The moral hazard occurs in a situation in which a party engages in risky behavior because a bad outcome, should it occur, will impact another party. So, the person taking the risk is, in essence, insulated.
The rocky road of the United States economy in the past six years or so epitomizes the moral hazard concept. Mortgage brokers collected billions in fees for making loans for which they were not on the hook. Loans were passed like hot potatoes from banks to Fannie Mae (a quasi-governmental organization), which securitized the debt by essentially chopping it up into small bonds. These bonds were given high ratings by agencies (Moody’s, S&P), which also had no skin in the game. Eventually, they went bad when home buyers couldn’t pay the mortgages for homes they never really could afford in the first place.
Even some buyers were playing the moral hazard game, believing that if they couldn’t afford the home, they could sell it to someone else and make a profit. Some got into homes with no money down. So, the system eventually crashed, and what happened? The federal government bailed out the banks. Banks got tons of taxpayer money. Goldman-Sachs gave record bonuses in 2009 while the economy was on its knees.
Some homeowners who bought more home than they could afford got bailed out with loan modifications, sometimes involving principal reduction. Some walked away unscathed. No reward was given for those who bought within their means. The economy languished and who came to save the day? The Federal Reserve, under the leadership of Ben Bernanke. They took unprecedented measures, printing money like crazy. The “one percenters” saw that the game was fixed, and bought stocks knowing that the Fed would continue to run interference and give steroid shots (money printing) if the economy began to collapse.
Now in 2014, we have Janet Yellen taking over as Fed chair and continuing to enable. The moral hazard that caused the whole problem in the first place is thriving. In my view, we will never have an actual recovery until we start punishing bad behavior and rewarding good behavior. What a concept!