Dear Wall Street Journal, Please Learn the Definition of ‘Moral Hazard’
From the WSJ:
A Chaotic Sunday Opens Wall Street’s Week
Moral Hazard’s Exit
Leaves Investors
To Sort Out the Mess
By ANNELENA LOBB
September 15, 2008; Page C1Investors are going to be staring in the face of moral hazard when markets open Monday.
The collapse of Wall Street firm Lehman Brothers Holdings Inc. coupled with a restructuring of insurer American International Group Inc. and a deal by Merrill Lynch & Co. to sell itself to Bank of America could cause a decline, particularly among financial stocks, when markets open.
Despite serious efforts by potential bidders and Lehman, a deal never came together over the weekend, largely because the federal government refused to put up any cash. After backstopping Bear Stearns, Fannie Mae and Freddie Mac, the Treasury and Federal Reserve said no more.
The government’s logic was that if investors were bailed out again, they would expect a bailout every time, and the so-called moral hazard would disappear, making people willing to take massive risks in the belief they would be saved.
No. That is not what ‘moral hazard’ means. Moral hazard is, as Wikipedia so eloquently puts it, “the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.” Thus, in this case, it wasn’t a risk that moral hazard would disappear; it was instead a risk that a bailout would create moral hazard, by insulating investors from the consequences of risks they had taken on, and thus encouraging similar risky behavior in the future.