What is moral hazard?

Since the 1998 bailout of LTCM, there has been an ongoing discussion of "moral hazard". What is it? Put simply, it is the risk that if the government bails out one or more firms, other firms may then take on additional risk or fail to adequately manage existing risk on the theory that they too are likely to get bailed out if they get into trouble.

Bear Stearns and Lehman Brothers are perfect examples.

People figured that Bear Stearns was "too big to fail" (really "too big and important to be allowed to fail") and sure enough, the government stepped in and arranged a takeover. Then, along came Lehman Brothers. A lot of people sincerely believed that it would simply be another Bear Stearns kind of bailout. The concept of "moral hazard" caused the management of Lehman to assume that if they were not able to somehow arrange financing on their own, then at least the government would would step in and "save the day." But, somehow a bailout for Lehman simply never happened, and the CEO was left standing alone asking "Where was our bailout?" This was a perfect example of "moral hazard" in action, both on the lead in and on the followthrough.

The basic problem here is that there is no true "insurance" with rules in place for complex financial institutions on Wall Street. Each bailout of a Wall Street firm is an ad hoc affair.

What we desperately need is some fixed capital requirement rules and an FDIC-like insurance system so that the big bank/investment funds will be "insured" and dealt with in a uniform manner when the rules are triggered.

Ditto for mutual funds and money market funds. We have a temporary Treasury guarantee program for money market funds, but it is only temporary. The fiasco with The Reserve funds illustrates why we need an FDIC-like preemptive "insurance" program for money marke6t funds. As things stand right now, people may be assuming that Treasury will continue to protect money market funds after the temporary guarantee program expires next month, but there is no such guarantee, so we have to cope with yet another moral hazard.

-- Jack Krupansky