Posted by Contract theory studies the mechanism by which economic entities undertake contractual obligations in the presence of information asymmetry – which can in turn lead to adverse selection and moral hazard.
Information Asymmetry: This refers to the situation when one party to a transaction has superior information as compared to the other counterparty. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well.
Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge.
With increased advancement in technology, asymmetry information has been on the decline as a result of more and more people being able to easily access all types of information.
Information Asymmetry can lead to two main problems: Adverse Selection and Moral Hazard.
Adverse Selection: This refers to the situation when immoral behavior takes advantage of asymmetry information before a transaction is completed. For example, a trader who has inside information that a particular company is to announce liquidation might be tempted to sell the company’s shares.
Moral Hazard: Immoral behavior that takes advantage of asymmetric information after a transaction is completed.
For example, in the recent period of global economic crisis, the US Government has resorted to bailing out banks and insurance companies by providing capital. For example, AIG, one of the largest insurers in the world was taken over by US Government and provided with funds. Subsequent to this, there is always a risk that certain banks may decide to increase lending based on the fact that any future losses would automatically be funded by the US Government. This moral hazard has potential to emerge in the system. Appropriate checks and balances need to be maintained. In the case of AIG, bonus was issued to employees from the bailout funds given by the US Government, which was a burden to the taxpayer. This resulted in a few employees gaining at the expense to the taxpayer and US Government.
Akerlof’s Lemons: Akerlof’s 1970 essay, “The Market for Lemons” is one of the most important studies in economics of information and importance of information symmetry. He analyses a market for an asset where the seller has more information than the buyer regarding the quality of the product.
This is explained by referring to the market for used cars (Akerlof uses the word, “Lemon” to refer to a defective old car). Akerlof’s “lemon effect” points out that when a car owner tries to sell his brand-new used car which has been driven for only a few kilometers, he has to accept a significantly reduced price because now there is an asymmetry of information between seller and potential buyer about the quality of used car.
The Latter fears that the reason the owner wishes to sell is because the car is a “lemon,” while even if it is not, there is no way the owner can give this information to the buyer. At the same time demonstration cars which are stationed at dealer’s shop, sell at a relatively smaller discount because the dealer can still attach the producer’s warranty to it.
Another example is, assume that you purchased a new automobile. You have paid the dealer the full price of a new car. Now, after 1 week, you decide to resell this new car – which you have not driven around at all. The market price that the car fetches would definitely be at a discount to the new car’s showroom price. This is because the perspective buyer would have doubts about the asset’s performance, because the car is no longer new – even though it is only a week old.
Similarly, if one compares the credit market in India, in the 1960’s, local lenders charged interest rates that were twice as high as the rates in large cities. They took advantage of the non-availability of information to the rural areas, as well as operational difficulty in disbursement of credit to the grassroots levels of the society. This emphasizes the need for Government and public financial institutions / banks to take adequate measures to reduce information asymmetry. Lately, this has been largely offset with the emergence of banking / developmental / microfinance institutions in rural India. By better information dissemination, it is possible for the public sector banks to communicate the prevailing rate of interest to the rural population who require credit towards agricultural activities.
Thus, according to Akerlof, many market institutions may be regarded as emerging from attempts to resolve problems due to asymmetric information.
Discussion of theoretical concepts of risk, associated relationship with returns as well as information asymmetry is incomplete unless practical circumstances in the form of case studies are analyzed. Let us understand some of the events of historical significance, that have impacted not only the Indian Financial Markets but the Global Financial System as a whole.
Cases: Events of Historical Significance
A bubble (with specific reference to financial markets) is an economic cycle characterized by rapid expansion followed by a contraction. It is a surge in asset prices, often more than warranted by the fundamentals and usually in a particular sector. A market bubble is usually followed by a drastic drop in prices as a massive sell off occurs. The bubble theory asserts that security prices rise above their true value and will continue to do so until prices go into freefall and the bubble bursts.
Bubbles occur in economies, securities, stock markets and business sectors because of a change in the way the market participants conduct business. This can be a real change, as occurred in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift, as happened during the dotcom boom in the late ’90s and early 2000s. During the boom people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurred. Bubbles in equities markets and economies causes resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate. Thus, there is little long-term return on those assets.
More recently, the housing markets bubble burst in the developed markets. This was also due to the sub-prime mortgage crisis – which was the result of increase in interest rate (US Fed rates) from 1% in June 2004 to 5.25% in June 2006.
Case-1: The Great Depression of 1929: The Stock Market crash of 1929 was marked by a severe downturn in equity prices that occurred in October of 1929 in the United States, and which marked the end of the “Roaring Twenties.” The crash of 1929 did not occur in one day but was spread out over a two-week period beginning in mid-October.
The first portion of the crash occurred on October 24, a day known as Black Thursday. The following week brought Black Monday (Oct 28) and Black Tuesday (Oct 29), when the Dow Jones Industrial Average (commonly referred to as the DJIA) decreased more than 20% over those two days. Pre-existing selling pressure and fear in the stock market were exasperated by a flood of sell orders that shut down the ticker-tape service that provided stock prices to traders. With key information missing from the markets, selling intensified even further.
Despite a few attempts at recovery, the stock market continued to languish, eventually falling almost 90% from its peak in 1929. The period preceding the decline in October 1929 witnessed equity prices increasing to all-time high multiples of more than 30 times earnings. The benchmark DJIA had increased 500% in just five years. This type of hyper-growth has shown itself to be unsustainable over time, as market generally perform their best when they can grow steadily.
It took over 25 years for the DJIA to get back to the highs of the 1929 market, as the U.S. economy suffered through what we now call the Great Depression. Major new legislative and regulatory changes were enacted following the speculative bubble and crash of the 1920s in an effort to prevent the same situation from happening again.
Case-2: Stock Market Decline in 1987: A rapid and sever downturn in stock prices occurred in late October of 1987. After five days of intensifying stock market declines, selling pressure hit a peak on October 19 (commonly referred to as the known as Black Monday of 1987). The DJIA fell a record 22% on that day alone. Trading was halted in many stocks during the day as order imbalance prevented true price discovery.
The exact cause of the crash has been analyzed by many experts. This was a rare phenomenon in that the market made up most of its losses rather quickly, rather than preceding a protracted economic recession. Some people point to the lack of trading curbs. Some of the experts have identified the source of decline as the algorithmic trading software in place at the time. The period before October 1987 saw the DJIA more than triple in five years. The price-earnings (P/E) multiples on stocks had reached above 20, implying very bullish sentiment. And while the crash began as a U.S. phenomenon, it quickly affected stock markets around the globe; 19 of the 20 largest markets in the world saw stock market declines of 20% or more.
Investors and regulators learned a lot from the 1987 crash, specifically with regards to dangers of automatic or program trading. In these types of programs, human decision-making is taken out of the equation and buy or sell orders are generated automatically based on the levels of benchmark indexes or specific stocks. In a disorderly market, human intervention is required more than ever to assess the actual situation.
Case-3: Collapse of the Long-Term Capital Management (LTCM): This case refers to a large hedge fund led by Nobel Prize-winning economists and renowned Wall Street traders that nearly collapsed the global financial system in 1998 as a result of high-risk arbitrage.
The fund formed in 1993 and was founded by renowned Salomon Brothers bond trader John Meriwether.
LTCM started with just over USD 1 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities that are incorrectly priced relative to each other. Due to the small spread in arbitrage opportunities, the fund had to leverage itself highly to make money. At its height in 1998, the fund had USD 5 billion in assets, controlled over USD 100 billion and had positions whose total worth was over a USD 1 trillion.
Due to its highly leveraged nature and a financial crisis in Russia (i.e. the default of government bonds) which led to a flight to quality, the fund sustained massive losses and was in danger of defaulting on its loans. This made it difficult for the fund to cut its losses in its positions. The fund held huge positions in the market, totaling roughly 5% of the total global fixed-income market. LTCM has borrowed heavily to finance its leveraged trades. Had LTCM gone into default, it would have triggered a global financial crisis, caused by the massive write-offs its creditors would have had to make. This would have led to cascading effect (ripple effect) across the entire global financial markets.
In September 1998, the fund, which continued to sustain losses, was bailed out with the help of the Federal Reserve and its creditors took over its operations. Systematic meltdown of the market was thus prevented.
Case-4: The Indian Stock Markets in 1992: India had its fair share of turmoil, as a result of systematic deficiencies in processes and financial systems. One such case was the stock market scam of 1992.
Harshad Mehta was an Indian stockbroker and is alleged to have engineered the increase in share price of the BSE in 1992. Exploiting several loopholes in the banking system, Harshad Mehta and his associates siphoned off funds from inter-bank transactions and bought shares heavily at a premium across many segments, triggering an increase in Sensex (index of BSE).
When the scheme was exposed, the banks started demanding the money back, causing the collapse. Harshad Mehta was later charged with 72 criminal offenses, and more than 600 civil action suits were filed against him. He died in 2002 with many litigations still pending against him.
This incident exposed the dubious ways of accessing funds from the banking system to finance share purchase. The mechanism through which the scam was affected was the Ready Forward (RF) deal. The RF is in essence a secured short-term (typically 15-days) loan from one bank to another. A bank lends against government securities just as a pawnbroker lends against jewelry. The borrowing bank actually sells the securities to the lending bank and buys them back at the end of the period of the loan, typically at a slightly higher price. Ready-Forward deals were used to channel money from the banking system into financial markets. Ready forward deals involve two banks brought together by a broker in lieu of a commission. The broker handles neither the cash nor the securities, though that was not the case in the lead-up to the scam.
In this settlement process, deliveries of securities and payments were made through the broker. That is, the seller handed over the securities to the broker, who passed them to the buyer, while the buyer gave the cheque to the broker, who then made the payment to the seller. In this settlement process, the buyer and the seller might not even know whom they had traded with, either being known only to the broker.
The brokers could manage primarily because by now they had become market makers and had started trading on their account. To keep up a semblance of legality, they pretended to be undertaking the transactions on behalf of a bank.
Another instrument used in a big way was the “Bank Receipt” (BR). In a ready forward deal, securities were not moved back and forth in actuality. Instead, the borrower, i.e., the seller of securities, gave the buyer of the securities a BR. A BR confirms the sale of securities. It acts as a receipt for the money received by the selling bank, hence the name “Bank Receipt”. It promises to deliver the securities to the buyer. It also states that in the meantime, the seller holds the securities in trust of the buyer.
Two banks, the Bank of Karad (BOK) and the Metropolitan Co-operative Bank (MCB), were alleged to have issued BRs as and when required, for a fee. Once these fake BRs were issued, they were passed on to other banks and the banks in turn gave money to the broker. The banks’ lending money against BR assumed that they were lending against government securities and the BR were legitimate. This money was used to drive up the prices of stocks in the stock market. When time came to return the money, the shares were sold for a profit, and the BR was retired. The money due to the bank was returned.
Once the scam was exposed, though, a lot of banks were left holding BRs which did not have any value. The banking system suffered loss of approximately Rs. 4000 crores.
Case-5: Indian Stock Market in 2001: Another Similar incident was the stock market scam which occurred in 2001.
The scam unfolded as the stock market crashed on 1st March 2001. It was alleged that Ketan Parekh was involved in this incident. He is said to have serviced his network of clients by buying huge stakes in several companies. These stocks were bought at low prices and pledged as collateral for funds when they gained value in the market.
A cooperative bank provided funding for the huge stakes kept as collateral. Funds were accessed through the pay orders and borrowings from the bank. The pay orders affected a number of public sector banks also. When the stock markets crashed in March 2001, the SENSEX declined by 23% and the stocks purchased declined by 70%.
Unanticipated volatility in stock markets led to liquidity problems. Even the Calcutta Stock Exchange had to bear the brunt of this scam due to its lack of regulation which allowed illegal Badla practices.
SEBI implemented various measures in the trading system to monitor such unhealthy practices to safeguard the interest of the investors like banning of Badla System, which was replaced by Rolling Settlement by mid 2001, by imposing deposit margins and restrictions on short sales.
Case-6: Global Credit Crisis of 2008: The increase in interest rates by the United States Federal Reserve (commonly referred to as US Fed), from 1% in June 2004 to 5.25% by June 2006, led to a cascading effect on the Housing markets in US. By this time, there was a housing market bubble that was created due to lending to sub-prime borrowers. These sub-prime borrowers are a class of investors who did not have a substantially high individual credit rating. Nevertheless, many mortgage loans were issued to this class of investors, due to increasing housing rates and low interest rates.
Thus, when the interest rates increased, there was an immediate decline in demand of new-home sales and even existing-home sales declined in US. The housing market bubble collapsed, leading to decrease in home rates. The high interest rates also resulted in increasing default by home loan borrowers. The mortgage loans which used the high value of the houses as collateral were unsustainable, because the secured asset’s value itself declined. This led to a cascading effect on the global economy. High interest rates also led to decreasing bond prices, resulting in losses for investment banks which had too much exposure to financial assets.
Lehman Brothers, which was one of the largest investment banks in the world, with over USD 600 billion in exposure to financial assets suffered huge losses. These huge losses were a result of decreasing bond prices and unreasonable valuation of exotic derivative instruments such as Credit default Swaps which were executed in the over-the-counter markets. Lehman could not unwind its exposure to such financial assets and derivatives instruments. This was because there were no takers for such high-risk assets. This led to margin calls on Lehman. Subsequently, Lehman filed for bankruptcy. The US Government did not intervene in the collapse of Lehman, thus increasing the counterparty default risk for the entire market. All institutions which executed deals with Lehman were exposed to risk of default by Lehman. This led to a huge selloff in financial markets. Equity, Commodity and Currency Markets were impacted due to this event. This Global Financial Markets were even more impacted because, it was not clear to which institution in the world has executed contracts with Lehman.
The credit crisis necessitated the United States Government to institute crisis-funding (bailout) of specific banks / financial institutions. The terms of the funding ensured that such institutions abided by strict regulations as laid down by the US Fed, the US Congress and the regulators such as Securities Exchange Commission (SEC), etc.
