Financial Structure and Moral Hazard

Chapter 8

Nat Springer
sprinn@rpi.edu

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

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

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

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

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)

Solutions to Principal/Agent
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

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

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

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

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

Tools to solve MH
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!

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

Problems with Covenants

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

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