One of the central questions in the current crisis is why the financial system seems so slow and/or unable to renegotiate debt contracts that seem likely to default. The answer is critical as the private sectors and the government think about the new financial architecture. There are many theories out there, some of which suggest that what we are observing is an optimal response to asymmetric information (Kellogg’s Art Raviv is one of the main contributors to the early theoretical literature on this topic). Since a lender does not want to renegotiate with all borrowers but only the truly insolvent ones, delay arises as the lender tries to figure out who is who, or imposes costs and actually denies some truly insolvent debtors so that the truly solvent do not find refinancing attractive. Another theory however is gaining some credence and is highlighting a rather widespread problem that financial innovation has failed to deal with: a separation of control rights from ownership. In the renegotiation case, the idea is that some debtors have purchased credit default swaps so that they actually do not have a financial stake in whether the debt pays off or not. This is nicely expounded by Henry Hu in the Wall Street Journal. But this sort of problem is actually quite widespread. The dramatic increase in the ability to hedge risks has lead to a dramatic increase in the separation of control rights from the asset’s payoff. As another example, a stock owner who has purchased a put to insure the downside risk has voting power – the control rights of equity – but would choose to reject a re-organization or merger plan that solidifies the business for the long term while cementing a significant loss. Instead, the hedged owner would vote to risk bankruptcy for a chance of a higher stock price above the strike price. Sounds a lot like not selling a security for a loss and instead holding onto it in the hopes its price rises or it pays off in the end.
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