Moral hazard is essentially a situation or risk that party has been dishonest in their business dealings.
When two parties agree to deal with each other, whether it be a transaction or sign a contract, there is an element of trust involved. Both parties assume that the other has been truthful in representing their interests and will act responsibly and in good faith. This second principle can be especially important as one party may benefit at the expense of the other by not acting inf good faith. For instance oligopolies such as OPEC often fall apart because dishonest members can directly benefit by undercutting agreed upon prices by the oligopoly. This can be countered by including clauses that make all afflicted parties share responsibility and risk (such as penalties for breaking the agreement) but still in practice it can be difficult to keep all parties honest in such a situation.
The risk that a party has been dishonest is called the moral hazard.
Moral Hazard and Government Intervention
The Credit crisis of 2008, like many financial crises before it, has once again brought the issue of moral hazard to the fore. Critics of the Federal Reserve and the Federal Government have argued that by intervening to save Bear Stearns and bailout Fannie Mae, Freddie Mac, AIG, General Motors and Ford that the government is increasing moral hazard. This line of thinking asserts that by coming to rescue firms who have taken great risk or been irresponsible actually increases systemic risk as other firms will be encouraged in the future to take greater risk than they should in the future with the belief that the Federal gov't will be there to bail them out. Critics assert that firms that made bad bets should be allowed to fail, anything else they say rewards bad behavior.
Proponents of the bailouts say they were necessary to save the financial system from systemic collapse and that risk outweighs the moral hazard risk. Furthermore they claim the extreme loss of shareholder value also lessens the moral hazard risk.
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