Moral Hazard in the Financial Crisis of 2008

Open Access
Author:
Brozick, John Anthony
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Dr J Randall Woolridge, Thesis Supervisor
  • Joseph Randall Woolridge, Thesis Supervisor
  • James Alan Miles, Honors Advisor
Keywords:
  • moral hazard
  • financial crisis
  • lehman brothers
  • bear stearns
  • aig
  • tarp
  • troubled assets relief program
  • paulson
  • hank paulson
  • henry paulson
  • bernanke
  • ben bernanke
  • treasury
  • federal reserve
  • government intervention
Abstract:
Throughout the credit crisis, the government prevented a depression-like scenario by providing assistance for a select few firms that were deemed too big to fail. Did this government assistance set a precedent that encourages surviving firms to take on even more risks, or has moral hazard been kept at bay? No one may be able to agree on a definitive answer, but most can agree that risk tolerances today are much lower than pre-crisis levels. Some even suggest that banks are becoming too cautious as they hold excess reserves when they should be taking on more risk by lending more freely. The observation of increased risk aversion is a short-term phenomenon because the pain felt by the recent credit crisis is fresh on the mind. Moral hazard, on the other hand, is a long term problem that lurks in the depths of the corporate psyche and waits to unleash its destructive power once the next asset pricing bubble is formed. Asset pricing bubbles are a sign of well functioning financial markets, but too much of a good thing can be a bad thing. Asset pricing bubbles should be embraced for the fundamental service they provide for the economy: they help to reign in risk if the downside is absorbed by the risk-taker. When government intervention eliminates all or part of a risk-taker’s downside by forgiving a portion of the principle payment on an individual’s mortgage or providing a lifeline to an insolvent financial firm, the individual or firm will have a greater incentive to take on more risk in the future.