Financial Innovation
Information Asymmetry
P.V. Viswanath
Summer 2007
Information Asymmetry and
Adverse Selection
Information Asymmetry between the two
parties to a trade sometimes prevents the
occurrence of that trade, even if it is potentially
beneficial to both parties.
This is also termed adverse selection.
An example of adverse selection is when
people who are high risk buy insurance
because the insurance company doesn’t know
that they are high risk. If this is a pervasive
phenomenon, insurance companies might
refuse to write such policies.
Information Asymmetry
Another classic case is with used cars: the owner of
the used car knows much more about the car than the
buyer.
The buyer therefore has to discount the value of the
car to take into account this additional risk.
Effectively, if the owner is willing to sell for $10,000,
the buyer says: it must be worth less, else why is he
willing to sell so low, and asks for a lower price.
But if the seller agrees, then the same argument
applies again, and the buyer would have to demand a
lower price.
It can happen, then,that no price is acceptable to both
parties.
Moral Hazard and Agency Costs
Many problems in finance have to do with
the fact that mutually desirable trade
(investment) does not occur because of an
agency problem, also known as moral
hazard.
Because of agency costs, if the parties
traded, they would end up incurring
unnecessary costs by acting in ways that
they would have avoided in the absence of
the trade.
Insurance
The classic example is that of insurance.
Suppose that the local insurance company
introduces fire insurance to your
neighborhood, and you can now buy fire
insurance for your home.
The insurer looks at the historical
probability of fire in houses like yours in
your neighborhood and quotes you a
premium.
Insurance & Moral Hazard
But now that you have fire insurance, you don’t
have the same incentive to protect your home
from fire, particularly if it will involve your
spending money that will not be reimbursed by
the insurance company, such as for fireresistant paint.
This is a problem if the expected damage from
fire due to not having fire-resistant paint (say,
$D) is lower than the cost of the paint (say $C).
This is a problem if the expected damage from
fire due to not having fire-resistant paint (say,
$D) is lower than the cost of the paint (say $C).
Insurance and Moral Hazard
This means that the insurance company must
now charge you a higher premium, of at least $D
to be compensated for the higher chance of fire.
Hence, you end up paying $D in higher
premiums, instead of $C (which is less than $D)
in higher paint costs.
The market for ins might even dry up!
(Assumption: the ins co cannot check up on
whether you practice optimal risk management.)
What’s the solution?
Deductibles? Co-insurance?
Adverse Selection and Moral
Hazard
Adverse Selection and Moral Hazard both
derive from information asymmetry.
However, adverse selection has to do with the
inability of one party to observe the current
status of the other party – prior to the trade.
Moral Hazard occurs because one party
cannot observe the actions of the other party
during their contractual relationship and
hence cannot perfectly verify performance.
High cash-down mortgages
Green Point Mortgage Co. in 1997
started making loans based on how
much the borrower can put down.
With large down payments, borrowers
have a greater incentive not to default.
Else, it would take longer for borrowers
to build up equity.
Information Asymmetry and
Equity Issues
When a firm issues stock, the market
frequently marks the stock price down.
Since the firm could have issued debt,
but chose not to, investors infer that
the stock must be currently overpriced
to make a stock issue attractive to the
firm.
Putable Stock
This is stock that can be sold back to
the issuer at the option of the holder.
Reduces the information asymmetry
problem involved in stock issues.
Signals that reasons other than
overvaluation of stock are key to the
stock issue.
Bear Stearns MBS deal
Standard MBSs pool mortgages of different
kinds, and do not provide much information
on subsets of the pool.
The new BS issue (October 1999) is an IO
deal that creates tranches on the basis of
coupon rates.
This allows investors to estimate prepayment
risk much more precisely.
This means that investors do not have to
price the issue lower because they have less
information than the issuer and have to
assume the worst.
Decoupling credit and interest risk
In Feb. 1999, Chicago Federal Home Loan
Bank started its Mortgage Partnership Finance
Program.
Usually when loans are sold to FNMA or
Freddie Mac, both credit and interest rate risk
are sold.
The originating bank can evaluate credit risk
better; hence there is a problem of
information asymmetry. If credit risk cannot
be correctly priced, the bank may not be able
to sell the loans and may end up taking too
much risk.
In the MPF program, only interest rate risk is
sold.
Project Financing
Project financing separates a single
project from the rest of the firm.
Payments to the lender are made only
from the cashflows generated by the
project.
Hence, information asymmetry
regarding the rest of the firm is
irrelevant.
Tracking Stock
By separating the firm into parts
without decoupling its operations,
tracking stock tries to reduce
information asymmetry, while keeping
economies of scale and operating
synergies.
This is akin to project finance. In this
case, the target investor is an equity
investor.
Leverage and excessive risk-taking: I
The existence of debt introduces
incentives for the firm to take excessive
risk.
Example: Consider these two projects
faced by a firm with a promised
payment of $500,000 to debtholders.
There are only two possible states of
the world, both equally likely.
Leverage and excessive risk-taking: II
Payoffs to the two projects
Prob. Proj. 1
Proj. 2
State 1
0.5
$600,000 $1,000,000
State 2
0.5
$600,000 $0
Expected
Value
$600,000 $500,000
Proj. 1 is better for the entire firm
Leverage and excessive risk-taking: III
Payoffs to the bondholders
Prob. Proj. 1
Proj. 2
State 1
0.5
$500,000
$500,000
State 2
0.5
$500,000
$0
$500,000
$250,000
Expected
Value
Proj. 1 is better for bondholders
Leverage and excessive risk-taking: IV
Payoffs to the equityholders
Prob.
Proj. 1
Proj. 2
State 1
0.5
$100,000
$500,000
State 2
0.5
$100,000
$0
$100,000
$250,000
Expected
Value
Proj. 2 is better for equityholders
The reason for the bad choice is that stockholders do
not share in the upside but share in the downside.
Excessive risk and convertible debt
Convertible debt might solve the
excessive risk taking problem.
It gives bondholders the option to
convert in good states and allows them
to share in the firm’s prospects.
This reduces shareholders’ incentives to
increase the firm’s riskiness because
sharing between bondholders and
stockholders is more symmetric.
Potential problem: renegotiation-proof?
Discounted Stock Purchases
In August, 1999, Hudson United
Bancorp introduced a discounted stock
purchase program for long-time clients.
This aligns bank and client objectives
and reduces moral hazard.
Question: Is this renegotiation-proof?
Debt Overhang
Consider a firm with $4000 of principal and
interest payments due at the end of the year
(assume $3500 lent at 14.29% stated). If
there is a recession, it will be pulled into
bankruptcy because its cash flows will be only
$2400. Else, it will have cash flows of $5000.
The firm could avoid bankruptcy in a recession
by raising new equity to invest in a new
project (soon after beginning). The project
costs $1000 and brings in $1400 in either
state and has an NPV > 0.
Recession and Boom states are equally likely.
Will it do the right thing and raise new equity
funds?
No equity solution
Firm Without Proj Firm With Proj
Firm
Cashflows
Bondholders’
payoff
Boom
Recession Boom Recession
5000
2400
6400
3800
4000
2400
4000
3800
0
2400
0
Stockholders’ 1000
claim
The new project will not be undertaken. Stockholders
have on av. $500 without the project, and $200 with the
project [(2400)/2 – 1000].
And maybe no debt solution
Firm W/o Proj
Firm W/ Proj
Boom Recesn Boom Recesn
5000
2400
6400
3800
Firm
Cashflows
Bondholders’ 4000
payoff
Stockholders’ 1000
claim
2400
5429
3800
(4000+
1000x1.
1429)
0
971
0
Equityholders won’t want to borrow money on the original terms
either; it still won’t be worthwhile.
Debt Overhang: Senior Debt
One Solution:
Suppose the new project could be
financed separately, say, under debtorin-possession financing, or a new issue
that would be senior to the previous
issue (at 10.5%).
Then, the new project would be
undertaken; and bondholders would be
better off.
Senior Debt/Project Financing
Firm W/o Proj
Firm With Project
Boom Recesn
Boom
Recesn
Firm
5000
Cashflows
Sr
0
Bondholdr
Jr
4000
Bondholdr
2400
6400
3800
0
1050
1050
2400
4000
2750
Stockholdr 1000
0
1350
0
Debt Overhang: Loan Commitments
Two stage financing structured as a loan commitment.
Fee = $150 plus 110% of draw-down.
Tot Ret for bondholders (w/proj) =
0.5(5100/4500)+0.5(3800/3500)=10.95%
Firm W/o Proj
Firm W/ Proj
Boom
Recess’n Boom
Recess’n
Firm Cashflows
5000
2400
Bondholders’
claim
4000
2400
(3500x1.10
+150)
5100
3800
(4500x1.10
+150)
Stockholders’
claim
1000
1300
0
6400
3800
0
Loan Commitments
This works because part of the payoff is
independent of the amount borrowed.
This allows the “interest” rate to be
smaller.
As a result, the disincentive to borrow
isn’t as large, when a good project
turns up.
Movie financing
CineVisions Ice, run by Peter Hoffman and
Graham Bradstreet, provides insurancebacked 'gap' financing for motion picture
productions.
Insurers underwrite a "layer" of bank loans
that make up part of the financing package
for a slate of films
If the movies don't meet the expected
revenues during the lifetime of the policies,
the insurers pay the claims to the banks.
Movie Insurance
Normally, films are risky to insure, but in this
case, because there is a slate of films, the
cross-collateralization makes it less risky.
This then takes more risk out of the
financing, as well.
In addition, insurance would provide negative
incentives to producers.
Hence CineVision has high deductibles and
requires producers to take larger equity
stakes so they'll have a tangible incentive to
make commercial winners.