Thursday, April 14, 2016

Interesting critique of the Big Short (moral hazard)


  1. This is an interesting clip on the Big Short. Moral Hazard is promoted by greed and irresponsibility, and causes one party to take greater risks knowing that someone else will bear the costs and that there will be no consequences. The global financial crisis of 2007 did not happen overnight, it had its roots in the housing market crash dating back to 1992, when Fannie Mae and Freddie Mac, both backed by the federal government, began to take on risk through mortgage lending practices in an effort to meet affordable housing quotas by increasing the percentage of lending to low income borrowers. By 2008, more than half of their home mortgages were sub-prime. Borrowers were unable to pay the mortgages that they couldn’t afford in the first place and the housing market came crashing down. Many went bankrupt, others simply walked away from their homes and mortgages leaving the banks with unpaid debt and housing that was worth less than outstanding debt. The government had to step in to control the situation to prevent a total collapse in the banking industry. What followed was an overwhelming economic crisis with financial bailouts throughout the financial and insurance industries as well as the auto industry. Billions of dollars fell on the shoulders of current and future U.S. taxpayers.
    Financial crises have been occurring for the past 40+ years, each becoming more disastrous over time. Will history continue to repeat itself? More than likely yes, if there are continued safety nets in place and no penalty to those responsible for making high risk decisions. Those that have received government bailouts must reform business practices and make it a priority to repay bailout debt, and the government must eliminate the loopholes in regulation that gives the impression its okay to make bad business decisions. A higher standard of ethics and integrity needs to replace greed and irresponsibility. This will require strong leadership and a comprehensive plan that will lead to long term growth, with tough measures for those that break the rules.

    Spencer, A. (n.d.). A History of the Past 40 Years in Financial Crises. International Financing Review Supplement. Retrieved April 15, 2016 from

  2. Moral hazard is a problem in lending for both the lender and borrower. Borrowers who are least likely to repay loans are the most likely to apply for them, and if banks grant the loans, allowing these borrowers to use less of their own money, these borrowers are willing to take bigger risks. This was the case in the 2008 financial crisis. Moral hazard was a problem in the 2008 financial crisis because people bought homes that cost much more than they could actually afford. Initially, banks were very stringent on who they gave loans to. They only gave loans to people they had a reasonable assurance could pay them back. Often a 20% down payment was required. According to the video, because of government policies, HUD had to loan money to people who make less than the median income where they live. In 1993 that number was 30% of their loans. In 2000, it was 50%, and by the end of 2008 it was 56%. The goal was to increase the number of people living the American dream, which is homeownership, but it failed to take into account moral hazard. Because little or no money was required for a down payment, homeowners were less invested in the home, and there was little consequence to walking away when they could not afford payments anymore. While lending practices are more stringent now, banks still approve people for mortgages for much more than people can afford. Customers who are not financially literate will go by the banks estimation of what they can afford, not do their own calculations, and be at risk for not being able to make their payments. The lesson here is that the government should consider moral hazard and ways to reduce it when making policies.

  3. When discussing the financial crisis of 2008, it seems that there was a lot of finger pointing from the public towards Wall Street, Wall Street towards the Government and the Government towards Wall Street. The video portrays that it was not Wall Street and the big banks but the federal government and its imposed quotas of which it required 30% of prime loans to be given to people who were in low to moderate income brackets and would otherwise be deemed unqualified for a mortgage before the quota. Eventually that 30% quota was increased by HUD to 50%, and while the idea of giving people a chance to own a home is a good one, the actual implementation was one that could have been better thought out since many borrowers were given loans based little on fiscal qualifications, but rather the desire to increase the housing market to a larger group of citizens.

    Over the 15 years from 1993 to 2008, the number of unqualified borrowers were up now to 56%. People were borrowing out of their income bracket and taking out mortgages they were not able to sustainably pay off. When this all came to head, we experienced the financial crisis of 2008. While I do think the increase in the imposed quota was not a smart move in the long term, it created a financial boom based off fake money in the long term, eventually that long term hit and the housing market and the mortgage market experienced losses of up to 81% of the losses came from the 56% of risky mortgages.

    While the video points the finger at the government, whom I do think holds a large portion of the blame, I do think the blame does need to be placed on the big Wall Street firms and the borrowers themselves. Wall Street I think while the video states that Wall Street takes advantage of the system, however to state that they took advantage of market conditions due to irresponsible market regulations. While the market regulations may have been lacking, Wall Street firms are often forecasting on ways to increase profits so they must have had some idea as to what the end result would have been from those lax regulations. Also, I think the borrowers are also at fault because they were taking on mortgage responsibilities that were well out of their reach and benefiting from it until the bubble burst. When you look at all parties involved, it was a perfect storm of one party taking advantage of another and eventually a whole country was affected by the behaviors of all the parties involved.

    1. Reply to Jeffrey Kinney

      I agree with your statement that “it was a perfect storm of one party taking advantage of another and eventually a whole country was affected by the behaviors of all the parties involved”. This is the essence of Moral Hazard. The government, in an effort to help underprivileged people, gave Freddy Mac and Fannie Mae requirements that they must offer mortgages to subprime borrowers. This loosening of credit standards allowed many people to be able to afford a larger house than they really should have been able to buy, and increased the size of the mortgage market. The big banks saw the increase in the market and realized that they would be shut out of the market by their own credit standards, so they had to retaliate by offering mortgages to their own subprime borrowers.

      However, the banks knew that this was a risky investment, and they needed to hedge against losses by purchasing insurance against the investments. This is where companies such as Lehman Brothers come in. They saw a market opportunity to underwrite mortgage backed securities and make a profit.

      The whole house of cards started to fall when these subprime mortgage borrowers began to default. Because the borrowers were underwater on their homes’ values, they decided to walk away and leave the debt with the government backed Fanny Mae and Freddy Mac, and the big banks that had been offering the mortgages. When the banks tried to collect on the insurance coverage for the defaults, Lehman Brothers and other insurance companies didn’t have the capital to pay all of their obligations. The banks lost big, and credit completely dried up. Credit (i.e. money lending) is what drives business, especially small businesses who need small loans to make payroll and keep running from month to month. No credit, no money, no economic activity. In other words, a great recession; all caused by the good intentions of the government!



  4. The American Enterprise Institute’s video, The Big Short and the 2008 Financial Crisis, is an interesting case study into moral hazard - a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost.

    Popular culture reinforces the fat-cat angle on how the seeds to the Great Recession were sown – a convenient narrative for policy makers who at least share the blame for the outcome. But with every election, a new evil must be created and destroyed so why not take one more hack at America’s favorite villains – Wall Street Banksters!

    It’s too bad that politicians are seemingly so ill-informed about economics – which IS NOT ASYMETRIC INFORMATION. It’s even worse when they deflect their own responsibility to the point where they fail to learn from their past errors. Lehman Brothers wasn’t too big to fail, I just hope we never see the day when the United States isn’t, either.


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