Financial Innovation Information Asymmetry

1
Financial InnovationInformation Asymmetry

• P.V. Viswanath
• Summer 2007

2
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 doesnt know that they are high
  risk. If this is a pervasive phenomenon,
  insurance companies might refuse to write such
  policies.

3
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.

4
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.

5
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.

6
Insurance Moral Hazard

• But now that you have fire insurance, you dont
  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 fire-resistant
  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).

7
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.)
• Whats the solution?
• Deductibles? Co-insurance?

8
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.

9
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.

10
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.

11
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.

12
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.

13
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.

14
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.

15
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.

16
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.

17
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
18
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
Expected Value 500,000 250,000
Proj. 1 is better for bondholders
19
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
Expected Value 100,000 250,000
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.
20
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
  firms prospects.
• This reduces shareholders incentives to increase
  the firms riskiness because sharing between
  bondholders and stockholders is more symmetric.
• Potential problem renegotiation-proof?

21
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?

22
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 gt 0.
• Recession and Boom states are equally likely.
• Will it do the right thing and raise new equity
  funds?

23
No equity solution
Firm Without Proj Firm Without Proj Firm With Proj Firm With Proj
Boom Recession Boom Recession
Firm Cashflows 5000 2400 6400 3800
Bondholders payoff 4000 2400 4000 3800
Stockholders claim 1000 0 2400 0
The new project will not be undertaken.
Stockholders have on av. 500 without the
project, and 200 with the project (2400)/2
1000.
24
And maybe no debt solution
Firm W/o Proj Firm W/o Proj Firm W/ Proj Firm W/ Proj
Boom Recesn Boom Recesn
Firm Cashflows 5000 2400 6400 3800
Bondholders payoff 4000 2400 5429 (40001000x1.1429) 3800
Stockholders claim 1000 0 971 0
Equityholders wont want to borrow money on the
original terms either it still wont be
worthwhile.
25
Debt Overhang Senior Debt

• One Solution
• Suppose the new project could be financed
  separately, say, under debtor-in-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.

26
Senior Debt/Project Financing
Firm W/o Proj Firm W/o Proj Firm With Project Firm With Project
Boom Recesn Boom Recesn
Firm Cashflows 5000 2400 6400 3800
Sr Bondholdr 0 0 1050 1050
Jr Bondholdr 4000 2400 4000 2750
Stockholdr 1000 0 1350 0
27
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/o Proj Firm W/ Proj Firm W/ Proj
Boom Recessn Boom Recessn
Firm Cashflows 5000 2400 6400 3800
Bondholders claim 4000(3500x1.10150) 2400 5100 (4500x1.10150) 3800
Stockholders claim 1000 0 1300 0
28
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 isnt as
  large, when a good project turns up.

29
Movie financing

• CineVisions Ice, run by Peter Hoffman and Graham
  Bradstreet, provides insurance-backed '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.

30
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.