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Moral Hazard - How Moral Hazard Works

What is Moral Hazard?

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Moral hazard is a concept saying that people will take risks if they have an incentive to do so. The idea is that people might ignore the moral implications of their choices. Instead, they will do what benefits them the most. The concept of moral hazard comes from the insurance industry.

Moral Hazard and Consequences

Most people understand the tradeoff between risk and reward. If you take risks, there may be consequences. However, you might be rewarded.

What if those tradeoffs go away? If you knew you could take risks without consequences, would you take more risk? What if you take advantage of somebody else, who must suffer the consequences for you?

Morality and Moral Hazard

For many, morality is the only thing that stops them. They know they can get away with taking risks, but they don't feel that it's the right thing to do.

For example, you might get unlimited car insurance on your rental car. This creates a moral hazard. If you drive through the mountains, you may not worry about banging it up on rough roads or scratching it up in thick brush. In other words, you might be reckless. Any damage to the car is not your problem, but it is somebody's problem.

Moral hazard says that the more you feel insulated from risk, the more temptation you have take it.

Moral Hazard and Loans

Moral hazard is also important for lenders. You might borrow money to buy a home. If you fail to repay the loan, what happens?

In most cases, your credit will suffer. It will be more difficult for you to borrow in the future, and you may have to pay higher interest rates. You may even have difficulty getting a job or insurance coverage. Your credit is the "stick" (along with your morals, presumably) that keeps you from chasing the carrot of taking free money.

Moral Hazard Fears in 2008 Mortgage Crisis

In the mortgage crisis that peaked in 2008, many worried about moral hazard. Homeowners walked away for mortgages, regulators dumped money into the system, and the government bailed out a few firms responsible for the mess. Observers feared that moral hazard would grow if borrowers and firms started to believe they could increasingly get away with taking big risks.
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