Presentation on theme: "The Principal-Agent and Moral Hazard Problem"— Presentation transcript:
1 The Principal-Agent and Moral Hazard Problem Zach Bishop Brian Lee Jonathan Mascolo Nicole Lee David Van Buren Hoa Pham
2 Moral Hazard in Equity Contracts The Principal-Agent Problem
3 Equity contracts: claims to a share in the profits and assets of a business. example: common stockA particular type of moral hazard that results from equity contracts is the principal-agent problem.
4 Principals: all the stockholders Principals: all the stockholders. They own the majority of a firm’s equityAgents: the managers that only own a small percentage of the firm.The moral hazard occurs when agents don’t try to maximize profits because they only receive a fraction of what the principals receive for the profits.
5 The Ice Cream ExampleYour 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.
6 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.
7 The moral hazard from principal-agent could be even worse because there is a chance that Steve pockets all the profits as cash and tells you that there were no profits this year.A more complicated real life example would be Steve buying other firms that increase his power but do not increase profits at all.The main problem is that the principals do not know completely what the agents are doing.
8 The Enron Scandal and Moral Hazard Enron, the 7th 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.Largest U.S. buyer/seller of natural gas and electricity.Enron heavily involved in energy brokering, electronic energy trading, global commodity and options trading, etc.
9 Enron’s Schemes: Enron senior management used complex and murky accounting schemesreduce Enron’s tax paymentsinflate Enron’s income and profitsinflate Enron’s stock price and credit ratinghide losses in off-balance sheet subsidiariesengineer off-balance sheet schemes to funnel money to themselves, friends, and familymisrepresent Enron’s financial condition in public reports
10 Remedies to the Situation Reform of Generally Accepted Accounting Practices (GAAP) Prior to 2002.Separation of Auditor and Company.Reform of company regulation.Management liable for company reports.Sarbanes-Oxley Act (SOX) of 2002U.S. legislative response to reform accounting procedures.Rules and regulations concerning auditing.
11 Ways to help solve the principal-agent problem There are four ways to help resolve Principal-Agent Problem:Production of Information: MonitoringGovernment RegulationFinancial IntermediationDebt Contracts
12 Monitoring Monitoring Conflict with monitoring Is a way for the firms to reduce the principal-agent problem.ExpensiveTime consuming
13 Government Regulation Government sets up Laws.Standard accounting principlesCriminal penaltiesStiff laws on hiding and stealing profitsProblems with RegulationThe main purpose of government regulation.
14 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.
15 Debt Contracts A debt contract helps regulate mangers Verify the firm’s profitsA debt contract is a contractual agreement by the borrow to pay the lender fix dollar amount.
16 Financial StructureThese four tools help shape the financial structure in the United States.They help share information to the publicThey regulate firms from trying to hide profitsThey reduce managers from only benefiting themselvesHelps to keep the firms and the public on equal grounds
17 Moral Hazardthe risk that one party to a transaction will engage in behavior that is undesirable from the other party’s point of view.
18 How Moral Hazard Influences Financial Structure in Debt Markets Debt Contracts are still subject to moral hazard even with the advantagesBorrowers have an incentive to take on investment projects that are riskier than lenders would like.
19 Moral Hazard RisksIt’s a very risky investment but if Steve is successful then he has a strong incentive to take on the riskier investment.You on the other hand, would be unhappy because if Steve were unsuccessful, then you would lose all your money you lent him.
20 Tools to Help Solve Moral Hazard Net Worth and CollateralMonitoring and Enforcement of Restrictive CovenantsFinancial Intermediation
21 Net Worth and Collateral When borrowers have more at stake because their net worth is high or the collateral they have pledged to the lender is valuable
22 A Solution that High Net Worth and Collateral Provides to the Moral Hazard Problem Make the debt contract incentive compatibleincentive-compatible: having the incentives of both parties to a contract in alignment
23 Monitoring and Enforcement of Restrictive Covenants Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior
24 Forms of Covenants to discourage undesirable behavior to encourage desirable behaviorto keep collateral valuableto provide information
25 Covenants to discourage undesirable behavior Function in two forms:- restricting the use of money so that it can only be used on certain criteria- barring the use of the capital so it can not be used for certain purposes.
26 Covenants to encourage desirable behavior. Require a firm to maintain certain good business practices, such as minimum holdings and insurance.
27 Covenants to keep collateral valuable Require proper protection of the asset, an example would be homeowners insurance as part of a mortgage
28 Covenants to provide information Require the provision of information by the borrower to the lender, making it easier to monitor the firm.
29 Corporate Scandal of 2002 Moral hazard and principal-agent problem. How Tyco and WorldCom got into trouble?
30 Characteristics Agent: Greedy CEOs and CFOs Principal: corporate workers and investorsLax Monitoring: insufficient auditingLack of leadershipStrong incentives for committing fraudConsider their companies as piggy banks
31 International TycoCEO Kozlowski was accused of looting $170 million for extravagant lifestyle from Tyco and obtaining $430 million by fraud in the sale of company shares.Often asked the board for loan and forgiven later.Both CEO and CEFO conspired to falsify the financial statements to inflate stock.
32 WorldComCEO Bernard Ebbers was under pressure due to margin calls because the his WorldCom's stock was declining.Asked the boards for personal loan and guarantee of 400 millions.CFO Scott Sullivan also cooked the book to boost the WorldCom's stockInternal audit uncovered 3.8 billions of the fraud.The SEC launched investigation and WorldCom declared bankruptcy.
33 Consequences Stocks became worthless Thousand of workers were out of job and lost pensionInvestors lost moneyCEOs and CFOs were convicted for fraud and theft, each was sentenced 25 years or moreCorporate oversight and accounting reforms were initiated and enforcedOther example: Enron, Adelphi, Global Crossing, etc.