Credit Crisis of 2007-08: Moral Hazard and Adverse Selection

The year 2007/08 has experienced global financial crises characterized by contracted liquidity in world money markets and banking institutions caused by the “failure of investment firms and mortgage companies which invested heavily in subprime mortgages” (Gretchen). Subprime lending is a term that refers to an exercise of advancing loans to trustworthy borrowers by the lending institution. The worth of a borrower to repay borrowed money is determined by his disposable income, credit history and size of the down payment made on loans.

The failure of these firms has been credited to the moral hazard behavior of lending institutions. This crisis is said to have started in “The United States as a result of increasing housing prices and the increased default rate on subprime mortgages” (Lahart). Prior to 2007 there were deteriorating lending standards, increased loan incentives and increasing house prices that motivated borrowers to acquire more mortgages in the belief that it would be easy to refinance in the future. But things went against the expectations of investors; interest rose, the prices of houses declined to make repayment difficult. There was much “default in refinancing and housing properties foreclosure” (Rhodes).

The result was that many financial institutions suffered losses across the world forcing central banks to advance funds to their member banks to cool the situation. This is what is referred to as a bailout and is aimed at stimulating economic growth, strengthening banks and restoring confidence in the capital markets. “In September 2008, the crisis accelerated developing into world financial crisis” (Anup). Many world stock markets numbers plunged causing many people to withdraw their money from securities and equities. The world food prices shot up and the price of crude oil increased.

Lending institutions advance loans to borrowers for a purpose of making returns and hence creating credit. Both the borrower and the lender bear the risk involved in the transaction. A certain rate of interest is attached to each credit borrowed and its magnitude depends on foreseen loan risk, inflation and the ability of the borrower to repay. If the loan is risky and the borrower is foreseen to default to repay based on history, then the lending institution protects itself by charging high-interest rates and vice versa. If the level of inflation is foreseen to be higher in the future, then a high-interest rate is attached to the loan. When financial institution advances risky loans they believe that it has the potential to pay more because it has a high-interest rate.

A moral hazard is a situation whereby “lending institution advance risky loan with anticipation that it will pay more if the investment turns out well but it will not bear the losses if the investment fails”(Lawrence). This is believed to be the reason behind the financial crisis witnessed across the world. If lenders behave in this manner, then depositors and other creditors suffer from this risky decision taken by the lending institutions; in case they lose their cash deposited in this institution. Borrowers can also exercise moral hazard. This is expressed in the way they spend their cash especially borrowed money. They may spend or invest their fund without care hence defaulting to repay.

Financial institutions usually give loans to those people perceived to be in a position to repay the borrowed cash. A borrower has to present collateral as a guarantee in case he or she fails to refinance the credit. Due to fear of suffering losses banks are unlikely to give credit to people perceived to have a high risk of default. The creditworthiness of the borrower can be assessed by the history of loan repayment or default, bankruptcy and debt experienced of the borrower. Credit includes loans, mortgages and credit cards.

Although credit might be given to the right person that is a person who is worthy get credit, default payment may happen due to some avoidable circumstances. For instance, increased inflation rates may weaken currencies increasing the risk of default.

Then what might have gone wrong. United States economy is the biggest economy in the world and if it gets into crisis other countries’ economies are affected. This financial crisis is believed to have started in the U.S. and sprawled in other countries. The practice of moral hazard by the lending institutions is the main reason which triggered the financial crisis.

The allegation on what might have caused the crises to include; lenders lending to borrowers who might have not understood the term of the loan or lending to people who could not afford the rate of interest, with prior knowledge of their credit characteristics. Some of these loans had high lending fees and some hidden terms. Again loans were given to people with a high risk of default. “There was increased demand in the market for loans from customers who were believed to credit trustworthy” (Gretchen). As a result of increased demand for loans coupled with low-interest rates, many lenders entered the lending market to gain from the increased demand. Even some lenders offered to reduce their interest on loans to attract more borrowers.

It’s believed many lenders at this period assumed the risk of lending to people with bad credit history in order to gain from the expanding loan market. Bearing in mind the position of some borrowers, they went ahead to loan people with bad credit history. These loans are believed to have a greater risk to the lender due to the assumed credit unworthiness of the borrower. To offset this risk lenders usually offer loans with high-interest rates, but the case here was different since the lenders wanted to attract more borrowers, with high charges on credit card users, they relaxed the idea of attaching high-interest rates to these loans.

If lenders offer to lend to borrowers with less than ideal credit records, then this borrower might utilize this opportunity to buy homes, purchase cars and even finance other expenses. However, to secure these loans borrowers have to bear the increased cost of borrowing attributed to high-interest rates on the loans: this is also witnessed in capital markets whereby investors take risks by investing in treasury bills with anticipation of earning a high return. This move by a lending institution to lend to credit unworthy borrowers attracted more people with less income into borrowing.

Then what happened was that, due to high yields of the loan, eventually the capability of the borrower to repay was surpassed. What followed is a situation that we can refer to it as a meltdown. There were increased mortgage and loans defaults resulting in too many mortgage lenders’ failure or being pronounced bankrupt. “Failure of these institutions caused prices in mortgage-backed securities to market to collapse threatening U.S. housing market and the economy as a whole”( Lahart)

The crisis in the U.S had far effects across the world since “banks had repackaged debts in securities held by banks and traders on the US, European and Asian markets” ( Anup). This crisis caused a reduction in the value of assets of investors who had invested in the mortgage industry. Being unable to value their assets caused uncertainty which is unfavorable in the investment environment. With market uncertainty setting in banks restricted lending to each other and to businesses causing interest rates to shoot up. As a result, many businesses across the world with no one-to-one relation with the U.S started experiencing difficulties.

Many market analysts blamed the lenders and the government for the meltdown. Lenders’ immoral lending practices and lack of government oversight were the reason behind this crisis. Others blamed the mortgage brokers for steering borrowers into loans that they could not afford and borrowers’ behavior of securing loans that they could not repay.

The impacts of the crisis had a major effect across the world. Many financial institutions in the U.S. suffered losses of more than “U.S. dollars 501 billion of august 2008” (Josh & Bradley) caused by raising loan defaulters and loan provision losses. Profits declined from “$ 35.6 billion to $19.3 billion during the first quarter of 2008” (Josh & Bradley) as compared to the previous year of 2007. As result, many mortgage companies shut down while others were sold and others merged.

The capital markets across the world plunge with different market indices recording low numbers. Also, there was a lot of panic from investors causing them to take their “money out of risky mortgage bonds and equities and put it in commodities” (BBC news). Financial speculation in the commodity market caused the “world food crisis and increased oil price” (BBC news).

The figure below shows the fluctuating price of food across the globe in 2007/2008. (BBC News)

Fluctuating price of food across
Figure 1

This was caused by speculators who sold their equities to venture into the food and raw materials to make fast returns. The economy was not speared either because many homeowners were left wealth less due to reduced home prices. Jobs losses were experienced especially in the financial industry where many firms collapsed. It is estimated that over “65,400 jobs were lost in the U.S as of September 2008” (Dickler). Lack of credit caused reduced sales in the motor industry. As a result of the crunch, some strong global economies have “plunged into recession” (Anup).

Lehman Brothers were heavily hit by the crisis; as a result, lay more than 20,000 workers were laid off. Lehman brothers holdings have been a world financial services firm dealing in investment banking, equity and private banking. In September 2008, the firm of in verge of being declared bankruptcy and threat of been sold due to its financial difficulties caused by the global financial crisis of 2008. The firm was estimated to incur debt of “$613 billion, $155 billion in bond debt, and assets worth $639 billion” (money.cnn.com)

Washington mutual which savings bank and the former largest saving and loan association were also affected by the financial crunch. On September 25th, 2008, it was seized by the U.S thrift supervision and placed under receivership. “Its subsidiaries were also sold by the federal deposit insurance corporation” (Linda). Its closure is believed to be the biggest bank failure in the USA.

The behavior of lending firms needs to be controlled to avoid future occurrences of the same. Some of these measures include; regulation regarding lending practices, bankruptcy and licensing of financial institutions. This will help in ensuring transparency in the lending transaction among lenders. Government to control the number of firms participating in the mortgage business and ensure banks have sound financial base to support them in case of difficulties.

Government should also educate borrowers and house owners on matters concerning credit borrowing. This is aimed to encourage borrowers to acquire loans that they are capable of repaying. Lending institutions should their customers o credit card usage rates to avoid misappropriation of borrowed funds. Finally, banks should practice ethical lending practices: by giving loans to people with less risk of default and with desirable credit repayment history.

References

Anup shah, 2008, Global financial crisis 2008.

BBC News, 2008, the cost of the food.

Dickler Jessica, 2008,  Lehman layoffs, the tip of the iceberg.

Gretchen Morgenson, Crisis room in the market for mortgages.

Josh Fineman and Bradley Keoun, Merrill Lynch Posts Fourth Straight Quarterly Loss. Web.

Lahart Justin, 2007, Egg cracks differ in housing, finance shells wall.

Lawrence Summers, 2007, Beware, moral hazard fundamentalist, financial times. Web.

Linda, Shen, 2008, Washington bank split from holding company, sparing. Web.

Money.cnn.com, Lehman Lists Debts Of $613 Billion in Chapter 11 Filing. Web.

Rhodes, Trevor. 2008, “American Foreclosure” Everything U Need to Know… about Preventing & Buying, McGraw-Hill.

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NerdyTom. (2022, June 9). Credit Crisis of 2007-08: Moral Hazard and Adverse Selection. Retrieved from https://nerdytom.com/credit-crisis-of-2007-08-moral-hazard-and-adverse-selection/

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NerdyTom. "Credit Crisis of 2007-08: Moral Hazard and Adverse Selection." June 9, 2022. https://nerdytom.com/credit-crisis-of-2007-08-moral-hazard-and-adverse-selection/.

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NerdyTom. 2022. "Credit Crisis of 2007-08: Moral Hazard and Adverse Selection." June 9, 2022. https://nerdytom.com/credit-crisis-of-2007-08-moral-hazard-and-adverse-selection/.

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NerdyTom. (2022) 'Credit Crisis of 2007-08: Moral Hazard and Adverse Selection'. 9 June.

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