Reducing moral hazard: Why only creditors should trade bonds.

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kmarinas86's picture
kmarinas86
Status: Silver Member (Offline)
Joined: Dec 29 2008
Posts: 164
Reducing moral hazard: Why only creditors should trade bonds.

When people think about trading bonds, they almost unanimously think about lenders trading them. Almost never do we see creditors trading their bonds. Here is why I think this may be superior than having only lenders trade bonds:

Creditors can exchange the bonds for their mutual benefit:

  • One creditor may need more cash than expected but finds out that it does not need to keep the money for long, and that returns on investment are projected higher than originally expected. So this creditor thinks that having more cash in the hand for the moment is worth hastening full payment of the bonds.
  • The other creditor may have plenty of cash but finds out it will need to keep the money longer because the interest on the bond is costing the creditor too much money too soon. So this creditor thinks that having less expenses in the next few years is worth having less cash on hand in the short run.

In this way, the risk of the creditors can be reduced, all without increasing the price for the bond. This could also be done with mortgages. However, it would have to be done with consent of the mortgage borrowers. Trading credit card balances and interest rates might also be a good idea too.

I believe implementing this idea would reduce moral hazard because by doing this creditors can reduce the risk of defaulting. Does trading bond "ownership" reduce the risk of default as effectively as allowing bond "slaves" to trade their liabilities? Clearly if people can trade their bonds without "refinancing" the bonds, this would reduce the risk for the lender and the creditors. In other words, more money can be lent within the same risk appetite, and expected returns may realize in situations where they would otherwise have not.

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