"There was a sufficiently dire and dreadful outcome for that company" [Bear Stearns] to mitigate any moral hazard issue.

From Q&A, as reported by Market News International.

There are those who have suggested that by intervening to forestall, and ultimately prevent, a bankruptcy filing by Bear Stearns, the Federal Reserve risks magnifying the chance of future financial crises, by insulating market participants from the consequences of excessive risk taking...

The negative consequences to Bear’s owners and employees from recent events have been very real—so real that no owner or executive or director of a financial firm would want to be in Bear Stearns’ position. While we clearly knew that our actions, both in the context of the JPMorgan Chase transaction and in the establishment of the Primary Dealer Credit Facility would affect incentives for financial market participants, adding to the risk of “moral hazard,” we believe that the lesson of the actual outcome for equity holders will serve to check and even diminish incentives for undue risk-taking.

We did not bail out Bear Stearns. Bear Stearns' shareholders took a very significant loss. An 85-year-old company lost its independence and became acquired by another firm. Many Bear Stearns employees, as you know, are concerned about their jobs. I don't think any company is interested in repeating the experience of Bear Stearns.

The line that separates restoring market function from merely redistributing losses and gains is not a bright one. This is the reason that policymakers only rarely and reluctantly intervene in markets.

Also, the distinction between liquidity problems and insolvency is not a trivial one when monetary authorities respond to troubles of market players. The critical evaluation is the systemic risk posed by the failure of an institution.

Some believe the Fed has overreacted. Others have said the central bank has been slow to respond to building problems. And still others have warned that the Fed has crossed lines that define appropriate function.

But from where I stand, Fed actions were taken with a prudent acknowledgement of the unintended consequences that may accompany almost all policy interventions.

While governments cannot and should not uniformly avoid public support for creditors of failing banks, they should seek to minimize that support because of the distortions it produces. Such public support—even when it passes a benefit-cost test at the time of provision—encourages future risk-taking by institutions whose creditors expect to benefit from future support. Such risk-taking can even contribute to the specific financial conditions that prompt further government support. The key to addressing these costs is, when times are good, to act to reduce creditors’ expectations of receiving protection.

...

Policymakers should also undertake steps to better understand the potential for spillovers before large institutions get in trouble, as this would allow them to target any support they provide, or perhaps make it more likely that support could be avoided. Because I believe spillovers drive the provision of after-the-fact government support, I am not convinced that other approaches are as likely to alter creditors’ expectations.

Recent events have likely reaffirmed and strengthened some creditors’ expectations of support, or have created those expectations for the first time. I think one would be hard pressed to dismiss our analyses or proposals by claiming that such expectations do not exist. On the opposite end of the spectrum, some might dismiss our suggestions, arguing that we cannot influence creditors’ expectations. I reject that view as equally untenable. We simply cannot allow widespread perceptions of government support to pervade the financial system. Experience in other countries suggests that such a strategy is quite costly. And, in any case, our proposals seek to reduce systemic risk, an outcome presumably shared by policymakers regardless of their views on TBTF per se.

As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.

Of course, even Taylor's research points out that periods of financial stress may require policy responses that differ from the usual prescriptions... The baseline outlook may be only modestly affected by the conditions, but there may be risks of substantial spillovers that could lead to persistent declines in credit intermediation capacity or large declines in wealth. These in turn would reduce business and household spending. In such cases, policy may take out insurance against these adverse risks and move the policy rate more than the usual prescriptions of the Taylor Rule.

Now if we took out such insurance too liberally or too often, then private sector markets would change their views regarding policy and alter their base level of risk-taking. But in doing so, we likely would observe inflationary imbalances emerging or unusual volatility in output. So part of our job as a central bank is to properly price these insurance premiums against the achievement of maximum employment and price stability over the medium term. Importantly, when insurance proves to be no longer necessary, removing it promptly and recalibrating policy to appropriate levels will reiterate and reinforce our commitment to these fundamental policy goals. And if we are transparent so that markets understand that we will adhere to this strategy, such insurance-based monetary policy will not encourage excessive risk-taking.

As has been true of many financial innovations in the past, the benefits of this disaggregated originate-to-distribute model may have been obvious, but the problems less so.  ... Originators had every incentive to maintain origination volume, because that would allow them to earn substantial fees, but they had weak incentives to maintain loan quality.  When loans went bad, originators lost money, mainly because of the warranties they provided on loans; however, those warranties often expired as quickly as ninety days after origination.  Furthermore, unlike traditional players in mortgage markets, originators often saw little value in their charters, because they often had little capital tied up in their firm.  When hit with a wave of early payment defaults and the associated warranty claims, they simply went out of business.  While the lending boom lasted, however, originators earned large profits.  

It's not our job to prevent people from suffering losses who presumably knowingly took risks. That's not our job and we certainly don't want to be perceived as having that as our goal, as bailing out people and leading to a psychology in which they feel, 'Don't worry about taking risks in the future because nothing bad could happen because the Fed will bail us out'. That would be very, very bad. That's the moral hazard problem.

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Our focus has to be on the economy and the innocent bystanders ... Our job is to do our best to create a firewall so the fire
doesn't hurt innocent victims, all the rest of the people in the economy who have nothing to do with this.

From press Q&A as reported by Market News International

In trying to help homeowners, we must also be careful to recognize the existing legal rights of investors, avoid actions that may have the unintended consequence of disrupting the orderly functioning of the market, or unnecessarily reducing future access to credit. Provisions intended to immunize servicers from liability should be crafted to avoid creating moral hazard of parties disregarding their contractual obligations, which would ultimately have negative impacts for markets and consumers.

There are also opportunities for FHA to look for ways to better meet subprime borrowers needs.[11] Greater outreach to borrowers and lenders seems needed. Potentially, FHA may want to raise loan amounts, if they are binding, in high cost markets. And of course there seems to still be a need to simplify and streamline the program for both borrowers and lenders. I should stress that our focus on the opportunities for the FHA program to play a role in alleviating this crisis does not represent advocating a government bailout of lenders, investors, or reckless borrowers. Rather, I am advocating using existing programs for what they were designed to do provide an option for low- and moderate-income borrowers to obtain financing at more affordable rates.

There is a sense in which a Fed put does exist. However, those who believe that the Fed put reflects unwise monetary policy misunderstand the responsibilities of a central bank. The basic argument is very simple: A monetary policy that stabilizes the price level and the real economy cannot create moral hazard because there is no hazard, moral or otherwise. Nor does monetary policy action designed to prevent a financial upset from cascading into financial crisis create moral hazard. Finally, the notion that the Fed responds to stock market declines per se, independent of the relationship of such declines to achievement of the Fed’s dual mandate in the Federal Reserve Act, is not supported by evidence from decades of monetary history.

Central banks seek to promote financial stability while avoiding the creation of moral hazard.  People should bear the consequences of their decisions about lending, borrowing, and managing their portfolios, both when those decisions turn out to be wise and when they turn out to be ill advised.  At the same time, however, in my view, when the decisions do go poorly, innocent bystanders should not have to bear the cost. 

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To be sure, lowering interest rates to keep the economy on an even keel when adverse financial market developments occur will reduce the penalty incurred by some people who exercised poor judgment.  But these people are still bearing the costs of their decisions and we should not hold the economy hostage to teach a small segment of the population a lesson.

 

It is important to recognize that the Federal Reserve cannot resolve this price discovery problem. The markets will have to figure this out.  Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks.  Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery.

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In the current environment, providing insurance through a reduction in the fed funds rate creates its own set of additional risks. It may exacerbate moral hazard problems as I suggested earlier.