The Moral Hazard perspective on the financial crisis of 2008: An Explanation for How Moral Hazard lead to the default on the subprime mortgage, Lehman brothers and the collapsed Enron.

ABSTRACT

This article will explain how did the moral hazard become a typical problem I the economy system, and how the asymmetric information lead to the major financial crisis of 2001 and year 2008. Therefore, it is important to obtain better understanding on its nature and its roles to overcome and to prevent the future crisis, defaults, bankruptcy and downline. Others than this perspective, this paper will also focus discusses the moral hazard perspective on past financial crisis, from Enron bankruptcy to the Lehman Brother cases, the subprime mortgage defaults, and housing market collapse. The paper will also examine the potential for moral hazard in the financial system leading up to this crisis and determine the effect of these crises to the world economy.

Moral Hazard occurred when a party or a person engages in a risky behavior or decision where another entity bears most of the cost in that particular decision or event that lead to an unfavorable outcome (Claassen 2015). Moral Hazard is a type of asymmetric information in economy where the risk-taking party knows more about its intention than the party who pay the consequences of the risk (Dowd 2009). The best example arose in the principal-agent problems, the owners of corporation, shareholders as the principal will not in charge in the day to day operation but manager as the agent will have more information about their actions or intention to make risky decision (Panda and Leepsa 2017). Therefore, managers may act in their own interest instead of the shareholders’ best interest, and this led to moral hazard where the interests of the agent and the principal are not aligned. The shareholders will bear most of the cost on the decision made by the managers.

The financial crisis case due to moral hazard consequences is the bankrupt of Enron filled in the year ended 2001. Enron used to be the one of the top-ten largest U.S public company in year 2000 with around $100 billion annual income (Healy and Palepu 2003). However, around $31.24 billion debt was reported when the company declared bankrupt in year end 2001 (Healy and Palepu 2003). It is obvious that the company has over leveraging and taken too many debts without noticing the investors and the shareholders. According to the investigation by FIU, the fund manager had purposely hidden the information by using the external auditing firm (Busato and Coletta 2017). In this way, the management succeed to hide the high leverage ratio data from its shareholder, and continuing to leverage more debts without reporting on the balance sheet. Eventually, the company unable to deal with this huge amount of debts, and no longer able to pays their creditors which forcing it to declare bankruptcy. The shareholders and investors lose billions dollar, which means they lost almost everything they had invested in the company. Therefore, moral hazard happened when the manager(agent) fail to supply information of the company to sophisticated institutional investors and shareholders (Siller-Pagaza and Otalora 2009).

Moral Hazard is the argument that often arises in the analyze of the causes and the effects of the Great Recession, the action of Federal Reserve (Fed) trying to rescue the big bank and financial institution which were on the threshold of bankruptcy (Busato and Coletta 2017). In order to rescue some of the important America’s bank, the governance Fed creates moral hazard on a huge scale, making a vague impression that government guarantee that some certain financial institutions is “too big to fail”, companies with extremely high risk such as Bear Stearns, AIG, Fannie Mae and Freddie Mac were guarantee by the government(Harris 2012). However, this action actually encourages the reckless, irresponsible