Value Creation: Economics, Agency Problems, and Credit Services

1
Value Creation Economics, Agency Problems, and
Credit Services

• Week 4 September 14, 2006

2
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?

3
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

4
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?

5
Inter-temporal Consumption/Investment
96K
89K
III
I
II
(85K - 33K)/1.1 40K
52K
45K
Consumption Later
10K
40K
80.9K
87.3K
Present Value of Consumption
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Risks and ReturnsSample 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?

7
Returns and Risk
Expected Returns
0
Variability of Future Returns
8
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

9
Principal-Agent Problems
Monitor/Control
Price/Set Terms
Produce/Deliver
Market/Inform
Bear/Share Risk
Fund/Invest
tM
t0
t -K
Moral Hazard
Adverse Selection
Take Actions
Select Contract
10
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?

11
Financial Markets

• Economic concepts and financial markets
• Marginal revenue and cost
• Substitutes and complements
• Problems in implementation
• Data
• Market definitions
• Examples of markets

12
Pricing and Terms in Credit

• Revolving credit and term loans
• Interest rates
• Balances
• Fees
• Conditions
• Real world implementation

13
Resources to Provide Credit

• Types of human resources
• Types of information
• Types of analytical competence
• Desired sales skills
• Sources of training/experience

14
Activities in Credit(and other financial
services)

• Setting Terms/Pricing
• Communicating/Marketing
• Producing/Delivering
• Controlling/Monitoring
• Funding/Investing
• Risk Bearing/Risk Shifting

15
Market Power in Credit(and Other Financial
Services)
Marginal Cost of Funds
Cost of Funds
Interest Rate
Rcompetitive
Marginal Return
Loans
Market Share with Market Power
16
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

17
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

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Types of Combinations

• Horizontal/Vertical/Conglomerate
• Norwest BancorporationWellsFirst Interstate,
  ChaseChemical, GoldmanSachsSpearLeeds, many
  others
• B of A and Nationsbank acquire software firm Meca
  for home banking
• Mellon BankBoston CompanyDreyfus
• Accounting treatment
• Pooling and stock repurchases
• Purchase accounting

19
Value in Mergers

• Synergies gt (AB) gt 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

20
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

21
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

22
Penetration of Financial Services
Marginal costs
Marginal costs
Prices, Costs
Marginal costs
Market Demand
23
Analyzing Credit MarketsDemand for Credit

• Determinants of need for credit --
• investment in real assets
• liquidity
• restructuring
• Real asset demand
• Other demands for credit
• Review Flow of Funds

24
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

25
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

Bad Credit Risk
Cost of Balances
Commitment Fee
Good Credit Risk
Balances
Compensating Balance
26
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

27
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

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Resolving P-A Problems inLoan Sales

• Recourse
• Guarantees
• Structuring deal
• Equity-like portion
• Problems from regulators
• Real-world examples
• CMOs (REMICs)

29
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.)

30
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 1230pm)
• Raise questions concerning project before due date