Financial Structure and Moral Hazard Chapter 8

Nat Springer Sage 3602 (the Annex) Office Hours Monday 12:00-2:00 Thursday 12:00-2:00 By appointment Sage 3602 (the Annex) Office Hours Monday 12:00-2:00 Thursday 12:00-2:00 By appointment

Overview In equity contacts (stocks) Principal-agent problem Asymmetric Information Solutions In debt markets (bonds) Moral hazard Solutions In equity contacts (stocks) Principal-agent problem Asymmetric Information Solutions In debt markets (bonds) Moral hazard Solutions

Eight Great Puzzles Stocks only 9.2% of external funding Bonds only 35.5% of external funding Bank loans 55.3% of external funding Only large, est. firms have access to securities market Collateral reqd for most debt contracts Debt contracts are complicated and lengthy 5% of investment is direct between saver/investor Highly regulated financial system Stocks only 9.2% of external funding Bonds only 35.5% of external funding Bank loans 55.3% of external funding Only large, est. firms have access to securities market Collateral reqd for most debt contracts Debt contracts are complicated and lengthy 5% of investment is direct between saver/investor Highly regulated financial system

Principal Agent Problem Separation of owners from managers: agent (manager) acts in own interest, not in interest the interest of the of the principal (stockholder) -Play with other peoples money -Not pursue profit maximization -Failure to modernize, satisfied with status quo -No incentive to work too hard -Spend on unnecessary things -High personal salaries -Embezzlement Separation of owners from managers: agent (manager) acts in own interest, not in interest the interest of the of the principal (stockholder) -Play with other peoples money -Not pursue profit maximization -Failure to modernize, satisfied with status quo -No incentive to work too hard -Spend on unnecessary things -High personal salaries -Embezzlement

I know what you dont know… Managers have control over information Monitor their own activities (accounting, work hours, extra funds for company lunch) Orchestrated information asymmetry (CEO projects company image, talking points) Pre-dated stock options Make risky business decisions Negative feedback loop Enron, World.com Can get away with a lot Later chapter, U.S. savings and loan crisis 1980s Managers have control over information Monitor their own activities (accounting, work hours, extra funds for company lunch) Orchestrated information asymmetry (CEO projects company image, talking points) Pre-dated stock options Make risky business decisions Negative feedback loop Enron, World.com Can get away with a lot Later chapter, U.S. savings and loan crisis 1980s

Jerome Kerviel and Societe Generale Go to clip…

Conflicts of Interest Economies of scope Underwriting and researching in investment banking Tweak information to increase underwriting value Spinning: underpriced IPOs to CEOs for future business Auditing and consulting in accounting firms Dont criticize their own systems Skew results to increase business (Arthur Andersen) Economies of scope Underwriting and researching in investment banking Tweak information to increase underwriting value Spinning: underpriced IPOs to CEOs for future business Auditing and consulting in accounting firms Dont criticize their own systems Skew results to increase business (Arthur Andersen)

Solutions to Principal/Agent Monitor and Audit Government Regulation Financial Intermediation Monitor and Audit Government Regulation Financial Intermediation

Monitor or Audit Reduce asymmetric information Principal knows what the agent is doing Debt contract: periodic payments Problems Conflicts of interest Costly If private, though, can keep information proprietary Regulatory disclosure creates free riders, disincentive to audit at all since its costly **Why banks, not securities markets, provide most funds Reduce asymmetric information Principal knows what the agent is doing Debt contract: periodic payments Problems Conflicts of interest Costly If private, though, can keep information proprietary Regulatory disclosure creates free riders, disincentive to audit at all since its costly **Why banks, not securities markets, provide most funds

Government Regulation Federal Exchange Commission Require Standard Audit practices Laws against fraud, stealing Problem: detection difficult, costly (cost- benefit) Federal Exchange Commission Require Standard Audit practices Laws against fraud, stealing Problem: detection difficult, costly (cost- benefit)

Two Examples Elliot Spitzer vs. Investment Banks No research/underwriting for investment banks No spinning Recommendations must be public (free rider) Sarbanes-Oxley 2002 Created public accounting oversight board Increased SEC budget No audit/consulting for accounting firms Independent auditors CEO must sign-off on financial statements Elliot Spitzer vs. Investment Banks No research/underwriting for investment banks No spinning Recommendations must be public (free rider) Sarbanes-Oxley 2002 Created public accounting oversight board Increased SEC budget No audit/consulting for accounting firms Independent auditors CEO must sign-off on financial statements

Financial Intermediation Mutual/Retirement Funds Can afford to audit (still free rider) Diversify risk of bad and good investors Venture Capital Firms Put partners on board of directors No outside sales of stock until after initial period Mutual/Retirement Funds Can afford to audit (still free rider) Diversify risk of bad and good investors Venture Capital Firms Put partners on board of directors No outside sales of stock until after initial period

In Debt Markets/Contracts Borrowers have wrong incentive To be risky: only have to pay back fixed amount, so why not go for broke! Proposes one investment, proceeds on another Lose some of the money on bad investment simply increases the need for a more risky investment Borrowers have wrong incentive To be risky: only have to pay back fixed amount, so why not go for broke! Proposes one investment, proceeds on another Lose some of the money on bad investment simply increases the need for a more risky investment

Tools to solve MH Net worth Restrictive Covenants Financial Intermediation Net worth Restrictive Covenants Financial Intermediation

Net Worth and Collateral Net worth: difference between assets and liabilities Have something to lose Incentive compatible: reverses MH, now borrower also has something to lose Problem: People with collateral dont need loans as much! Net worth: difference between assets and liabilities Have something to lose Incentive compatible: reverses MH, now borrower also has something to lose Problem: People with collateral dont need loans as much!

Restrictive Covenants Write restrictions and monitor compliance Example: loss of collateral if miss monthly payment, default on loan Restrictive covenants Specific activities permitted Encourage activity (link mortgage and life ins.) Require collateral to be kept in good condition Require information, audit of borrower Write restrictions and monitor compliance Example: loss of collateral if miss monthly payment, default on loan Restrictive covenants Specific activities permitted Encourage activity (link mortgage and life ins.) Require collateral to be kept in good condition Require information, audit of borrower

Problems with Covenants Free riders Restrictions lessen the attractiveness of loan Cant rule out every risk Always hidden information, intentions Subprime mortgage crisis Free riders Restrictions lessen the attractiveness of loan Cant rule out every risk Always hidden information, intentions Subprime mortgage crisis

Financial Intermediation Use banks! Non-traded private loans Economies of scale with auditing, paperwork, etc. (even have client pay for it) 2 benefits Cuts out free riders (cant bid on loans) Keep information proprietary Use banks! Non-traded private loans Economies of scale with auditing, paperwork, etc. (even have client pay for it) 2 benefits Cuts out free riders (cant bid on loans) Keep information proprietary

Agency Theory and Development Economic analysis of AS and MH Akerlof and Stiglitz Asymmetric info, underdeveloped financial mechanisms, and growth Bad property rights Red tape Bad info Corruption Hernando de Soto - The Mystery of Capital Economic analysis of AS and MH Akerlof and Stiglitz Asymmetric info, underdeveloped financial mechanisms, and growth Bad property rights Red tape Bad info Corruption Hernando de Soto - The Mystery of Capital