In this chapter, we briefly review two important recent financial crises, S&L and subprime mortgage crises, and discuss why moral hazard issues should be carefully considered in formulating financial engineering problems. We explain how ignoring moral hazard can lead to the overvaluation of assets and to under-investment problems passing up positive net present value projects. In particular, if misaligned incentives are widespread in the industry, inducing managers to excessively compete over similar investment opportunities, the industry can collapse with a nontrivial probability, as systematic risks common in the industry move in unfavorable direction. Even when incentives optimally designed, agency problems still fundamentally affect the whole financial markets in equilibrium, and thus financial engineering problems.
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