The economic reasoning behind bailout or no bailout.

While bailout seems to be the financial term du jour, right behind it is the more ambiguous “moral hazard.” Treasury Secretary Henry Paulson cited moral hazard as the reason not to swoop in to save Lehman Bros. and Merrill Lynch. Puzzling to many, though, was that while moral hazard was discussed in conjunction with the rescues of Bear Stearns, AIG, Fannie Mae, and Freddie Mac, it wasn’t a deal breaker in any of those cases. So, what exactly is moral hazard, and why does it matter sometimes more than others?

Simply put, moral hazard is the idea that insurance in any form makes people riskier. If I have health insurance, I'm more likely to skydive. If I have fire insurance, I'm more likely to burn sandalwood candles in my bedroom. And if I'm an institutional investor whose holdings are protected by an implicit understanding that the Fed will bail me out if I get in over my head, I'm more likely to double my holdings of subprime mortgage-backed securities rather than cut my losses and pull out when the housing market starts to drop.

The actual words moral hazard have a long history. Using them in the context of financial risk is a return to etymological roots; hazard was originally the name of a dice game, the Middle Ages precursor to craps, on which bets were placed and fortunes could be swiftly lost. For centuries, the resulting use of the word hazard carried a whiff of the unsavory due to its association with gambling.