Solving Incentive Problems

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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.

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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 wont receive higher price
  because their owners have no way of credibly
  supporting claims of good quality.

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• 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.

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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 dont get to sell a useful
  product and the elderly dont get the insurance
  they want.

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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.
• HMOs - 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.

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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.

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Moral Hazard

• Leland and 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.

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• 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.

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Alternative Methods of Loan Disposition
Type Who Holds Title? Who Monitors and
Bears Default Loss -------------------------
------------------------------------------------ L
oan Sale Purchaser Purchaser Syndication Joint
Lead Lender Participation Originator Lead
Lender Securitization Conduit Third-party
guarantor
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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 principals
  expense.
• This problem is very general - applies to almost
  any economic interaction including
  owners-managers, managers-subordinates,
  customers- suppliers etc.

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• 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.

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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
well- managed firm to buy them and fire poor
managers.
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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 firms 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.
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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.
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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.
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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.
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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 cant be costlessly
copied.
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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.
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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.
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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.
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Black-Scholes Model - Nearly Exact Option Pricing
Model
C0 P0N(d1) - E e-rt N(d2) where Price of
Stock P0 Exercise price E Risk free rate
r Time until expiration in years t Normal
distribution function N( ) Exponential
function (base of natural log) e
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Note Here the hedge ratio is represented by
N(d1) and N(d2) where where
Standard deviation of stocks return
s Natural log function ln
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TO GET THE VALUE OF THE CALL, C0

• EXAMPLE ASSUME
• Price of Stock P0 36
• Exercise price E 40
• Risk free rate r .05
• time period 3 mo. t .25
• Std Dev of stock return s .50
• Substitute into d1 and d2.

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• Substitute d1, d2 and other variables in the main
  equation
• C0 36N(-.25) - 40e-.05(.25)N(-.50)
• Look up in the normal table for d to get N(d).
• here N(d1) N(-.25) .4013
• and N(d2) N(-.50) .3085
• Substitute in the main equation

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Use Put-Call Parity Formula to Get Put Price
T0 PUT PRICE EXAMPLE - use info above
- you need the call price 2.26 - 36
39.5 5.76
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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.
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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 borrowers 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)

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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.
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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 firms 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 d1 and d2.
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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.
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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 firms stock has a return standard
deviation of 0.30, and the risk-free rate is 10
percent, what should be the annual guarantee
premium?
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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.
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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 firms shareholders -
  used in takeovers.

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• PBGC does not determine how benefits or
  contributions are calculated. A firms 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 funds 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.

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Problem Now suppose everything is the same as
above except that your pension fund is invested
in your firms 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 PBGCs guarantee?
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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?