Moral Hazard and the Soft Budget Constraint: A game-theoretic look at the primal cause of the sub-prime mortgage crisis
This paper addresses one of the major causes of the sub-prime mortgage crisis prevalent in large American mortgage houses by the end of 2006. The moral hazard scenario and consequent malpractices are addressed with respect to the soft budget constraint. This analysis is done by first looking at the Dewatripont and Maskin model (1995), and then suitably modifying it to model the scenario at a typical mortgage lender. This simplistic model provides useful insight into how heightened bailout expectations, caused by precedent actions by the Federal Reserve, fueled risky behavior at banks who thought themselves to be "too-large-to-fail."
- The Tower