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Financial Structure and Moral Hazard

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)

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Financial Structure and Moral Hazard

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  1. Financial Structure and Moral Hazard Chapter 8

  2. Nat Springer sprinn@rpi.edu • Sage 3602 (the Annex) • Office Hours • Monday 12:00-2:00 • Thursday 12:00-2:00 • By appointment

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

  4. 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 req’d for most debt contracts • Debt contracts are complicated and lengthy • 5% of investment is direct between saver/investor • Highly regulated financial system

  5. 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 people’s 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

  6. I know what you don’t 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 1980’s

  7. Jerome Kerviel and Societe Generale • Go to clip…

  8. Conflicts of Interest • Economies of scope • Underwriting and researching in investment banking • Tweak information to increase underwriting value • Spinning: underpriced IPO’s to CEO’s for future business • Auditing and consulting in accounting firms • Don’t criticize their own systems • Skew results to increase business (Arthur Andersen)

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

  10. 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 it’s costly **Why banks, not securities markets, provide most funds

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

  12. 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

  13. 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

  14. 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

  15. Tools to solve MH • Net worth • Restrictive Covenants • Financial Intermediation

  16. 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 don’t need loans as much!

  17. 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

  18. Problems with Covenants • Free riders • Restrictions lessen the attractiveness of loan • Can’t rule out every risk • Always hidden information, intentions • Subprime mortgage crisis

  19. 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 (can’t bid on loans) • Keep information proprietary

  20. 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

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