Wednesday, April 7, 2010

moral hazard revisited

Alex Tabarrok draws attention to a paper by Richard Squire in the Harvard Law Review:

If liability on a firm’s contingent debt is especially likely to be triggered when the firm is insolvent, the contract that creates the debt transfers wealth from the firm’s creditors to its shareholders. A firm therefore has incentive to engage in correlation-seeking — that is, to incur contingent debts that correlate, or that through asset purchases can be made to correlate, with the firm’s insolvency risk. The consequence is an overuse of contingent debt that destroys social wealth through overinvestment, higher borrowing costs, financial distress, and potential systemic risk. Correlation-seeking is especially pernicious because, unlike other forms of shareholder opportunism such as asset substitution, it can reduce risk to shareholders even as it increases shareholder returns.

AT: It's long been known that a firm close to bankruptcy has an incentive to gamble because if the gamble pays off the shareholders prosper and if the gamble fails then the shareholders are no worse off (since the firm was already close to bankruptcy). But gambles like this add to shareholder value primarily by transferring wealth from the creditors who bear the downside risk without any hope of upside gain.

Squire shows how this idea is magnified when we add contingent debt and correlated asset returns. A contingent debt is one that must be paid only in certain states. If the shareholders take on contingent debt and at the same time buy assets with low or negative payoffs in the same set of states then the shareholders can focus the downside risk into the states in which they are bankrupt anyway - thus focusing the downside risk onto unsecured creditors. (the rest here)

[a commenter adds: As firms get closer to insolvency, managers and directors become exponentially more sensitive to risk of personal liability and thus much more conservative. Further, creditors' monitoring increases exponentially as said risk rises (gambles always need a counterparty and they disappear in insolvency situations). The gambles by large firms occur more during times of complacency. -- MR, as so often, indispensable for supposedly unfun things]

1 comment:

Anonymous said...

Morales wrote this as the intro to his "Creditism - The Global Credit Economy" global economic theory back in 2003.
The dangers of credit use and expansion have been suggested through the works of authors and playwrights for thousands of years. In sources ranging from the Christian Bible to more recent works such as David Harvey’s “The New Imperialism” these warnings about credit have been clearly stated. Countries participating in the Global Economy, even those with comparative skills, like technologies, and natural endowments enjoy different level of access to world credit markets. These uneven conditions have been brought about by a new Imperialist Credit Culture, which has taken root and is hidden in the imperfections of the once powerful capitalist economic system. In this work the source of control will be refer to as the International Credit Consortium (I.C.C.); this I.C.C. while avoiding any risk of association for the “Moral Hazard” (“Moral Hazard” Horkheimer/Adorno) of:

(1) involving labor markets of periphery and semi- periphery
(2) Economic systems - behind a vial of international cooperation.

The World Trade Organization (W.T.O.) supports a disassociation of human/world culture responsibilities for those countries, each counties, populations are only the responsibility of their domestic governments and not the ICC even though use of labor and commodity resources are gathered and used by these multinationals removing power and economic influences from local governments and populations. The Consumer market of the United States - “The Core Economy” (The Capitalist World-Economy Immanual Wallenstein: 1979), which is now based upon consumption value and not labor value of the individuals in this market place – serves only as a source of credit value and neither collects real-values of capital nor production at any level.

Perhaps, could he have spelled, someone would have noticed in time?