Limited liability & bubbles

Economics Economics Questions
1

Has anyone written on any possible connection between LLCs and the excessive risk-taking present in bubble markets?

For example, suppose we have two identical individuals, both of which borrow money to make an investment. One person invests through a LLC he owns which took out a loan, while the other took a loan directly. For the sake of example, say the loan’s interest rate is 0%.

One investment is very high risk, and has an expected ROI of -50% to + 50%.

The other’s ROI is safe at +5% to +10%.

The private investor realizes that the second investment is the better choice. The LLC, however, can default on its loan without effecting its owners. This alters the range of expected ROI. It becomes 0% to +50%. To him the first investment is the better choice, but the first investment is clearly expected to produce more social benefit.

Or is there an error in my reasoning?

2

What makes you think the entity doing the lending won’t take into account the true risk before parting with its money? If an LLC (or anyone else for that matter) is making risky investments, the terms of any loan they get would take the true risk into account.

3

Good question. Banks certainly didn’t seem to do this during the housing bubble though. Maybe cheap credit created large incentives for banks to lend out funds to whomever they could, so banks were much less risk adverse than they’d be otherwise?

4

Monetary inflation and low interest rates creates witless investors in every sector, and banks don’t seem to go unscathed. Otherwise we wouldn’t have bank runs, right?