The Amazing Race

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Principal Agent Problems in the Financial Crisis of 2007-2009

BMI Master Thesis

November 2009

Jasper Holke Klein
Supervisor: Rob van der Mei

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Faculty of Sciences
Business Mathematics and Informatics
De Boelelaan 1081a
1081 HV Amsterdam
Preface

This paper is one of the last compulsory elements of the program Business Mathematics and Informatics at the VU University Amsterdam. The objective of this subject is to demonstrate the student's ability to describe a problem in a clear manner for the benefit of an expert manager. This is accomplished by doing a literature research and to apply this research to a practical situation. I have always had a strong interest in strategic thinking. One of the ways that this is modeled in the scientific theory is through game theory. From the broad range of subjects that are available in game theory I decided to focus on information asymmetry and, more specifically, on the principal-agent relationship as this theory is very widely applicable and has a strong explanatory power. In this way I was able to combine my interest in strategic thinking and the financial sector and able to give a clear explanation for the events that happened within the financial crisis of 2007 - 2009. Finally, I would like to thank my supervisor Rob van der Mei for his comments and suggestions.

Amsterdam,
November 2009,
Jasper Holke Klein
Summary
This paper analyses the origin of the financial crisis from a game theoretic perspective. We use the principal-agent theory as a basis for our analysis. Principal-agent theory is broadly applicable in situations where multiple parties strive to maximize their utility and which have asymmetric information. The financial crisis started after the bust of the US housing bubble, which originated as a result of irresponsible profit maximization by parties in the mortgage lending chain. Those parties couldn’t be held accountable for their actions as they were able hide information from their counterparties and government. After the bust of the housing bubble, the losses of the sub-prime mortgages greatly affected the financial system. No one could determine the financial stability of their counterparties anymore, which let to a complete stop on credit lending between the financial institutions. Many institutions had a high leverage and a high funding with short term debt, which got them into liquidity troubles and even bankruptcies.

We found the following principal-agent relationships present in the financial crisis: 1. Mortgage borrower and lender (two-sided problem)
2. Mortgage lender and investment bank
3. Investment bank managers and stockholders
4. Investment bank and government
5. Investment bank, rating agencies and investors
6. Investment bank and financial institutions
7. Financial institutions and creditors
8. Financial institutions and customers / investors

Recommendations
Most of the principal-agent problems in the financial crisis require government regulations to be solved. The solutions aim at protecting the financial illiterate, making all parties accountable for their actions and providing transparency in the financial markets.

The following actions should be taken by the US government to solve the principal-agent problems: • Standardize mortgage contracts and borrower information and add a suitability requirement on mortgages to protect the financial illiterate mortgage borrowers. • Remove non-recourse mortgages, which will make borrowers accountable for the quality of their houses, removes default opportunities and forces them to pay more attention to the financial aspect of the mortgage. • Require mortgage lenders to hold on to a part of each mortgage, which makes it unprofitable for them to provide irresponsible mortgages. • Regulate the leverage ratio and economic capital of investment banks. This makes the investment banks less...
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