304 Part Three Best Practices in Capital Budgeting
bre44380_ch12_302-326.indd 304 09/11/15 07:55 AM
A manager on a fixed salary could hardly avoid all these temptations all of the time. The
resulting loss in value is an agency cost.Agency Problems and Risk Taking
Because managers cannot diversify their risks as readily as the shareholders, one might expect
them to be too risk-averse. Indeed, evidence suggests that managers seek a “quiet life” when
the pressure to perform is relaxed.^4 But there are plenty of exceptions.
First, the managers who reach the top ranks of a large corporation must have taken some
risks along the way. Managers who seek only the quiet life don’t get noticed and don’t get
promoted rapidly.
Second, managers who are compensated with stock options have an incentive to take more
risk. As we explain in Chapters 20 and 21, the value of an option increases when the risk of
the firm increases.
Third, managers sometimes have nothing to lose by taking on risks. Suppose that a
regional office suffers large, unexpected losses. The regional manager’s job is on the line, and
in response he or she tries a risky strategy that offers a small probability of a big, quick payoff.
If the strategy pays off, the losses are covered and the manager’s job may be saved. If it fails,
nothing is lost, because the manager would have been fired anyway. This behavior is called
gambling for redemption.^5
Fourth, organizations often hesitate to curtail risky activities that are delivering—at least
temporarily—rich profits. The subprime crisis of 2007–2009 provides sobering examples.
Charles Prince, the pre-crisis CEO of Citigroup, was asked why that bank’s leveraged lending
business was expanding so rapidly. Prince quipped, “When the music stops . . . things will be
complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still
dancing.” Citi later took a $1.5 billion loss on this line of business.Example: Agency Costs and the Subprime Crisis “Subprime” refers to mortgage loans
made to home buyers with weak credit. Some of these loans were made to naïve buyers who
then struggled to keep up with interest and principal payments. Some were made to oppor-
tunistic buyers who were willing to bet that real-estate prices would keep improving, so that
they could “flip” their houses at a profit. But prices fell sharply in 2007 and 2008, and many
buyers were forced to default.
Why did so many banks and mortgage companies make these loans in the first place? One
reason is that they could repackage the loans as mortgage-backed securities and sell them at a
profit to other banks and institutional investors. It’s clear with hindsight that many buyers of
these mortgage-backed securities were in turn naïve and paid too much. When housing prices
fell and defaults increased, the prices of these securities fell drastically. For example, Merrill
Lynch wrote off $50 billion of losses and was sold under duress to Bank of America.
Although there’s plenty of blame to pass around for the subprime crisis, some of it must
go to the managers who promoted and sold the subprime mortgages. Were they acting in
shareholders’ interests or their own interests? We doubt that their shareholders would have
endorsed the managers’ tactics if the shareholders could have seen what was really going
on. We think that the managers would have been much more cautious if they had not had the
chance for another fat bonus before their game ended. If so, the subprime crisis was partly an(^4) S. Mullainathan and M. Bertrand, “Do Managers Prefer a Quiet Life? Corporate Governance and Managerial Preferences,” Journal
of Political Economy 111 (2003), pp. 1043–1075. When corporations are better protected from takeovers, wages increase, fewer new
plants are built, and fewer old plants are shut down. Productivity and profitability also decline.
(^5) Baring Brothers, a British bank with a 200-year history, was wiped out when its trader Nick Leeson lost $1.4 billion trading in
Japanese stock market indexes from a Barings office in Singapore. Leeson was gambling for redemption. As his losses mounted, he
kept doubling and redoubling his trading bets in an attempt to recover his losses.