J. K. Dietrich - FBE 525 - Fall, 2006 Value Creation: Economics, Agency Problems, and Credit...
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Transcript of J. K. Dietrich - FBE 525 - Fall, 2006 Value Creation: Economics, Agency Problems, and Credit...
J. K. Dietrich - FBE 525 - Fall, 2006
Value Creation: Economics, Agency Problems, and Credit
Services
Week 4 – September 14, 2006
J. K. Dietrich - FBE 525 - Fall, 2006
Sources of Value in Financial Services
Where does ultimate value come from? What problems must be solved? What services and can financial institutions
provide? What value is there for investors in
financial services? What determines amount of value extracted
by financial service firms?
J. K. Dietrich - FBE 525 - Fall, 2006
Value Creation in Theory
Value is addition to customers’ expected utility
Increased expected utility comes from– Improvement in intertemporal consumption– Exploitation of investment opportunities– Risk management
Apply each in this discussion
J. K. Dietrich - FBE 525 - Fall, 2006
Inter-temporal Consumption and Investment: Example
Income now $40,000 and in future $45,000 Invest in tuition now and $30,000 future
income with schooling will be $85,000 Interest rate 10% Draw tradeoffs What is current wealth under schooling and
no schooling How can financial services add value?
J. K. Dietrich - FBE 525 - Fall, 2006
Inter-temporal Consumption/Investment
Present Value of Consumption
Con
sum
ptio
n L
ater
$10K $40K $80.9K
$52K
$45K
$87.3K
($85K - $33K)/1.1 + $40KI II III
$96K
$89K
J. K. Dietrich - FBE 525 - Fall, 2006
Risks and Returns:Sample Problem
How can diversification increase expected utility?
How can reducing equity stake increase expected utility?
How can financial service firm add value? What are sources of this value?
J. K. Dietrich - FBE 525 - Fall, 2006
Returns and Risk
Exp
ecte
d R
etur
ns
Variability of Future Returns0
J. K. Dietrich - FBE 525 - Fall, 2006
Principals and Agents Principals are the beneficiaries of wealth, that is, it
is their expected utility that should be maximized Agents undertake activities that can benefit or
harm principals and their expected utility Examples: asset-management, credit, securities
trading Most financial services are covered by contracts
intended to minimize the conflict between principals and agents
J. K. Dietrich - FBE 525 - Fall, 2006
Principal-Agent Problems
Fund/Invest
Produce/Deliver
Take ActionsSelect Contract
Monitor/Control
Market/Inform
Price/Set Terms
Bear/Share Risk
t=0 t=Mt= -K
Adverse Selection Moral Hazard
J. K. Dietrich - FBE 525 - Fall, 2006
Principal-Agent and Information Asymmetry Problems
Who are principals? Who are agents? In previous examples, what are borrowers?
Financial institutions? What are sources of conflicts? Types of information How can you realize value in information?
J. K. Dietrich - FBE 525 - Fall, 2006
Financial Markets
Economic concepts and financial markets
– Marginal revenue and cost
– Substitutes and complements Problems in implementation
– Data
– Market definitions Examples of markets
J. K. Dietrich - FBE 525 - Fall, 2006
Pricing and Terms in Credit
Revolving credit and term loans Interest rates Balances Fees Conditions Real world implementation
J. K. Dietrich - FBE 525 - Fall, 2006
Resources to Provide Credit
Types of human resources Types of information Types of analytical competence Desired sales skills Sources of training/experience
J. K. Dietrich - FBE 525 - Fall, 2006
Activities in Credit(and other financial services)
Setting Terms/Pricing Communicating/Marketing Producing/Delivering Controlling/Monitoring Funding/Investing Risk Bearing/Risk Shifting
J. K. Dietrich - FBE 525 - Fall, 2006
Market Power in Credit(and Other Financial Services)
Rcompetitive
$ Loans
Inte
rest
Rat
e
Cost of Funds
Marginal Return
Marginal Cost of Funds
Market Share with Market Power
J. K. Dietrich - FBE 525 - Fall, 2006
Market Power Requires a Well Defined Market
Geography– Locally isolate markets (e.g. Illinois, etc.)
– Language, customs, legal environment No substitutes, poor competition
– Ability to bear/share risks
– Competitors not interested Retail markets Wholesale markets
J. K. Dietrich - FBE 525 - Fall, 2006
Combinations: Definitions
Merger = Shareholder approved joining of activities of two firms– Friendly– Proxy contest
Acquisition = Buy stock without shareholder or necessarily management approval– Friendly takeover– Hostile takeover
J. K. Dietrich - FBE 525 - Fall, 2006
Types of Combinations Horizontal/Vertical/Conglomerate
– Norwest Bancorporation+Wells+First Interstate, Chase+Chemical, GoldmanSachs+SpearLeeds, many others
– B of A and Nationsbank acquire software firm Meca for home banking
– Mellon Bank+Boston Company+Dreyfus Accounting treatment
– Pooling and stock repurchases– Purchase accounting
J. K. Dietrich - FBE 525 - Fall, 2006
Value in Mergers
Synergies => (A+B) > A + B Revenue synergies
– Cross selling– Market power– Strategic alliances
Cost synergies– Economies of scale and scope– Vertical integration, tax savings, regulation– Unused debt/borrowing capacity
J. K. Dietrich - FBE 525 - Fall, 2006
Possible Revenue Synergies
Changing market for deposits– Reduced deposit demand– Money market mutual funds– New savings vehicles (IRAs and annuities)
Changing markets for credit– Commercial paper and “junk bonds”– Consumer credit and ABS
Problems: Bankers, investment bankers, insurance agents, and brokers different
J. K. Dietrich - FBE 525 - Fall, 2006
Cost Synergies
Larger size or broader operations are used to justify mergers
Redundant investments (branches, systems) Economies of scale
– Difficult to measure with multiple outputs Economies of scope
– Efficiencies depend on combination of outputs All efficiencies depend on resource
flexibility
J. K. Dietrich - FBE 525 - Fall, 2006
Penetration of Financial ServicesMarginal costs
Marginal costs
Marginal costs
Market Demand
Pri
ces,
Cos
ts
J. K. Dietrich - FBE 525 - Fall, 2006
Analyzing Credit Markets:Demand for Credit
Determinants of need for credit --– investment in real assets– liquidity– restructuring
Real asset demand Other demands for credit Review Flow of Funds
J. K. Dietrich - FBE 525 - Fall, 2006
Term Setting and Monitoring in Credit
Terms include both a range of covenants and penalties/costs/sanctions
Chan and Thakor analyze effects of collateral surrendered with non-payment
Diamond stresses value creation from monitoring when a cost can be imposed on borrower
Important is effect on borrower incentives
J. K. Dietrich - FBE 525 - Fall, 2006
Pricing to Create Value
Fees on commitments vs compensating balances– Notion of a separating equilibrium– Separation by different expected to costs of
borrowers of different types
Cos
t of
Bal
ance
s
Balances
Good Credit Risk
Bad Credit Risk
Commitment Fee
Compensating Balance
J. K. Dietrich - FBE 525 - Fall, 2006
Symmetry/Differences Penalty vs. Collateral
Penalty costs borrower but does not provide gain for lender
Collateral costs borrower but does provide gain to lender
Both terms require monitoring to assure value and existence of collateral or satisfaction of other term
Both require control procedures
J. K. Dietrich - FBE 525 - Fall, 2006
Loan Sales and Participations
Principal-agent problems with loan sales– Payoffs to originator reduced– Costs of non-compliance reduced– Adverse selection in sales
Sources of value– Diversification– Comparative advantage in origination– Cost of funds
J. K. Dietrich - FBE 525 - Fall, 2006
Resolving P-A Problems inLoan Sales
Recourse Guarantees Structuring deal
– Equity-like portion– Problems from regulators
Real-world examples– CMOs (REMICs)
J. K. Dietrich - FBE 525 - Fall, 2006
Researching Market Size Regulatory data
– Federal Deposit Insurance Corporation (FDIC)– Federal Financial Institution Examination Council (FFIEC)– Annual Reports of regulators like Securities Exchange
Commission, Commodity Futures Trading Commission Industry sources
– Annual Reports and Statistical Abstracts of industry entities (e.g. New York Stock Exchange, Chicago Board of Trade)
– Industry associations (e.g. Institute of Life Insurance, Investment Company Institute, etc.)
J. K. Dietrich - FBE 525 - Fall, 2006
Next Week...
Prepare Chapter 9 for Thursday, September 28, 2006
Chase case discussion also for Thursday, September 28, 2006
International Securities and Hambrecht cases will be discussed on Saturday, September 30, 2006 (starting at 12:30pm)
Raise questions concerning project before due date