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.

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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 behavior. Lehman Brother was the fourth largest investment bank in US and the top supplier of commercial paper before it filed for its bankruptcy. In 2006, the Lehman Brothers began to leverage high-risk investment, and most of these investments were in subprime mortgage bundles and derivatives, similar to most others bank but in a greater level sometimes as high as 30 times their equity (Klepczarek 2017). In 2007, the housing bubble started to burst, and the subprime mortgage market started to collapse but Lehman Brothers was slower to recognizes the news compare to others firms. Then, the firm decided to take a gamble by doubling down their investment for subprime mortgage, with the hopes that the market began to climb and earn an enormous profit on it.

Unfortunately, there was no recovery in that market and Lehman Brothers move quicker toward bankruptcy. In order to prevent its own demise, Lehman Brothers was aggressively seeking for a merger or sale to another firms. Dick Fuld, the CEO of Lehman at that period, started to approach Bank of America, Korea Development Banka and the UK-based bank Barclays to discuss about potential mergers (Wallison 2011). However, none of the banks accepted the offer. On July 21 2008, the Secretary of the Treasury, Hank Paulson, set up a meeting between Lehman Brothers and Bank of America (Busato and Coletta 2017). However, the Bank of America stalled and eventually backed out due to the huge amount of debts. The worst situation happened when the major clients, including JP Morgan, began to demand cash for their pulled out investments rather than the collateral insured by the commercial paper market. Eventually, the Chair of Securities and Exchange Commission called Lehman Brothers and persuaded them to file for Chapter 11 bankruptcy. On 15th September 2008, Lehman Brothers filed for bankruptcy and the greatest failure in the US history with a total of $613 billion worth of liabilities listed in Lehman Brothers filling (Ohoukoh 2012). This immediately led to vast amount of impact on the global financial markets, spreading the impact to some individual or business that apparently seemed to have no connection with Lehman Brothers. The collapse of Lehman Brothers is often seen as the main trigger that led to Great Recession.

The argument for moral hazard in Lehman Brother case is that the Federal Reserve (Fed) creates moral hazard on protecting those big banks and firms, those big banks generally assumed that they would be taken care by the government (Busato and Coletta 2017). Therefore, those investment bank started to engage in risky behavior and invested in subprime mortgage which was a questionable investment. To made things worse, Lehman Brothers decided to take a gamble on the subprime mortgages even they know that the housing market started to collapse.

One of the best solutions to overcome the Enron case is to put a limit to the growing number of corporate governance scandals by applying Sarbanes-Oxley Act (SOA) (Cullinan 2004). SOA allow the firm to improve the performances of financial auditors and directors by increasing the potential consequences, making fraudulent activities easier to detect and reinforcing the securities laws. The alternative solution for the Lehman Brothers is to limit the engagement power of the government by setting up a stricter regulation (Ohoukoh 2012). Government should only involve in the economy market when they are really needed otherwise it will bring out massive impact on the market.

In conclusion, moral hazard is the major factors that lead to those financial crises that mentioned above in the history. Although moral hazard is currently one of the most underrated problem in the economic system, but if we considered it back as the main roles, that cause certain big financial problems. It is important for us to come out with several possible solutions to overcome or to prevent the past events happen in the future. From the case of Enron, there is no doubt that the managers or executives in the company were irresponsible in terms of their risky speculation, they have failed in their responsibility and trust towards their shareholders and investors. On the order hands, the Lehman Brother case provides an indispensable example for most of the study of moral hazard in the financial institutions. The intervention of government is a policy that really needs to be stopped because sometimes it is encouraging firms to make risky and irresponsible behavior.  Therefore, firm and government should not only perform ethical but also limit the involvement of government to prevent the “traditional” definition of moral hazard from occurring again.

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