The Meaning of Moral Hazard

The dictionary definition of moral hazard is “the possibility of loss to an insurance company arising from the character, habits or circumstances of the insured”. In the parlance of modern risk management, that is called reputation risk.

But being vacated by a modern equivalent has not meant the demise of moral hazard. On the contrary, the term has been usurped for use in an ideological war. Its new meaning is “the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to risk”. This modern meaning is deceiving on two levels.

First, moral hazard always refers to the government rescue/bailout of a private business. So in bringing up moral hazard, it is the involvement of the government that is being criticized. In this way, the populace is conditioned to reject or, at least, grow distaste for, government “paternalism”. Needless to say, when the going gets tough, the government does what it has to do, moral hazard or not. Secretary Paulson discussing Bear Stearns bailout, as reported in The New York Times:

In Washington, the Treasury secretary … signaled strong support for the Fed’s role in supplying a lifeline to Bear Stearns during crisis negotiation, saying his priority was to stabilize the financial system and to worry less right now about the problem of avoiding a “moral hazard” by bailing out errant institutions. “We’re very aware of moral hazard,” Mr. Paulson said in a television interview … “But our primary concerns right now – my primary concern – is the stability of our financial system, the orderliness of the markets. And that’s where our focus is.”

Second – and this is the more critical point – the focus, central point and raison d’etre of any government bailout is rescuing the creditors, not the shareholders; shareholders do not count.

So if the news reports that Treasury secretary Paulson pressured JPMC to low ball the Bear Stearns price to $2 to avoid the appearance of moral hazard are true, either Paulson himself was fooled/indoctrinated by the definition of moral hazard, or he put it out as a red herring.

If the former case is true, then the Bear employees really got the most unjust and unjustified of shafts. If the latter case is true, it is a testimony to what we already know: the critical issues that count are not even on the agenda; they are beyond discussion.

Just wanted to clear the air, now that the news of Fannie and Freddie’s bail-out is in the air.