The Fed's bail out of Bear Stearns continues to raise questions about "moral hazard". The term "moral hazard" applies to the situation where a party believes it won't have to face the full consequences of its actions. As a result, this gives it an incentive to act in ways that may be inappropriate.

In the subprime crisis, moral hazard can apply to both borrowers and lenders. In the case of borrowers, there have been instances where people have taken out more money than they could handle believing it was ok because it wasn't their money anyway and in any case, they could always declare themselves bankrupt. In the case of lenders, credit was offered to high-risk customers, and the loans were packaged and then sold as paper to other lenders who were to bear the risk of default.

Professor Ann Graham says the bail out of Bear Stearns, which uses taxpayers money to guarantee the bank's troubled subprime mortgages, has all the features of moral hazard. "This subprime mortgage situation has so many levels of risk-shifting. It looks like a nation-wide shell game. Not even the experts have unraveled all the financial machinations that spun out of subprime mortgages, so we still don't know where the actual losses will reside. And it's impossible to tell when enough government assistance is enough - and when it simply makes a bad situation worse," she says in her Banking Law Prof blog.

New York University professor Nouriel Roubini concurs and has told Investment News it's a dangerous development and we have not seen anything like since the Great Depression.

"It's the beginning of a radical change in monetary policy. It's not just the $30 billion that the Fed confirmed to Bear Stearns via JPMorgan - there were two other major options that went in the same direction. One was the decision [two weeks ago] to provide $200 billion so that all primary dealers, including non-bank financial institutions, would be able to swap their illiquid and toxic MBS [paper] for safe Treasuries. The other was the Fed giving any primary dealer, including non-banks, access to the Fed discount window on the same terms as banking institutions. This is a radical change; we haven't seen anything like this since the Great Depression. These are financial institutions that are not regulated or supervised by the Fed. The Fed has no idea of whether they are just illiquid or insolvent, which creates a massive moral hazard problem. It's a radical shift in the way the Fed operates - and a dangerous way, I would argue ... You're telling people that even if they have made reckless lending and investment decisions, mismanaged risk or continue to do stupid things, the government will bail them out. We are in a systemic financial crisis."

Still, James Surowiecki in the New Yorker says that while the bail out does run the risk of moral hazard, there was a bigger risk of financial contagion. Bear Stearns was simply too big, too dumb and too interconnected to fail. And in a case, the rescue might have sent a warning to investors who had placed too much faith in the ability of Wall Street to manage its business. Hopefully, it's been an important lesson.

"You might, then, see the Fed's willingness to help investment banks as evidence of their indispensability," Surowiecki writes. "But what it really underscores is how badly Wall Street has managed its business in recent years. Because investment banks' trades and investments are typically very highly leveraged-Bear Stearns, for instance, had borrowed thirty dollars for every dollar of its own-the banks need to be exceptionally good at managing risk, and they need to insure that people trust them enough to lend them huge sums of money against very little collateral. You'd expect, then, that Wall Street firms would be especially rigorous about balancing risk against reward, and about earning and keeping the trust of customers, clients, and lenders. Instead, most of these firms have taken on spectacular amounts of risk without acknowledging the scale of their bets to the outside world, or even, it now seems, to themselves...Now that the Fed has stepped in, it's possible that things will go back to normal. But let's hope they don't get too normal: one of the biggest problems in the market in the past decade has been that lenders, clients, and even ordinary small investors have put far too much faith in the magical abilities of Wall Street firms, and have failed to give their promises and performance proper scrutiny. Markets require trust to work well, but when trust is blind they are almost guaranteed to go haywire."