The term "moral hazard" is heard a lot lately, and its current usage has nothing to do with former New York Gov. Eliot Spitzer's sex life. It refers to the economic principle that people and corporations will behave recklessly when they believe they will be bailed out of any losses, throwing off the risk and reward balance of markets. Individuals who used their ever-appreciating homes as piggy banks have been guilty of moral hazard, though the lenders who put unsophisticated borrowers into unaffordable mortgages are even more responsible. Even Federal Reserve chairmen have promoted moral hazard.
It explains how we got into the current housing-fueled financial mess in the first place, and how the fix — particularly the recent interest rate cuts and corporate bailouts — could make the cure as hazardous as the disease.
A high-profile example of moral hazard played out recently in the rescue of investment banking icon Bear Stearns. When the Fed took emergency action to keep Bear from defaulting on its financial obligations, company chairman James Cayne was off playing cards in a bridge tournament. Bear executives had made risky, leveraged bets on questionable debt, apparently on the assumption that nothing bad could happen, and they were right. They got bailed out at the expense of taxpayers, who have taken on much of the risk, and Bear stockholders, particularly lower-level employees who didn't get out in time.
Along those lines, Fed Chairman Ben Bernanke extended low-cost loans to private bankers such as Bear and cut interest rates again, by another 0.75 percentage points. It's supposed to free up credit markets that propel our economy and to lower mortgage rates so that the sagging real estate market will (hopefully) get back on track.
The Fed also warned about rising inflation, which usually leads to interest rate increases rather than cuts. And remember, it was then Fed Chairman Alan Greenspan's easy-money policy that fueled the housing bubble that started all this.
Despite the risks, Bernanke probably made the best choices, for now. If he had let Bear Stearns go under, it could have sparked a financial panic. Interest rate cuts should help avert a deep recession, though they can't go much lower.
But what if Wall Street and Main Street get the wrong message? If consumers borrow beyond their means to repay once again, or corporations make more risky bets figuring they'll be bailed out, nothing will have been learned. This could be our last chance to get it right before the real bill for moral hazard comes due.