Do moral hazards matter?

I recently had a lengthy conversation with a friend about healthcare and the housing market collapse. In the conversation, I attempted to illustrate my perspective based on my friend's personal investing practices.

So a little background on options and puts before I go on. In derivatives, "puts" can be purchased to protect yourself against declines in stock prices. Say I buy Microsoft stock for $25 a share. At the same time, I could buy a put that enables me to sell the stock to someone else at some point in the future for $25. So if the stock goes down to $20, I can "put" my shares to someone else for the pre agreed price of $25, and save myself from losses.

But the put costs me money, so I balance the risk of losing on my investment against the cost of the put.

Back to my friend. I asked my friend how my friend's investing would change if every stock purchase came with a free put. Meaning my friend could never loose money, only got the upside, and all of the declines in value would be covered by the free put. My friend acknowledged the new strategy would be to leverage everything to buy as much as possible to take advantage of the risk free profits. This is called a moral hazard.

I pointed out that the housing/mortgage market had been covered by several of these free or undervalued puts in the form of implicit and explicit "too big to fail" thinking.

My friend responded, "Moral hazard had nothing to do with it!"

So I ask, does moral hazard apply? If moral hazard applies to the individual, why would it not apply to the whole market? Does moral hazard have anything to do with it?