17-08-2014, 03:20 PM
MORAL HAZARD (Extract)
One might surmise that, like matter, risk is inherent and cannot be created or destroyed. However, the choices of our corporate decision makers can actually amplify risk, while shareholders, as the residual claimant, are often left holding the bag.
To better understand this, we must define some terms. Economists label decision makers “agents,” acting on behalf of those they represent, their “principals.”
For publicly traded companies, these principles are the shareholders, sometimes called the residual claimants because they receive any profits left after all factors and accounts payable are paid, and debt-holders are paid off, too. Any residual that is left goes to shareholders. If there is nothing left, a corporation is declared insolvent and prone to reorganization or liquidation in bankruptcy court. In that case the residual claimant receives any remaining assets once everyone else is paid.
The principal-agent problem sets us up for some serious problems that no economic theory has successfully solved completely. To give us a sense of this principal-agent problem, let me relate to you a true story told to me by a former Fortune 500 chief executive officer who is now an ethics professor at a business school.
In his chief executive officer days, he received a presentation from his finance department regarding a new investment strategy. It depended crucially on housing prices. The young finance stars told him how much money the company would make if housing prices went up by 5 %. They also calculated what would happen if housing prices went up by 10% or even 15%.
Frustrated, the CEO asked them what would happen if housing prices went down. They said the model does not include that scenario because housing prices never go down. Within their realm of experience, they were correct.
Until 2007, housing prices at the national level rose consistently every year.
Incredulous, the CEO asked them why they would propose a plan that, if successful, could earn these young bucks millions of dollars in bonuses, but if it failed, could destroy the company and investment of thousands of shareholders. Of course, if the firm went bankrupt, all that would happen to the finance whizzes is they’d have to find a new job.
This story, in a nut shell, describes the Moral Hazard problem. When the decision makers do not face the brunt of the risk they generate, there is a serious, and sometimes tragic, mis-connect.
NB:
So when we invest in a publicly traded stock (aka becomes shareholder), should we take this MORAL HAZARD problem of a company in to account too?
In US, it is how Privatized Gain and Socialized Loses come about due to moral hazard throw out of the window.
One might surmise that, like matter, risk is inherent and cannot be created or destroyed. However, the choices of our corporate decision makers can actually amplify risk, while shareholders, as the residual claimant, are often left holding the bag.
To better understand this, we must define some terms. Economists label decision makers “agents,” acting on behalf of those they represent, their “principals.”
For publicly traded companies, these principles are the shareholders, sometimes called the residual claimants because they receive any profits left after all factors and accounts payable are paid, and debt-holders are paid off, too. Any residual that is left goes to shareholders. If there is nothing left, a corporation is declared insolvent and prone to reorganization or liquidation in bankruptcy court. In that case the residual claimant receives any remaining assets once everyone else is paid.
The principal-agent problem sets us up for some serious problems that no economic theory has successfully solved completely. To give us a sense of this principal-agent problem, let me relate to you a true story told to me by a former Fortune 500 chief executive officer who is now an ethics professor at a business school.
In his chief executive officer days, he received a presentation from his finance department regarding a new investment strategy. It depended crucially on housing prices. The young finance stars told him how much money the company would make if housing prices went up by 5 %. They also calculated what would happen if housing prices went up by 10% or even 15%.
Frustrated, the CEO asked them what would happen if housing prices went down. They said the model does not include that scenario because housing prices never go down. Within their realm of experience, they were correct.
Until 2007, housing prices at the national level rose consistently every year.
Incredulous, the CEO asked them why they would propose a plan that, if successful, could earn these young bucks millions of dollars in bonuses, but if it failed, could destroy the company and investment of thousands of shareholders. Of course, if the firm went bankrupt, all that would happen to the finance whizzes is they’d have to find a new job.
This story, in a nut shell, describes the Moral Hazard problem. When the decision makers do not face the brunt of the risk they generate, there is a serious, and sometimes tragic, mis-connect.
NB:
So when we invest in a publicly traded stock (aka becomes shareholder), should we take this MORAL HAZARD problem of a company in to account too?
In US, it is how Privatized Gain and Socialized Loses come about due to moral hazard throw out of the window.