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Moral Hazard and the Mortgage Industry

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Moral Hazard and the Mortgage Industry

Moral hazard describes behavior when the party responsible for the interests of another party has an incentive to put its interests first (Dowd, 2009). The possibility of it increases when the party does not necessarily suffer the consequences of its actions and thus becomes susceptible to taking more risk because it knows it would be protected.
An example of moral hazard is the subprime mortgage crisis, which preceded and “triggered” (Bernanke, 2012) the recent recession. To a great extent it was caused by excessive risk-taking by organizations “too big to fail”, meaning that “certain businesses are so important to an economy that disastrous consequences would result if they were allowed to fail” (Federal Reserve Bank of Kansas City). Before technological improvements would make it “relatively easy and cheap” (Wright, 2013) to transform illiquid financial assets as loans and mortgages through securitization and to sell them to investors, banks would approve mortgages with a goal of holding them until maturity. They would be carefully screening out possible delinquents and would aim to minimize their own risk and a prospective subprime borrower would not be considered. According to Dowd (2009), this “incentive is seriously weakened” if the bank (or any other financial institution such as a mortgage broker) is only originating the loan and collecting fees for it. The inherited risks involved in such practice are considerably higher since lenders no longer have an incentive to perform careful screening of their customers.
Increased risk-taking was not only on part of lenders - on the demand side, many borrowers acquired properties with smaller percentage of down payment. In addition, because of decreased underwriting standards more buyers entered the market and demand for housing - as well prices – increased. The moral...

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