Thursday, October 30, 2008

Agency Costs and the Financial Crisis

A number of my friends here in Silicon Valley have asked me about my thoughts on the financial crisis because they figured that a former investment banker might have an opinion. Some asked if marking to market was a culprit and others asked me why saving AIG made sense. The answers to these questions were: no, while marking to market is a problem, the only worse thing is not marking to market, and if AIG hadn't been bailed out, the entire financial system (worldwide) would have collapsed. AIG had so many credit default swaps and other exotic insurance products that the cost of capital would have sky rocketed, making the moves to LIBOR we have seen look positively mild.

I said I would write about agency costs and the financial crisis. Wikipedia does a nice job defining agency cost, "An agency cost is an economic concept on the cost incurred by an organization that is associated with problems such as divergent management-shareholder objectives and information asymmetry." If this is still abstract, perhaps an example will help. Let's take an employee, Mr. Hustle, a VP of Marketing at Company X. Mr. Hustle has a budget of $1M. Although it's December and he has only spent $650K of his budget, and he doesn't need to really spend the last $350K, his incentive is to spend every last dollar of his $1M budget. Why? Because if he doesn't spend it, he might have a smaller budget allotted to him next year, and a smaller budget means fewer resources, less power, etc. to Mr. Hustle. This is a classic agency problem. The agent here, Mr. Hustle, is using organizational resources for his own benefit. The classic means of addressing agency problems is to turn agents into principals by giving them stock options, thereby aligning executive interests with shareholder interests.

What happened on Wall Street is a classic agency problem. Well, it didn't just happen on Wall Street. It started with the mortgage broker. The broker didn't care if a lender could make payments or not because he/she got paid fees whether or not the lender was a good credit risk. Then the banks who owned the mortgages decided to offload the risk in questionable loans by securitizing them with some help from the investment banks. So, one could aver that the bank didn't care that it was a poor loan because the bank would minimize its risk. The investment bankers made money by structuring/originating the instruments and then made more money by selling them. They didn't care whether or not the lender made the payments because they got paid on the origination and on the sale of the product. Moreover, the banks then placed bets on whether or not people who took out the mortgages could pay them. Some of these loans had leverage of 40:1 because of these bets. That's agency cost, on top of agency cost on top of agency cost. Unfortunately, these agency costs will be incurred by us all, not just by the poor shareholders in Mr. Hustle's company.

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