chapter 8 ed

8/8/2019 Chapter 8 Ed

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DISCUSSION OUTLINE

How Moral Hazard affects the choice betweenDebt and Equity Contracts

- Moral Hazard in Equity Contracts: ThePrincipal-Agent Problem

- Tools to help solve the principal-agent problem

- Production of information: Monitoring

-GovernmentRegulationtoincreaseinformation

- Financial Intermediation

- Debt contracts


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DISCUSSION OUTLINE

How Moral Hazard Influences Financial Structure in DebtMarkets

- Tools to help solve moral hazard in debt contracts

- Net worth and collateral

-Monitoring and enforcement ofrestrictive covenants

-Covenants to discourage undesirablebehavior

- Covenants to encourage desirable behavior-Covenants to keep collateral available

- Covenants to provide information

- Financial Intermediation


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ASYMMETRIC INFORMATION

A situation that arises when one partysknowledge about the party involved in a

transaction makes it impossible to makeaccurate decisions when conducting thetransaction.


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ADVERSE SELECTION

Is an asymmetric information problem that

occurs before the transaction: Potential bad

credit risks are the ones who most activelyseek out loans. Thus the parties who are the

most likely to produce an undesirable

outcome are the ones most likely to engage

in transaction.


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MORAL HAZARD

Arises after the transaction occurs: The lenderruns the risk that the borrower will engage inactivities that are undesirable from the lenders

point of view because they make it less likelythat the loan will be paid back.

The analysis of how asymmetric informationproblems affect economic behavior is called

agency problem.


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THE LEMONS PROBLEM: HOW ADVERSE SELECTION

INFLUENCES FINANCIAL STRUCTURE

Lemons article by Nobel prize winner GeorgeAkerlof

It is called the lemons problem because itresembles the problem cause by lemons in theused-car market.

Potential buyers of used cars are frequently unable

to assess the quality of the car.


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THE LEMONS PROBLEM: HOW ADVERSE SELECTION

INFLUENCES FINANCIAL STRUCTURE

The price that a buyer pays must thereforereflect the average quality of the cars in themarket, somewhere between the low value of alemon and a high value of a good car.

The owner of a used car, by contrast, is morelikely to know whether the car is a peach or a

lemon. As a result of this adverse selection, few good

used cars will come to the market.


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LEMONS IN THE STOCK AND BOND

MARKETS

Suppose that our friend Irving the investor, apotential buyer of securities such as common stock,

cant distinguish between good firms with highexpected profits and low risk and bad firms with lowexpected profits and high risk.


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LEMONS IN THE STOCK AND BOND

MARKETS

The analysis is similar if Irving considers purchasinga corporate debt instrument in the bond market

rather than an equity share. Few bonds are likely to sell in this market, so it will

not be a good source of financing.


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TOOLS TO HELP SOLVE ADVERSE

SELECTION PROBLEMS

In the absence of asymmetric information, thelemons goes away.

If buyers know as much about the quality of usedcars as sellers, so that all involved can tell a goodcar from a bad one, buyers will be willing to payfull value for good used cars.


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PRIVATE PRODUCTION AND SALE OF

INFORMATION

One way to get this material to saver-lendershave private companies collect and produceinformation that distinguishes good from badfirms and then sell it.


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PRIVATE PRODUCTION AND SALE OF

INFORMATION

The system of private production and sale ofinformation does not completely solve the adverseselection problem in securities markets, however,

because of free-rider problem. The free-rider problem occurs when people who do

not pay information take advantage of theinformation that other people have paid for.

The free-rider problem suggests that the private saleof information will be only a partial solution to thelemons problem.


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GOVERNMENT REGULATION TO INCREASE

INFROMATION

Could financial markets benefit fromgovernment intervention?

The government could, for instance, produceinformation to help investors distinguish goodfrom bad firms and provide it to public free ofcharge.


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INFROMATION

In the United States, the SEC is the governmentagency that requires firms selling their securitiesto have independent audits, in which accountingfirms certify that the firm is adhering to standardaccounting principles and disclosing accurateinformation about sales, assets, and earnings.


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INFROMATION

Even when firms provide information to thepublic about their sales, assets, or earnings, theywill have more information than investor: Thereis a lot more to knowing the quality of a firmthan statistics can provide.

Bad firms will slant the information they are

required to transmit to the public, thus making itharder for investors to sort out the good firmsfrom the bad.


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FINANCIAL INTERMEDIATION

Another important fact that is explained by theanalysis here is the greater importance of banksin the financial systems of developing countries.

The better known a corporation is, the moreinformation about its activities is available in themarketplace.

Thus it is easier for investors to evaluate thequality of the corporation and determinewhether it is a good firm or a bad one.


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COLLATERAL AND NET WORTH

Collateral, property promised to the lender if theborrower defaults, reduces the consequences ofadverse selection because it reduces the lenders

losses in the event of a default. If a borrower defaults on a loan, the lender can

sell the collateral and use the proceeds to makeup for the losses on the loan.


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COLLATERAL AND NET WORTH

Net worth (also called equity capital), thedifference between a firms assets (what it ownsor is owned) and its liabilities (what it owes), can

perform a similar role to collateral. In addition, the more net worth firm has in the

place, the less likely it is to default, because thefirm has a cushion assets that it can use to pay

off its loans.


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MORAL HAZARD IN EQUITY CONTRACTS: THE

PRINCIPAL-AGENT PROBLEM

Equity contracts, such as common stock, are claimsto a share in the profits and assets of a business.

Equity contracts are subject to a particular type of

moral hazard called the principal-agent problem. When managers own a small fraction of the firm they

work for, stockholders who own most of the firmsequity (called the principals) are not the same people

as the managers of the firm, who are the agents ofthe owners.


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This separation of ownership and control involvesmoral hazard, in that the managers in control (theagents) may act in their own interest rather than in

the interest of the stockholders-owners (theprincipals) because the managers have less incentiveto maximize profits than the stockholder-owners do.


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Further indications that the principal-agentproblem created by equity contracts can besevere are provided by recent scandals in

corporations such as Enron and TycoInternational, in which managers have beenaccused of diverting funds for their own personaluse.

The principal-agent problem would not arise ifthe owners of a firm had complete informationabout what the managers were up to and couldprevent wasteful expenditures or fraud.


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PRODUCTION OF INFORMATION:

MONITORING

One way for stockholders to reduce this moralhazard problem is for them to engage in aparticular type of information production, themonitoring of the firms activities: auditing thefirm frequently and checking on what themanagement is doing.


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PRODUCTION OF INFORMATION:

MONITORING

Costly state verification makes the equitycontract less desirable, and it explains, in part,why equity is not more important element in ourfinancial structure.

The moral hazard problem for shares of commonstock will then be severe, making it hard for firms

to issue them to raise capital.


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INFORMATION

As with adverse selection, the government hasan incentive to try to reduce the moral hazardproblem created by asymmetric information,which provides another reason why the financialsystem is so heavily regulated.

However, these measures can be only partly

effective. Catching this kind of fraud is not easy;fraudulent managers have the incentive to makeit very hard for government agencies to find orprove fraud.


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Financial intermediaries have the ability to avoidthe free-rider problem in the face of moralhazard, and this is another reason why indirectfinance is so important.

Venture capital firms pool the resources of theirpartners and use the funds to help budding

entrepreneurs start new businesses.


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Venture capital firms have been important in thedevelopment of the high-tech sector in theUnited States, which has resulted in job creation,economic growth, and increased internationalcompetitiveness.


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DEBT CONTRACTS

Moral hazard arises with an equity contract,which is a claim on profits in all situations,whether the firm is making or losing money.

If a contract could be structured so that moralhazard would exist only in certain situation,there would be a reduced need to monitor

managers, and the contract would be moreattractive than the equity contract.


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DEBT CONTRACTS

Only when the firm cannot meet its debtpayments, thereby being in a state of default, isthere a need for the lender to verify the state ofthe firms profits.

Only in this situation do lenders involved in debtcontracts need to act more like equity holders;

now they need to know how much income thefirm has to get their fair share.


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DEBT CONTRACTS

The less frequent need to monitor the firm, andthus the lower cost of state verification, helpsexplain why debt contracts are used morefrequently than equity contracts to raise capital.


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HOW MORAL HAZARD INFLUENCES FINANCIAL

STRUCTURE IN DEBT MARKETS

Even with the advantages just described, debtcontracts are still subject to moral hazard.

Because a debt contract requires the borrowersto pay out a fixed amount and lets them keepany profits above this amount, the borrowershave an incentive to take on investment projects

that are riskier than the lenders would like.


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NETWORK AND COLLATERAL

One way of describing the solution that high networth and collateral provides to moral hazardproblem is to say that it makes the debt contractincentive-compatible; that is, it aligns theincentives of the borrower with those of thelender.


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NETWORK AND COLLATERAL

The greater the borrowers net worth and collateralpledged, the greater the borrowers incentive tobehave in the way that the lender expects anddesires, the smaller the moral hazard problem in the

debt contract, and easier it is for the firm orhousehold to borrow.

Conversely, when the borrowers net worth andcollateral are lower, the moral hazard problem isgreater, and it is harder to borrow.


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MONITORINGAND ENFORCEMENTOF

RESTRICTIVE COVENANTS

By monitoring Steves activities to see whether he iscomplying with the restrictive covenants andenforcing the covenants if he is not, you can makesure that he will not take risk at your expenses.


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COVENANTS TO DISCOURAGE UNDESIRABLE

BEHAVIOR

Some covenants mandate a loan can be usedonly to finance specific activities such as thepurchase of particular equipment or inventories.

Others restrict the borrowing firm fromengaging in certain risky business activities suchas purchasing other businesses.


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COVENANTS TO ENCOURAGE

DESIRABLE BEHAVIOR One restrictive covenant of this type requires the

bread winner in a household to carry lifeinsurance that pays off the mortgage upon thepersons death.

Restrictive covenants of this type for businessesfocus on encouraging the borrowing firm to keep

its net worth high because higher borrower networth reduces moral hazard and makes it lessthat the lender will suffer losses.


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COVENANTS TO KEEP COLLATERAL

VALUABLE Because collateral is an important protection for

the lender, restrictive covenants can encouragethe borrower to keep the collateral in goodcondition and make sure that it stays in thepossession of the borrower.


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COVENANTS TO PROVIDE

INFORMATION Restrictive covenants also require a borrowing

firm to provide information about its activitiesperiodically in the form of quarterly accountingand income reports, thereby making it easier forthe lender to monitor the firm and reduce moralhazard.

This type of covenant may also stipulate that thelender has the right to audit and inspect thefirms books at any time.


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Although restrictive covenants help reduce themoral hazard problem, they do no eliminate itcompletely.

It is almost impossible to write covenants thatrule out every risky activity.

Furthermore, borrowers maybe clever enough to

find loopholes in restrictive covenants that makethem ineffective.


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chapter 8 ed

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