Agency theory : how asymmetric information affects economic behavior

1. Agency theory: how asymmetric information affects economic behavior Asymmetric Information in Finance  Financial Structure • Adverse selection: Before a transaction Lemons Problem • Moral hazard: After the transaction • Principal – Agent Problem • Debtor & Risk • Conflicts of Interest TBTF: No Bank Left Behind

2. The Mantra: ...A healthy, vibrant economy requires a financial system that moves funds from people who save to people who have productive investment opportunities… The Trouble With Lending: • Worst risks line up first • Borrowers won’t do what they “promised” The Trouble With Buying a Share: • If it’s such a good deal, why offer it to me? • Management might ripoff, not share with shareholders So how can a financial system “move funds” from savers to entrepreneurs?

4. Financing business: Eight Facts • Stocks are not most important source of external financing • Issuing marketable securities (debt and equity) not the main way businesses finance operations • Indirect finance is much more important than direct finance • Financial intermediaries  the most important source of external funds • The financial system is (supposed to be) heavily regulated • Only large, well-established corporations have (had) easy access to securities markets to finance their activities  need reputation and net worth • Debt contracts: trust … but collateral • Debt contracts: trust … but restrictive covenants

5. Why Intermediaries? … Transaction Costs • Economies of scale • Expertise: information specialists to handle adverseselection and moral hazard problems • What went wrong? …Perverse incentives • Asymmetric Information Problems • Adverse selection before a transaction • “Lemons problem” • Moral hazard after the transaction • Debt & risky behavior…insurance & risky behavior • Managers and principal - agent problem • Conflicts of interest

6. Countering Adverse Selection Private production and sale of information...but there are problems • Free-rider problem • Perverse incentives: who pays Moody’s? Gov’t regulation to increase information...but there are problems • Regulatory capture…the revolving door Financial intermediation: information specialists?!? • Collateral and net worth…skin in the game • Romney on regulation & Dodd-Frank Countering Moral Hazard: Principal – Agent Problem Align manager incentives with owners’ • Stock/stock options/bonuses/bonus claw-backs Monitor  venture capital firms Avoid ownership debt not equity

7. Moral Hazard in Debt Markets • Borrowers have incentives to take on risk • Heads they win/Tails you lose Countering Moral Hazard in Debt Contracts • Net worth and collateral…skin in the game Incentive compatible…loss is borrower’s, not lenders • Enforce Restrictive Covenants Keep collateral valuable/Provide information But there are costs... • Cost of credit intermediation/state verification • Did borrower really lose...or is he ripping off? • When economy tanks, don’t bother to lend  credit crunch

8. Incentives leading to the subprime-triggered crisis • The Players • Homebuyer…live free…or default • Appraiser…fee • Mortgage broker…commission • Originate and sell • Securitizer: Investment banks/commercial banks • Fees, bonuses • Moving, not storage • Ratings agency…fee • “Investors”/GSEs…return • Government role • Regulation/supervision • Deposit insurance • Lender of last resort • TBTF…Too Interconnected to Fail

9. Denizens of the Pre-Crisis Financial System • Depository institutions • Federal loan programs (SBA,FHA) • GovtSponsoredEnterprises (Fannie Mae, Freddie Mac, FHLB) • Insurance Companies • Pension Funds • Diversified Broker-Dealers (Investment Bank Holding Cos.) • Mortgage Insurers • Monoline Insurers • Shadow Banks (Standalone and captive finance cos., conduits—single-seller, multi-seller, hybrid, repo, security arbitrage conduits—StructuredInvestmentVehicles, Limited Purpose Finance Cos., Credit Hedge Funds) • Money Market Intermediaries (MMMFs, overnight sweeps, cash “plus” funds, enhanced cash funds, ultra-short bond funds, local gov’t investment pools, securities lenders) • European banks

10. The Shadow Banking System: A Daisy Chain From origination to wholesale funding • Loan origination: Finance cos. funded by CommercialPaper • Loan warehousing: Conduits funded by AssetBackedCommercialPaper (the loans are the assets) • Pooling and structuring loans into AssetBackedSecurities: Broker-dealer ABS syndicate desks • ABS warehousing: Trading books funded by repos • Pooling ABS into CollaterizedDebtObligations: Broker-dealer syndicate desks • ABS intermediation: LimitedPurposeFinanceCos., Structured InvestmentVehicles, etc., funded by ABCP, bonds, notes • Wholesale funding of all of the above by MoneyMarketMutual Funds, money market investors. Also fixed income mutual funds, pension funds, and insurance cos. fund shadow banks by investing in their MediumTermNotes

12. Economies of Scope and Conflicts of Interest • Underwriting and Research in (what was) Investment Banking • Investment bank research used to underwrite securities serves sellers and buyers of the securities at same time …do not make negative or controversial comments about clients • Jack Klugman/Citi dotcom research/pre-school recommendations • Spinning: investment bank can allocate hot, underpriced, IPOs to executives of other companies in return for their companies’ future business • Auditing and Consulting in Accounting Firms INCEST • Auditors may skew opinions to get consulting business • May audit information systems or tax and financial plans put in place by their consulting counterparts • May provide an overly favorable audit to retain business Sarbanes-Oxley Act of 2002: SEC Oversight/CPA independence Audit committee independence/CEO-CFO signoff/… Global Legal Settlement of 2002: Separate research & underwriting

13. Chapter 8 Questions • Would the lemons problem be more severe for stocks traded on the New York Stock Exchange, where only large-cap(italization) companies are listed, or stocks traded over-the-counter? • Hint: Bernie Madoff once headed NASDAQ • Which firms are most likely to use bank financing rather than issue bonds or stocks to finance their activities? Why? • How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets? • Why can the provision of several types of financial services by one firm lead to lower costs of information production? • Why can the provision of several types of financial services by one firm lead to conflicts of interest?