Money banking and the financial system 1e by hubbard and OBrien chapter 09

Transactions Costs, Asymmetric Information, and the Structureof the Financial System C H A P T E R 9 LEARNING OBJECTIVES After studying this chapter, you should be able to: 9.1 9.2 9.3 A

Transactions Costs, Asymmetric Information, and the Structure

of the Financial System

C H A P T E R 9

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

9.1 9.2 9.3

Analyze the obstacles to matching savers and borrowers Explain the problems that adverse selection and moral hazard pose for the financial system

Use economic analysis to explain the structure of the U.S financial system

BUYER BEWARE IN FINANCIAL MARKETS!

•The fraud case filed by the SEC against Goldman Sachs in 2010 highlights the important problem of asymmetric information

•In this case, asymmetric information means that Goldman Sachs, as the seller

of the Abacus collateralized debt obligations (CDOs), clearly had more

information than did the buyers

C H A P T E R 9 Transactions Costs, Asymmetric

Information, and the Structure

of the Financial System

Key Issue and Question

Here are the key issue and key question for this chapter:

Issue: During the 2007–2009 financial crisis, many economists noted

that problems in the market for bonds had the potential to deepen the

economic recession and slow the recovery because firms rely more

heavily on bonds than on stocks as a source of external finance

Question: Why do firms rely more on bonds than on stocks as a

source of external finance?

9.1 Learning Objective

Analyze the obstacles to matching savers and borrowers

Obstacles to Matching Savers and Borrowers

Transactions costs The cost of a trade or exchange; for example, the

brokerage commission charged for buying or selling a financial asset

Information costs The costs that savers incur to determine the

creditworthiness of borrowers and to monitor how they use the funds acquired

The Problems Facing Small Investors

• Small investors and small- to medium-sized firms turn to financial

intermediaries to meet their financial needs

• Transaction costs can be reduced by taking advantage of economies of

scale.

Economies of scale The reduction in average cost that results from an

increase in the volume of a good or service produced

How Financial Intermediaries Reduce Transactions Costs

9.2 Learning Objective

Explain the problems that adverse selection and moral hazard pose for the

financial system

Economists distinguish between two problems arising from asymmetric

information:

Asymmetric information The situation in which one party to an economic

transaction has better information than does the other party

Moral hazard The risk that people will take actions after they have entered into a transaction that will make the other party worse off; in financial markets, the

problem investors experience in verifying that borrowers are using their funds as intended

Adverse selection The problem investors experience in distinguishing low-risk borrowers from high-risk borrowers before making an investment; in insurance, the problem that those most likely to buy insurance are also most likely to file

claims

Adverse Selection

• The seller of a used car has more information on the true condition of a car

than does a potential buyer

• The prices that potential buyers are willing to pay reflect the buyers’ lack of

complete information on the true condition of the car

•Because of asymmetric information, the used car market adversely selects the cars that will be offered for sale

The Problems of Adverse Selection and Moral Hazard

“Lemons Problems” in Financial Markets

• Consider a stock market example If 90% of the firms in the market are good firms and 10% are lemons, and the good firm’s share of stock is $50, then:

• So, you would be willing to pay $45.50 for a share of stock, but to a good

firm this is below the fundamental value of the stock

• Adverse selection is present in the bond market as well.

• As interest rates on bonds rise, a larger fraction of the firms willing to pay the high interest rates are lemon firms

Credit rationing The restriction of credit by lenders such that borrowers

cannot obtain the funds they desire at the given interest rate

• When lenders ration credit, firms—whether they are good firms or lemons—

may have difficulty borrowing funds

The Problems of Adverse Selection and Moral Hazard

“Lemons Problems” in Financial Markets

Attempts to Reduce Adverse Selection

• Disclosure of information to the SEC reduces the information costs of

adverse selection, but it doesn’t eliminate them for three reasons:

• Some good firms may be too young to have much information for potential

investors to evaluate

• Lemon firms will try to present the information in the best possible light so

that investors will overvalue their securities

• There can be legitimate differences of opinion about how to report some

items on income statements and balance sheets

Attempts to Reduce Adverse Selection

• Private firms have collected and sold information about firms to investors to

reduce adverse selection costs

• Information is collected from sources such as firms’ income statements,

balance sheets, and investment decisions

• Individuals who gain access to the information without paying for it are free

riders

The Problems of Adverse Selection and Moral Hazard

The Use of Collateral and Net Worth to Reduce Adverse Selection Problems

Collateral Assets that a borrower pledges to a lender that the lender may seize

if the borrower defaults on the loan

Net worth The difference between the value of a firm’s assets and the value of

its liabilities

How Financial Intermediaries Reduce Adverse Selection Problems

The information advantage banks gain from relationship banking allows them to

reduce the costs of adverse selection and explains the key role banks play in

providing external financing to firms

Relationship banking The ability of banks to assess credit risks on the basis

of private information about borrowers

The Problems of Adverse Selection and Moral Hazard

Making the Connection

Has Securitization Increased Adverse Selection Problems in the

Financial System?

• In the episode involving Goldman Sachs’s Abacus CDOs, one of the buyers, IKB, expected Abacus to be a good CDO According to the SEC, however, it

was designed to be a lemon

• The Abacus CDO resulted from the process of securitization, which involves

bundling loans, such as mortgages, into securities that can be sold in

financial markets

• The increase in securitization may have led to an increase in adverse

selection Securitization and the originate-to-distribute business model may

reduce banks’ incentive to distinguish between good borrowers and lemon

borrowers

Solved Problem 9.2

Why Do Banks Ration Credit?

During the spring of 2010, an article in the Economist magazine claimed

that small businesses are not getting access to credit

a Why would banks be unwilling to make loans to small businesses?

If the banks believe some of the loans are risky, why wouldn’t they just

charge a higher interest rate to compensate for the risk?

b Does it matter that the period involved here was shortly after the end of

a deep recession?

The Problems of Adverse Selection and Moral Hazard

Solved Problem 9.2

Why Do Banks Ration Credit?

Solving the Problem

Step 1 Review the chapter material.

Step 2 Answer part (a) by explaining how raising interest rates on loans can

increase adverse selection problems for banks.

High interest rates may attract less creditworthy borrowers A small business that is close

to declaring bankruptcy may be less concerned about having to pay a high interest rate

than would a borrower in better financial health.

Step 3 Answer part (b) by discussing whether it mattered that the period involved

was near the end of a deep recession.

During a recession, the financial health of households and firms will deteriorate, and the

number of lemon borrowers rises relative to the number of good borrowers So many

banks engaged in credit rationing by limiting the number of loans they offered rather than

increasing interest rates.

Moral Hazard

Moral Hazard in the Stock Market

• Moral hazard arises because of asymmetric information: The borrower

knows more than the lender does about how the borrowed funds will actually

be used

• The organization of large, publicly traded corporations results in a separation

of ownership from control.

Principal–agent problem The moral hazard problem of managers (the

agents) pursuing their own interests rather than those of shareholders (the

principals)

The Problems of Adverse Selection and Moral Hazard

Moral Hazard in the Stock Market

• Managers have an incentive to underreport profits so that they can reduce

dividends and retain the use of the funds

• To reduce this problem, the SEC requires managers to issue financial

statements

• Boards of directors meet infrequently and may not be independent of top

managers

• Some boards of directors use incentive contracts to align the goals of

managers with the goals of shareholders

• Compensation tied to the firm’s profits, however, may lead managers to

undertake risky investments

Moral Hazard in the Bond Market

• There is less moral hazard in the bond market than in the stock market

• To reduce moral hazard in bond markets, investors insert restrictive

covenants into bond contracts.

Restrictive covenant A clause in a bond contract that places limits on the

uses of funds that a borrower receives

The Problems of Adverse Selection and Moral Hazard

How Financial Intermediaries Reduce Moral Hazard Problems

• Financial intermediaries have evolved to fill the gap left by the

ban on banks making equity investments in nonfinancial firms.

Venture capital firm A firm that raises equity capital from investors to invest

in start-up firms

Private equity firm (or corporate restructuring firm) A firm that raises

equity capital to acquire shares in other firms to reduce free-rider and moral

hazard problems

• A market for corporate control provides a means to remove top management

Making the Connection

Why So Many Ponzi Schemes?

• Ponzi schemes derive their name from Charles Ponzi, an Italian

immigrant who lived in Boston in the 1920s

• Ponzi schemes are an extreme form of moral hazard

• During the financial crisis of 2007–2009, the most spectacular one was

a Ponzi scheme run by Bernard Madoff

• Investors were lured by Madoff because, not only were many legitimate

investments earning high returns, but the ever increasing complexity of

financial securities made the claims of Ponzi schemes seem more

plausible

The Problems of Adverse Selection and Moral Hazard

9.3 Learning Objective

Use economic analysis to explain the structure of the U.S financial system

Figure 9.1 Sources of External Funds to Small- to Medium-Sized Firms

Small- and sized businesses rely

medium-on loans—particularly mortgages—and trade credit as their major sources of external finance.

Conclusions about the Structure of the U.S Financial System

Figure 9.2

External Sources of Funds to Corporations

Three key features of the financial system:

1 Loans from financial intermediaries are the most important external

source of funds for small- to medium-sized firms.

Smaller firms cannot borrow directly from savers because transactions costs are too high; they cannot sell bonds or stocks because of the adverse selection and moral hazard problems that arise from asymmetric information

Conclusions about the Structure of the U.S Financial System

Three key features of the financial system:

2 The stock market is a less important source of external funds to

corporations than is the bond market.

• Most of the trading on the stock market involves existing shares, not new shares of stock

• In recent years, corporations have actually bought back from investors more stock than they have issued

• Moral hazard is less of a problem with debt contracts than with equity contracts

Three key features of the financial system:

3 Debt contracts usually require collateral or restrictive covenants.

• Large household loans use the good being purchased as collateral

• Many corporate bonds also specify collateral

• To reduce moral hazard, both loans and bonds typically contain restrictive covenants

Conclusions about the Structure of the U.S Financial System

• By reducing transactions and information costs, financial intermediaries can

offer savers higher interest rates, offer borrowers lower interest rates, and

still earn a profit

• Commercial banks, investment banks, and other financial firms are

continually searching for ways to earn a profit by expediting the flow of funds from savers to borrowers Some of these ways involve developing new

financial securities

Making the Connection

What Was the Problem with the Abacus CDOs?

• According to the civil fraud complaint the SEC filed against Goldman Sachs, potential purchasers of the CDO would be unknowingly buying a security

that had been constructed to fail

• The SEC argued that Goldman Sachs had an obligation to inform the other

potential investors that Paulson & Co intended to buy CDS contracts on the

CDOs after they were issued

• Goldman argued that it was not actually selling the CDOs but was instead

acting as a market maker in them

• Because the information costs of these securities are very high, they lack

transparency Goldman Sachs, in testimony before Congress, agreed that it

would be appropriate for the SEC to monitor the sale of complex securities,

such as the Abacus CDOs, more closely

Conclusions about the Structure of the U.S Financial System

Answering the Key Question

At the beginning of this chapter, we asked the question:

“Why do firms rely more on bonds than on stocks as a source of external

finance?”

We have seen that both the bond market and the stock market are subject to

problems of moral hazard In both cases, investors have to be concerned that

firms will not use received investment funds for their intended purpose

The problem of moral hazard is considerably less serious, though, when an

investor buys a firm’s bonds than when the investor buys a firm’s stock As a

result, investors are more willing to buy bonds than stock, which explains why

bonds are a more important source of external finance for firms

AN INSIDE LOOK AT POLICY

Ratings Downgrades Happen Too Late for Investors in Mortgage-Backed Securities

WALL STREET JOURNAL, Abacus Deal: As Bad As They Come

• Less than one year after the deal was completed, all the bonds that were

selected for Abacus 2007-AC1 were downgraded

• Ratings agencies contributed to the financial crisis by placing their highest

ratings on the Abacus deal and others like it

• The firm, Paulson & Co., specifically chose mortgage bonds that were likely

to go bad, and it bet against the deal

• Those who bought Abacus 2007-AC1 and other CDOs were the victims of

this asymmetric information

• The complexity of the deals made it difficult even for highly knowledgeable

investors to evaluate their worth

Key Points in the Article

AN INSIDE LOOK AT POLICY

In February 2008, ratings agencies downgraded nearly all the assets (including

the 90 mortgage bonds in Abacus 2007-AC1) that were packaged to form five

CDOs