Moral Hazard in Equity Contracts - Banking - Lecture Slides, Slides of Banking and Finance

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Moral Hazard in Equity Contracts

The Principal-Agent Problem

• Equity contracts: claims to a share in the profits and assets of a business. - example: common stock
• A particular type of moral hazard that results from equity contracts is the principal-agent problem.

The Ice Cream Example

• Your friend Steve wants to open an ice cream store. It costs $10,000 but he only has $1000.
• He asks you to invest the other $9,000. This entitles you to 90% ownership of the ice cream store.

• This means that if Steve works hard running the store and makes a $50,000 profit, he makes 10% of that which is $5,000.
• You make 90% of $50,000 which is $45,000.
• Steve could work less hard and spend the profit on other things because he isn’t being compensated enough.
• This is losing you money.

The Enron Scandal

and Moral Hazard

• Enron, the 7 th^ largest U.S. Company in 2001, filed for bankruptcy in December 2001.
• Company charged with securities fraud (fraudulent manipulation of publicly reported financial results, lying to the SEC)
• Enron investors and workers left with worthless stocks.

Enron’s Schemes

• 1993-2001: Enron senior management used complex and murky accounting schemes
• reduce Enron’s tax payments
• inflate Enron’s income and profits
• inflate Enron’s stock price and credit rating
• hide losses in off-balance sheet subsidiaries
• engineer off-balance sheet schemes to funnel money to themselves, friends, and family
• misrepresent Enron’s financial condition in public reports

Ways to help solve the principal-agent

problem

• There are four ways to help resolve Principal- Agent Problem: - Production of Information: Monitoring - Government Regulation - Financial Intermediation - Debt Contracts

Monitoring

Monitoring

• Is a way for the firms to reduce the principal-agent problem.

Conflict with monitoring

• Expensive
• Time consuming

Financial Intermediation

• Venture Capital Firm : pools the resources of their partners and use the funds to help entrepreneurs start a new businesses. - Helps eliminate the free-rider problem.

Debt Contracts

• A debt contract is a contractual agreement by the borrow to pay the lender fix dollar amount. - A debt contract helps regulate mangers - Verify the firm’s profits

Moral Hazard

• the risk that one party to a transaction will engage in behavior that is undesirable from the other party’s point of view.