'Moral Hazard': Why Risk Is Good

By Frank Ahrens
Washington Post Staff Writer
Wednesday, March 19, 2008

Golf has water hazards. Your car has flashing hazards. A bachelor party in Vegas has a host of potential hazards.

The phrase "moral hazard" has been percolating on Wall Street and in Washington in the past few days in the wake of the $30 billion federal bailout of the Bear Stearns investment bank, essentially driven out of business by the subprime mortgage crisis.

Moral hazard describes a situation in which a party is insulated from the consequences of its actions. Thus protected, it has no incentive to behave differently. Insurance companies coined the term to describe someone who, for instance, takes out a big auto policy, then leaves his car unlocked. If the car is stolen, the insurance company -- and its other customers -- pay the price for the reckless behavior.

In the case of Bear Stearns, critics have said that such highflying investment houses will continue to engage in risky activities with investors' money, knowing that if they blow it, the federal government -- read: taxpayers -- will bail them out.

During a House Budget Committee meeting in January, Rep. Scott Garrett (R-N.J.) cautioned: "It's very plausible to suggest that if government bails everyone out of this mess that we will continue to bail out bad actors in the future, and the market discipline that currently remains will further erode."

But after the Bear Stearns rescue, Treasury Secretary Henry M. Paulson Jr. said the bank got away with nothing. Trading for as much as $172 per share last year, Bear Stearns was snapped up by J.P. Morgan Chase for $2 per share.

"And when we talk about moral hazard," Paulson said on Monday, "I would say, 'Look at the Bear Stearns shareholder.' "

And that could be the moral to this hazardous story.

Staff researcher Richard Drezen contributed to this report.

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