Solving Incentive Problems Two Basic Incentive Problems Adverse

Solving Incentive Problems Two Basic Incentive Problems • Adverse Selection - fixed price insurance - bad risks. • Moral Hazard - change behavior after insurance purchase. • Both problems arise because of asymmetric information parties to financial contracts do not have the same information so one has an incentive to shortchange the other. • Financial innovations and financial intermediaries often help solve or reduce the severity of these problems. • Example: Banks monitor developers after making loan.

Adverse Selection Akerlof (1970) - Market for Lemons • Most economic models assume buyers and sellers have perfect or equal information. • Asymmetric information is a market failure. • Unsolved asymmetric information problem leads to fewer beneficial trades and lower overall economic welfare. • Question: Why are most used cars lemons? Asymmetric information - people more often want to sell the bad ones; the good ones are kept so that the average sales price will reflect poor quality - good ones won’t receive higher price because their owners have no way of credibly

Related Question: Why does the value of a new car drop suddenly after purchase from a dealer? • Some claim dealers charge for the joy of owning a new car. • More likely, after driving the car for a time, the owner learns about whether it is a lemon - owner has asymmetric information. If it is a lemon, she is more likely to try to sell it. If I buy new from a dealer, the chance I will get a lemon is smaller. I should be willing to pay extra for the lower probability. • This simple issue underlies many problems in finance and financial institutions and special financial products are often used to solve them.

Health Insurance • Example: Suppose it is your job to set a price for health insurance for people over 65. How do you do it? • Older people use more services so we set a high price. • But at the high price, those in good health may not buy. • Those with very poor health will buy - a bargain. • If you raise the premiums, more of the better risk leave, raising premiums again and again breaks down the market. • Result: insurers don’t get to sell a useful product and the elderly don’t get the insurance they want.

Potential Solution to Health Insurance Problem • Mandatory, government required health insurance. • Group insurance - working people are more likely to be healthy and health quality in the group more random. • Different levels of coverage and prices - self-selection. • Specialized health information gathering companies. • Testing - remove the asymmetry between the insured and the insurer. • HMO’s - advertise using only healthy people. - offer benefits like health club that only the healthy will value. - subtle tactics - top floor administration, application, offices - discourages the sick.

Other Financial Examples 1. Real estate agents - help resolve the information asymmetry between buyer and seller by passing information between them after screening for truthfulness. 2. Local banks - help solve the lemons problem in lending. • Suppose you set a fixed loan rate. Only the high-risk firms would apply. Furthermore, the best risks can raise funds from operations to fund their investments. • Local banks know the risks and collateral value of local firms and can reduce informational asymmetry by continually monitoring the borrowing firm.

Moral Hazard Leland Pyle (1977) - Signaling • Even local lenders with access to information on borrowers may still encounter asymmetric information problems after a loan is made. • Moral hazard problem - after a loan is made, borrowers have incentives to alter their projects in ways that are hard to observer but make them riskier. The riskier project has a bigger potential payoff but more chance for failure (loan default), the costs of which are born by the lender. • Solution - borrowers signal the quality of a project by the amount of their own capital they put into it.

• The lending market will offer lower interest rates for projects with larger owner equity. This separates projects by quality and allows lenders to offer a range of interest rates. • Question: Is this how the home mortgage market works? • Question: Since many mortgage lenders hold mortgages for a short time before selling the loans through GNMA guaranteed trusts, and they charge the same rate for each conventional loan, how strong are lenders’ incentives to accurately judge the default risk of each borrower? • Question: Given your answer to the question above, do you predict higher or lower default rates in the future? • Question: Are higher default rates an inefficient result? • Note: Electricity market deregulation – more brownouts.

Alternative Methods of Loan Disposition Type Who Holds Title? Who Monitors and Bears Default Loss ------------------------------------Loan Sale Purchaser Syndication Joint Lead Lender Participation Originator Lead Lender Securitization Conduit Third-party guarantor

Principal-Agent Problems Moral Hazards Jensen and Meckling (1976) • An agency relationship arises when a principal (owner) hires and agent (manager) to run her business or make decisions in her place. • Agency Problem: Since the principal can not continuously observe the agent or perfectly measure his performance, the agent may not work as hard as the principal would or may make decisions that benefit him at the principal’s expense. • This problem is very general - applies to almost any economic interaction including owners-managers, managers-subordinates, customers- suppliers etc.

• Jensen and Meckling focus on the agency problem between owners and managers - the separation of ownership from control of business decisions. • A business run by a 100 percent owner will have a higher value than one run by a professional manager - all else equal. • All else is not equal, however. Allowing tradable ownership shares improves liquidity, diversification through pooling and management specialization. Hence, there is a conflict between the benefits professional management and agency costs associated with separate ownership. • Financial firms try to limit agency costs.

General Solutions to Agency Problems 1. Management incentive compensation - options, bonuses. 2. Monitoring - auditors, boards of directors. 3. Bonding - deferred management compensation. 4. Debt - more debt puts pressure on managers to work hard to make debt payments - more common when project risk cannot be manipulated and where monitoring is costly. 5. Competition among managers for jobs and firms for customers. 6. Mergers and acquisitions - investment bankers job is to look for poorly-managed firm and arrange for wellmanaged firm to buy them and fire poor managers.

Agency Problems in Corporate Finance Problem: A firm wants to issue equity to finance new investment projects but cannot credibly tell investors that the investment will be profitable. Investors fear adverse selection where firms tend to finance very profitable investments with retained earnings and sell shares externally to finance less attractive investments. Investors-offer low price. Financial Solution: Convertible Debt - acts as insurance. The investor may accept convertible debt because if the investment is a poor one she has a more secure claim on the firm’s assets and if it is good then the debt will be converted to equity and the firm has the equity financing it wanted in the first place.

Alternative Solutions Alternative 1: The firm can sell equity (or debt) that has a put feature. If the investment is good, investors maintain their equity position. If the investment is bad, investors get their funds back assuming the firm is not bankrupt. Question: Any potential problems with this solution relative to convertible debt? Alternative 2: Collateralized debt. The firm can sell debt collateralized by its other projects that are easier to value and are not as risky. These funds can finance the new project at a reasonable cost. Potential Problem: Firm bears all the risk itself.

Macro Effects of Incentive Problems Steps in Explaining the Business Cycle 1. Profits fall in the short-term due to interest rate increases or cost inflation. 2. With internal cash-flow reduced, firms must issue more external financing to fund their investments. 3. But investors require higher returns (offer lower prices) for these securities because of adverse selection. 4. Fewer projects will have positive NPVs at the higher required returns. 5. Fewer projects are undertaken and economic growth falls. Corporate risk management smooths cash flows and helps avoid having to raise funds externally - Some insurance companies are considering offering Earnings Insurance.

Agency Costs in Financial Firms Due to the highly liquid nature of financial firms’ assets an liabilities, there is more potential for managers to manipulate risk and commit fraud/theft. Agency Solutions for Financial Firms 1. Risk-based reserve requirements. 2. Transparent organization and financial reporting. 3. Assets placed with a separate depository/custodian. 4. Separate decision-makers from ratification, accounting and reporting systems (e. g. billing agents from payments). 5. Management hierarchy levels that review major decision (e. g. , boards of directors). 6. Mutual monitoring - agents compete for promotions. 7. Redeemable shares - removes assets from management.

Solutions to Asymmetric Information 1. Gathering information - expert dealers, licensing. 2. Stratify the market so that people self-select into quality bins. 3. Bonding - putting up funds to insure performance. 4. Brand name or reputation - a type of bonding. 5. Collateral - also similar to bonding. 6. Guarantees - purchased from financial institutions or given by governments. 7. Signaling information that can’t be costlessly copied.

Call Option Definition: The right to purchase 100 shares of a security at a specified exercise price (Strike) during a specific period. EXAMPLE: A January 60 call on Microsoft (at 7 1/2) This means the call is good until the third Friday of January and gives the holder the right to purchase the stock from the writer at $60 / share for 100 shares. cost is $7. 50 / share x 100 shares = $750 premium or option contract price.

Put Option Definition: The right to sell 100 shares of a security at a specified exercise price during a specific period. EXAMPLE: A January 60 put on Microsoft (at 14 1/4) This means the put is good until the third Friday of January and gives the holder the right to sell the stock to the writer for $60 / share for 100 shares. cost $14. 25 / share x 100 shares = $1425 premium. Microsoft stock price was 53 at the time.

Variables Affecting Options Values 1. Time until expiration. 2. Stock return variance. 3. Stock Price. 4. Exercise price. 5. Risk-free rate. For our discussion of incentive problems, the return variance and the exercise price are the two variables that agents can manipulate in the situations we will discuss.

Black-Scholes Model - Nearly Exact Option Pricing Model C 0 = P 0 N(d 1) - E e-rt N(d 2) where Price of Stock = P 0 Exercise price = E Risk free rate = r Time until expiration in years = t Normal distribution function = N( ) Exponential function (base of natural log) = e

Note: Here the hedge ratio is represented by N(d 1) and N(d 2) where: where Standard deviation of stocks return = s Natural log function = ln

TO GET THE VALUE OF THE CALL, C 0 EXAMPLE: ASSUME Price of Stock Exercise price Risk free rate time period 3 mo. Std Dev of stock return • Substitute into d 1 and d 2. P 0 = 36 E = 40 r =. 05 t =. 25 s =. 50

• Substitute d 1, d 2 and other variables in the main equation C 0 = 36 N(-. 25) - 40 e-. 05(. 25)N(-. 50) • Look up in the normal table for d to get N(d). here N(d 1) = N(-. 25) =. 4013 and N(d 2) = N(-. 50) =. 3085 • Substitute in the main equation

Use Put-Call Parity Formula to Get Put Price T 0 = PUT PRICE EXAMPLE - use info above - you need the call price = 2. 26 - 36 + 39. 5 = 5. 76

Application of Option Pricing to Incentive Problems 1. Whenever financial firms or government agencies explicitly or implicitly guarantee (insure) a financial transaction, they bear a implicit cost and confer an explicit benefit. The cost can be estimated as the value of a put option and this value (an a profit markup) can be charged as an insurance “premium. ” 2. Guarantees create the potential for adverse selection and moral hazard which are often accentuated if the firm or agency fails to charge the appropriate premium. 3. Example: The government often declares disaster areas after a hurricane or flood and provides funds to help people rebuild their homes. Result: many people refuse to purchase disaster insurance and those that do find very high premiums.

Example: Risky Loans 1. Risky loans involve a risk-free loan and an implicit (or sometimes explicit) loan guarantee. Risky Loan Value = Risk-free Loan Value - Loan Guarantee Premium 2. Consider a borrower’s alternatives. • Borrower needs $100 and goes to a bank offering loans to businesses of its risk at 25% - $25 annual interest. The bank offers to lend to the U. S. government at 10%. • Borrower purchases a guarantee from an insurance company for a $15 annual premium and returns to the bank which offers to lend at 10% - $10 annual interest. • Loan rate = 25% = 10% (risk-free rate) + 15% (risk premium)

List of Other Examples 1. Product warrantees/guarantees. 2. Bank deposit insurance. 3. Crop insurance. 4. Price support programs - sugar, milk etc. 5. Student, small business and mortgage loan guarantees. 6. Parent companies often guarantee the debt of their subsidiaries - a large problem in Japan, Korea, etc. 7. Swaps entered into directly with counter-parties. 8. Marketing schemes - “satisfaction guaranteed or your money back. 9. Pension Fund guarantees.

Using Black-Scholes to get the Value of Loan Guarantees Problem: Suppose you are an insurance company and a firm wants you to insure its $200 million loan from Fleet Financial. The firm is putting up $40 million equity along with the $200 million loan to buy the Civic Center. The firm’s stock has a return standard deviation of 0. 50. If the risk-free rate is 10 percent, what should be the annual guarantee premium? 1. Get d 1 and d 2.

2. Get the normal probabilities. N(. 815) N(. 80) =0. 7881 and N(. 315) N(. 30) = 0. 6179 3. Get the Call Price. 4. Get the Put Price. We should charge at least $18. 29 million for the guarantee. If it is a 10 year loan and we wished to charge for a 10 year guarantee up front, use 10 instead of 1 in the model above.

Using Black-Scholes to get the Value of Pension Guarantees Problem: Your firm has a defined-benefit pension plan committing it to pay benefits with a present value of $100 million. The fund backing the plan, however, has $120 million in it now (over-funded by $20 million). Your plan is guaranteed by the Pension Benefits Guarantee Corporation (PBGC). Assume the firm’s stock has a return standard deviation of 0. 30, and the risk-free rate is 10 percent, what should be the annual guarantee premium?

Get the normal probabilities. N(1. 09) N(1. 10) =0. 8643 and N(. 79) N(. 80) = 0. 7881 Get the Call Price. Get the Put Price. PBGC should charge at least $2. 89 million for the guarantee.

Problems with PBGC Guarantee Premiums • Premiums are not set with an options model but using various ad hoc rules. Before 1994, the premiums were relatively low and had fixed maximums, leading to significant PBGC losses. • Firms can still opt out (in) of the PBGC insurance by switching from a fixed benefit (contribution) to a fixed contribution (benefit) plan or by contracting an insurance company to assume its obligations. The over-funded plans tend to opt out while deadbeats opt in - adverse selection and free rider problems. Social Security System solves these problems by making participation mandatory. • When an over-funded plan is extinguished, the excess assets go to the firm’s shareholders - used in takeovers.

• PBGC does not determine how benefits or contributions are calculated. A firm’s pension contribution depends upon its own assumptions on the expected return on fund assets, the work-life and retirement life of its covered workers, and the return on the assets supporting retirees’ annuities (FASB). Pension contributions and the determination of a fund’s under- or over-funding can be manipulated - 1991, Chrysler reported $3. 7 billion under-fund - PBGC estimate was $7. 7. • Payout is flexible so retirees may choose lump-sum payouts instead of annuities which reduces the assets backing the benefits or the remaining unretired workers - LTV executives change payout rules just before retiring - PBGC lost $230 m. • PBGC cannot restrict the risk of fund assets. The assets in the pension fund may be low risk or quite risky.

Problem: Now suppose everything is the same as above except that your pension fund is invested in your firm’s stock (an internet company) and its value just fell by 33 percent. This means that the fund backing the plan has only $80 million in it now (under-funded by $20 million). What happens to the value of PBGC’s guarantee?

Get the normal probabilities. N(-. 26) N(-. 25) =0. 4013 and N(-. 56) N(-. 55) = 0. 2912 Get the Call Price. Get the Put Price. PBGC should charge at least $16. 23 mm for the guarantee. Question: Why the big premium change? Any other ways for the firm to boost the value of its PBGC guarantee?