Moral Hazard and the Subprime Mortgage Crisis

what are the subprime crisis 4 acronyms?

ARM (adjustable-rate mortgage) MBS (mortgage-backed security) CDO (collateralized debt obligations) CDS (credit default swap)

what is a moral hazard?

a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk

what are financial derivatives?

Financial derivatives refer to financial assets/securities that derive its value from the performance of an underlying asset—MBS, CDO, CDS

why is the classic example of moral hazard insurance?

It is assumed that once someone is insured, they are willing to take more risks personally because the cost of the risk is mitigated because the insurance agency is required to pay the associated costs

what happened when the bubble burst with mass defaults on subprime loans

the MBS (mortgage-backed security) defaults. fall in home prices --> homes foreclosed had significantly less value as collateral --> value of the CDO (collateralized debt organization) lower --> issues of liquidity. With the default of MBSs, the holder of the CDS is now owed money by the seller.

what did the financial derivatives base their value on?

the likelihood of default and value of mortgaged homes