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Moral Hazard and Principle-Agent dilemma.

Moral Hazard and Principle-Agent dilemma. Presented by Joe, Erin, Rich, Arthur, Yihan . Principal-agent. Equity contracts- share in the profit of business The principals are stockholders who own the majority of a company’s equity An agent would be the firms manager’s. The Dilemma:.

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Moral Hazard and Principle-Agent dilemma.

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  1. Moral Hazard and Principle-Agent dilemma. Presented by Joe, Erin, Rich, Arthur, Yihan.

  2. Principal-agent • Equity contracts- share in the profit of business • The principals are stockholders who own the majority of a company’s equity • An agent would be the firms manager’s

  3. The Dilemma: • The managers(agents) have less incentive and motivation to maximize profits than the stockholders. • Why? • The manager’s own less of the companies equity and therefore would have less profit than the shareholders.

  4. SOLUTIONS!!!

  5. Solutions cont… • Production of Information- Monitoring • Fact 1 • Costly state verification

  6. Solutions cont… • Government Regulation to Increase Information • Fact 5 • Laws

  7. Solutions cont… • Financial Intermediation • Fact 3 • Venture Capital Firm

  8. Moral Hazard • Debt markets- fixed amounts periodically • Safer • Less need to monitor

  9. The Dilemma • Borrowers have an incentive to take on more risky investments

  10. SOLUTIONS!!!

  11. Solutions cont… • Net Worth and Collateral • Fact 6&7 • Incentive Compatible

  12. Solutions cont… • Financial Intermediation • Fact 3 & 4 • Banks/ Investment firms

  13. Solutions cont… • Monitoring & Enforcement of Restrictive Covenants • Fact 8 • Discourage undesirable Behavior • Encourage desirable behavior • Keep collateral valuable • Provide Information

  14. The Real World: • Enron • 7th largest US company • Leader of energy market • Owned 25% • Estimated worth of $77 billion

  15. Rumblings and Grumblings • October 2001 announced a loss of $681 million • Disclosed accounting “mistakes” • Led to a formal SEC investigation • Uncovered a huge complex web of lies and deception

  16. How does this happen? • Enron created many shell corporations that would consume these debts and contract on their balance sheets • Arthur Andersen was being paid $1 million a day and did not want to loose it’s biggest client • Shareholders just assumed everything was fine based on upper management’s word

  17. The Fallout • Top executives charged • Some went to jail • 1,000’s of employees lost retirements and 401k’s • Both Enron and Arthur Andersen collapse • At the time it was the largest bankruptcy in the history of the US

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