.3 (2009): p.16.

⁷ John, Bogle. The Battle for the Soul of Capitalism, New Haven: Yale UP, 2009. p.10.

⁸Michael, Simkovic. “Secret Liens and the financial Crisis of 2008.” American Bankruptcy Law Journal 83.4 (2009): p.253.

⁹Luciana Bebchuck and Jesse Fried. “Executive compensation as an agency problem.” Journal of Economic Perspectives 17.3 (2003): p.79.

¹⁰Arthur, Leid. “Some Hope for the Future after the Failed National Policy for Thrifts.” The Milken Institute Series on Financial Innovation and Economic Growth 5.1 (2004): p.36.

Click Here To Order Now!