The Market's Agency Problem
It is difficult to keep the behavior of agents aligned with the best interest of principals.
So glad we've almost made it
So sad they had to fade it
Everybody wants to rule the world
--Tears for Fears
When reading various Minyanville missives, such as Professor Shedlock's article about stock operations at Ambac (ABK) and Professor Nelson's piece about executive compensation at Merrill Lynch (MER), I'm reminded that a considerable portion of daily market behavior can be related to an academic stream of thought known as agency theory.
Jensen and Meckling's (1976) seminal work in agency theory was motivated by problems that arise from modern corporate ownership structure. For a variety of reasons, corporate owners (or principals) usually do not involve themselves directly in a firm's operating decisions. Instead, principals hire managers (or agents) and empower them with decision-making authority to run the company.
This can be problematic because agents may have different goals than principals, and agents may use their superior understanding and information about corporate machinations to appropriate value for themselves at the principals' expense.
While originally developed in the context of corporate ownership structure, agency theory readily applies to financial market behavior. It is rare today for investment capital to be managed by its owners. Instead, principals retain the services of agents (financial advisors, money managers, etc.) to manage the funds. Indeed, a single principal may retain a number of agents directly or indirectly. For example, an individual retains a financial advisor who invests some of the principal's capital in mutual funds, essentially making the fund managers indirect agents of the principal.
The important thing to keep in mind when viewing market behavior through the lens of agency theory it that it is difficult to keep agent goals and behavior aligned with the principal's best interest. Frequently, this misalignment manifests in agents taking more risk with investment capital than principals might take on their own.
Even incentives intended to better align principal and agent objectives, such as stock options, may turn agents into "risk lovers" and encourage behavior that exceeds the level of riskiness that is prudent for owners (Wiseman & Gomez-Mejia, 1998). Option-loaded managers can gain substantially from upward stock price movements while being shielded from downside, prompting these agents to "swing for the fences" when making financial decisions on behalf of their principals (Sanders & Hambrick, 2007).
This situation is exacerbated if principals do not have a clear idea of their investment goals, or if they themselves become extremely risk seeking (both of these conditions have been proposed to exist in today's market environment). This not only facilitates highly volatile incentive contracts with agents, but it may also reinforce agent perceptions of minimal penalty associated with risky behavior. If the pool of risk seeking principals is large, then agents may care little about negative outcomes such as termination for poor investment performance because of the likelihood of finding similar positions elsewhere working for other like-minded principals.
The agency perspective of market behavior helps me make sense of today's financial environment, and suggests a forward-looking proposition or two. Since the vast majority of buy and sell decisions in today's markets are made by agents, extreme levels of risk taking that we've been witnessing should not be surprising given the aggressive structure of agent incentive packages. Today's money managers often claim that they are "paid to take risk" (e.g., Biggs, 2006). Indeed they are.
Plausibly, measures of sentiment meant to capture extremes in bullish or bearish sentiment may lose some meaning in high risk-taking environments. Currently, agents seem willing to place sizeable bets on any market outcome, whether it be based on upward price movement, downward price movement, or even no price movement. Commitment to a particular direction seems relatively low although general commitment to risk appears relatively high.
Finally, it is principals, not agents, who control market tone over the long run. A durable change in today's risk-seeking environment will require principals to alter their attitudes and behavior towards a more conservative posture. Reshaping incentive systems to reduce risk-taking among agents would be one signal of such a change in mindset. More consequential would be principals pulling their capital back from agents to assume more direct control over risk management. Such a movement would be consistent with the deflationary threads weaving through some Minyanville commentary.
Quite likely, the specter of principals fleeing agents en masse is Wall Street's worst nightmare.
Biggs, B. 2006. Hedge hogging. Hoboken, NJ: John Wiley & Sons.
Jensen, M.C. & Meckling, W. 1976. Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3: 304-360.
Sanders, W.M. & Hambrick, D.C. 2007. Swinging for the fences: The effects of CEO stock options on company risk taking and performance. Academy of Management Journal, 50: 1055-1078.
Wiseman, R.M. & Gomez-Mejia, L.R. 1998. A behavioral agency model of managerial risk-taking. Academy of Management Review, 23: 133-153.
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