Financial InnovationInformation Asymmetry

P.V. ViswanathSummer 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 AsymmetryAnother 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.

InsuranceThe 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 HazardBut 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 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).

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 StockThis 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 dealStandard 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 FinancingProject 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 StockBy 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

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

Payoffs to the two projects

Proj. 1 is better for the entire firm

Payoffs to the bondholdersProb. 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

Leverage and excessive risk-taking: III

Proj. 1 is better for bondholders

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

Leverage and excessive risk-taking: IV

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 OverhangConsider 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

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].

And maybe no debt solution

Firm W/o Proj Firm W/ Proj

Boom Recesn

Boom Recesn

Firm Cashflows

5000 2400 6400 3800

Bondholders’ payoff

4000 2400 5429(4000+1000x1.1429)

3800

Stockholders’ claim

1000 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 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.

Senior Debt/Project Financing

Firm W/o Proj 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

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 6400 3800

Bondholders’ claim

4000(3500x1.10+150)

2400 5100(4500x1.10+150)

3800

Stockholders’ claim

1000 0 1300 0

Loan CommitmentsThis 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 financingCineVisions 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.

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.