Moral Hazard and the Optimality of Debt

Benjamin Hebert

Research Papers from Stanford University, Graduate School of Business

Abstract: Why are debt securities so common? I show that debt securities minimize the welfare losses from the moral hazards of excessive risk-taking and lax effort. For any security design, the variance of the security payoff is a statistic that summarizes these welfare losses. Debt securities have the least variance, among all limited liability securities with the same expected value. The optimality of debt is exact in my benchmark model, and holds approximately in a wide range of models. I study both static and dynamic security design problems, and show that these two types of problems are equivalent. The models I develop are motivated by moral hazard in mortgage lending, where securitization may have induced lax screening of potential borrowers and lending to excessively risky borrowers. My results also apply to corporate finance and other principal-agent problems.

Date: 2015-05
New Economics Papers: this item is included in nep-ban and nep-mic
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Related works:
Journal Article: Moral Hazard and the Optimality of Debt (2018)
Working Paper: Moral Hazard and the Optimality of Debt (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:stabus:3455

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