Download Week 2: Information Risk and Corporate Governance

Week 2: Information Risk and Corporate Governance
I. Systemic Risk and Moral Hazard
Systemic Risk: The risk that one key firm failing will cause a chain reaction
throughout the economy. In finance, systemic risk is the risk of collapse of an entire
financial system or entire market, as opposed to risk associated with any one
individual entity, group or component of a system. It can be defined as "financial
system instability, potentially catastrophic, caused or exacerbated by idiosyncratic 1
events or conditions in financial intermediaries".
Measurement of systemic risk:
1. Too Big To Fail test: The traditional analysis for assessing the risk of required
government intervention is the TBTF, which can be measured in terms of an
institution’s size relative to the national and international marketplace, market
share concentration (e.g., Herfindahl-Hirschman Index), and competitive barriers
to entry or how easily a product can be substituted.
2. Too Interconnected to Fail test: at the heart of most recent federal financial
emergency relief decisions, TICTF is a measure of the likelihood and amount of
medium-term net negative impact to the larger economy of an institution’s failure
to be able to conduct its ongoing business. The impact is measured not just on the
institution’s products and activities, but also the economic multiplier of all other
commercial activities dependent specifically on that institution.
Regulation:
Systemic risk, also called market risk or un-diversifiable risk, is a risk of security that
cannot be reduced through diversification. One of the main reasons for regulation in
the marketplace is to reduce systemic risk. However, regulation arbitrage - the
transfer of commerce from a regulated sector to a less regulated or unregulated sector
- brings markets a full circle and restores systemic risk2.
Moral Hazard:
1. Individual level: a CEO takes high risks because he/she knows the government
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The idiosyncratic risk (unsystematic risk) is the risk of price change due to a specific security, as
opposed to the overall market. This risk can be eliminated from a portfolio through diversification.
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For example, the banking sector was brought under regulations in order to reduce systemic risks.
Since the banks themselves could not give credit where the risks (and therefore returns) were high, it
was primarily the insurance sector which took over such deals. Thus the systemic risk migrated from
one sector (bank) to another (insurance) and proves that regulation of only one industry cannot be the
sole protection against systemic risks.
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will step in if things go wrong.
2. Firm level: If a firm knows the government will bail them out, they have an
incentive to take extra risk. If the risky situation pays off, the firm prospers. If
there is a poor result, the firm does not suffer the full loss because the government
will prevent bankruptcy.
II. History of Bailouts & Financial Crisis 2007
1. 1929-mid-1930s: during the Great Depression, the economy contracted severely
causing record unemployment and a large number of corporate and bank failures.
Ever since, economists have debated actions that might have limited the severity
of the Great Depression. One solution is to prevent key firms or banks from going
bankrupt because this would stop the “domino effect” .
2. 1930s-2000s: Over the years, there have been several such bailouts3.
3. Financial Crisis of 2007:
Triggered by falling housing prices:
Figure 10.2
Housing Prices
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Housing Price Index
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California
Florida
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Kansas
New York
100
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
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Securitization of Mortgage Loans: Most large banks and investment banks were
heavily involved in the residential real estate sector. Real estate loans were
packaged by lenders (banks) into pools sold to investors4.
Examples: U.S. Auto Industry (late 70’s to early 80’s); Long Term Capital Management (large
investment fund) (1998); Airline Industry (2001).
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Investors’ demand was high for bonds backed by mortgages because they paid higher interest than
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Falling housing prices → borrowers (residents) unable to pay for the lenders
(banks) → foreclosures → value of mortgage loan securities decline → banks
value (stock prices) decline → banks insolvency (to the investors)5.
Once foreclosures 6 on houses increased, many banks and investment banks
quickly became insolvent (as their stock prices fell). Insolvency of biggest
financial players put world financial market on brink of complete collapse.
Along with securitization, other financial products called Credit Default Swaps
(CDS) tied the fortunes of major banks and investment banks together. A CDS is a
form of insurance which protects the buyer of the CDS in the case of a loan
default. If the loan defaults, the buyer of the CDS can exchange the defaulted loan,
or in some CDSs the reduced cash value of the defaulted loan, for the face value
of the loan.
→ value of mortgage loan securities decline → investors request exchanges →
banks insolvency (to the investors)7.
Financial reporting insights:
1. For global investors, high information risk was included in mortgage loan
securities reported?
2. Securitization of mortgage loans: differ if measured by fair value or historical
cost accounting?
Bailouts in the Banking Industry: banks play a key role in the economy because
bank lending acts as a multiplier for the money supply. If banks stop lending or
are forced to call in loans, this has a direct effect on growth in the economy.
Federal government guarantees of customer deposits and federal intervention to
could be earned in U.S. T-bills and they were allegedly as safe.
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Bear Stearns & Lehman Brothers, both investment banks that survived the Great Depression, failed
in 2008. Citigroup, the top bank in the U.S. was essentially insolvent in 2008 as its stock price fell from
$50 to $1.
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The foreclosure process as applied to residential mortgage loans is a bank or other secured creditor
selling or repossessing a parcel of real property (immovable property) after the owner has failed to
comply with an agreement between the lender and borrower called a “mortgage” or “deed of trust”.
Commonly, the violation of the mortgage is a default in payment of a promissory note, secured by a
lien on the property. When the process is complete, the lender can sell the property and keep the
proceeds to pay off its mortgage and any legal costs, and it is typically said that “the lender has
foreclosed its mortgage or lien”.
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Failure of banks and investment banks triggered tens of billions in payments under CDS contracts
AIG, the world’s largest insurer, was made effectively insolvent by the CDS payments.
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prevent one bank failure from spreading to others.
Bailouts by the U.S. Government: The Federal Reserve and U.S. Treasury
responded to the pending collapse by propping up Citi and AIG and with hundreds
of billions of taxpayer dollars8. Congress rushed to approve the Troubled Asset
Relief Program, a $700 billion bailout for other firms to avoid a collapse of
financial markets and start banks lending again.
How bad was the recession?
Figure 10.1
Months of Recession
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Through May of
2009
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16
13
8
11
10
8
10
11
6
8
17
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Aug. May Feb. Nov. July Aug. April Dec. Nov. Jan. July July March Dec.
1929 1937 1945 1948 1953 1957 1960 1969 1973 1980 1981 1990 2001 2007
Date Recession
Begins
III. Corporate Governance Failures
1. Investment Banks: How could Bear Stearns and Lehman survive the Great
Depression but not this crisis?
(1) Compensation scheme for top employees rewards taking risky positions
(2) Cost of firm failing falls on shareholders and not on managers who earned
hundreds of millions in bonuses from taking high risks in a single sector of the
economy
(3) Investment banks were partnerships during Great Depression which meant the
managers were also the owners. In 2008, they were public companies with a
small fraction owned by managers and top employees.
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Freddie Mac and Fannie Mae, two large quasi-governmental housing lenders were bailed out for
about $200 billion.
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2. Banks:
(1) Banks relied on CDS contracts as loan insurance so they could move loans off
their balance sheets and make new loans backed by the same capital.
(2) Executives approved this ever increasing leverage because of the fees earned
from new loans which led to high executive bonuses.
(3) When financial markets collapsed and many CDS contracts became of
questionable value, banks fell below minimum capital requirements and
required bailouts.
(4) Shareholders were the big losers as the equity value in many banks was wiped
out.
3. Moral Hazard in Financial Crisis of 2007-2009?
(1) Compensation contract: High bonus for high profit and zero bonus for loss: the
best strategy over many years is high risk/high reward.
(2) Benefits from risk go to firm; big loss is paid by government.
4. Auto Industry:
The CEOs could produce the most profitable cars and let the government take the
risk of gas prices rising. In 2008, after a period of rising gas prices, gas topped $4
a gallon and the U.S. auto firms were hit hard as they were making primarily large
vehicles. As part of TARP, the government bailed out GM and Chrysler so that
they could restructure and become competitive in building smaller cars.
IV. International Perspective
1. Many international banks and investors owned large investments in bonds backed
by U.S. mortgages; CDS contracts were international as well.9
2. Other countries enacted their own bailout packages to try to avoid a spreading
financial collapse.10
3. Is all the concern about a “domino effect” justified? The experience of Iceland in
the recent financial crisis suggests it is.11
V. Summary
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AIG paid $58 billion to overseas banks to settle CDS contracts.
U.K. bank rescue plan totaled $850 billion.
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All three major banks in Iceland failed following a “bank run” on one bank that spread to the others.
Iceland’s currency and economy quickly collapsed soon after with the stock market losing 90% of its
value.
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1. In response to financial market failures triggered by falling housing prices, the
2.
3.
4.
5.
U.S. government bailed out many firms to try and avoid a major financial
collapse.
Most of the failures that led to bailouts can be traced back to poor corporate
governance as firms had bet their companies survival on a single sector of the
economy.
Were these high risk bets due only to perverse incentives in compensation
contracts or did moral hazard play a role? The effects are hard to separate.
When firms are “too big to fail” some firms appear to take actions that put the risk
of bad outcomes on the government (and ultimately on taxpayers).
The experience of the Great Depression and of Iceland in 2008 suggest that
allowing for cascading failures (the “domino effect”) in financial markets is much
worse than governments stepping in to bailout firms that are “too big to fail”.
For accounting research:
1. The transparency of financial reporting: information risk has been reflected in
current disclosure requirements?
2. The effects of corporate governance mechanism: can those charged with
governance effectively reduce such information risk?
3. Executive incentives, compensation contracts and behavior on ethical decision
making.
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