Wildhawk's  Instablog

I mentioned in my last post that my next post would be about strategies to reform executive compensation and compensation on Wall Street.  Given the recent outlandishly heavy-handed "ruling" by US Treasury "special master of compensation" Ken Feinberg, the topic is particularly poignant at the moment.  However, I'm going to preempt that post with a piece on healthcare reform, largely because I think too many people are missing the forest for the trees.

Enough commentators both on and off Seeking Alpha have outlined the numerous problems and benefits of our existing healthcare system in the US.  I won't belabor the point here by repeating.  However, I think one of the key things missing in the discussion goes back to a very fundamental issue: this isn't about insurance, it's about healthcare. 

The debate to date has largely been dominated by a discussion around public versus private options, anger and fear about government run healthcare, and the like.  What no one seems to be asking is, how do we get better outcomes and how do we deliver healthcare to people in a more cost effective way?  I'm not talking about delivering health insurance in a more cost effective way.  Health insurance is simply a tool that our system currently uses to administer the delivery of healthcare to the population. 

I'd venture to say that most people don't care one bit about their health insurance company, but they care deeply about their own healthcare. 

Health insurance companies' sole purpose is to administer the delivery of healthcare to their members in a profitable way.  If you look at most studies that detail the overall costs of healthcare, a very significant portion of these costs is made up of administrative costs for the delivery of care (one source I read recently said that fully 30% of healthcare costs in this country are attributable to the administration of care).  These administrative costs add no value to your healthcare and do absolutely nothing to generate a better healthcare outcome.  They don't allow you to spend more time with your doctor or help you be a better informed health consumer.  These administrative costs are nothing but overhead and don't add value to healthcare outcomes.

It stands to reason that if we were to find a way to reduce the administrative cost of the delivery of healthcare, we would get similar outcomes at a dramatically lower cost. 

So why, as a nation, do we continue to allow for profit insurance companies to consume 30% of the cost of our healthcare in this country while adding no value to healthcare outcomes?  What possible value are these companies providing that is worth that much money? 

Keep in mind that these companies make money in very few ways: they invest premium dollars (float) and they deny care that would otherwise be paid for.  That's it.  So in the end, these companies are profitable solely because the premiums they charge are above the cost of delivery and because they have the ability to deny care which appears to have been paid for via premiums.  If anyone can give me a single reasonable rationale as to how this possibly adds any value to healthcare outcomes, I'm all ears.

It seems to me that one of the first truly transformational steps to holding downs costs and delivering better healthcare outcomes in this country is to cut out the middleman or at the very least, legislate that the middle man be a not-for-profit enterprise. 

And this doesn't imply the necessity of a federal government run healthcare administration system like Medicare (though such an option could certainly exist).  The new entities could take the form of co-ops, or even mutual insurance companies legally obligated to act in the best interests of their members (and by extension, returning excess capital to those same members).  The costs savings to the rest of the nation in the form of lower healthcare costs and more favorable healthcare outcomes at the expense of effectively obliterating one for-profit industry are obvious.

So why isn't anyone in the debate telling it like it is: the debate isn't about insurance, it's about healthcare delivery and the best way to handle that as a nation?

Disclosure: no positions relevant to this discussion as of the time this article was published.

I've commented recently on what I view as the way to solve the next financial crisis before it starts: passing legislation making everyone who handles money a fiduciary.  But there is a more immediate and less drastic way to address the recent mess that the kings of Wall Street have gotten us all into- by reforming compensation structure.

Now before you go crying "Socialist!", I'm not talking about capping compensation.  I don't begrudge anyone from making as much money as they possibly can, as long as it's done ethically and legally.  But the recent populist rage around bonus compensation on Wall Street is real, and well deserved, in my view. 

The incentive structure on Wall Street has been completely off kilter for decades.  The typical compensation structure on Wall Street:

1) Incentivizes employees to take of the greatest amount of risk possible, creating a gambling mentality, especially in traders

2) Is not even a true incentive compensation structure, as there is limited, if any, downside to the individual from failure at either the individual or company level, so is anathema to the creation and maintenance of shareholder value

3) Creates the possibility, even likelihood, that the entire firm will collapse, destroying shareholders in the process

4) Accentuates antisocial outcomes to society at large and is a mockery of true capitalism

Let's assume for the moment that you are a trader on a Wall Street trading desk.  I can say with reasonable certainty that it's very likely that your bonus or "incentive" compensation is directly tied to the profits of your trades- the more money you make for the firm, the more money you take home, with no limit to the compensation you can make (theoretically).  So, at its core, your incentive is to make as much money as humanly possible for the firm. 

What's wrong with that, you say?  Isn't that what capitalism is all about?  Aren't corporations under an obligation to shareholders to try to make as much money as possible?

As a trader, how can you make as much money as possible for the firm? You've got to be the best, brightest, and most knowledgable trader possible, right?  Well what about the folks you aren't the best, brightest, or greatest researchers?  You take more risk.  Or you cheat or do something illegal (on Wall Street?  Never!)  It's as simple as that.  The greater risk you take, the bigger the gamble you make, the greater potential payoff if you are successful.  If you take outsized risks, you have larger potential rewards.  You are incentivized to take outsized risks with shareholder capital for the possible outcome of outsized personal rewards.  That puts the firm at greater risk of something bad happening as a result.

With upside also comes downside.  What happens when one of these trades (bets) goes terribly wrong (e.g. Amaranth)?  The fund (or even the entire firm) collapses.  The worst case scenario for the individual is that they lose a job.  In many cases, however, that trader can simply pick himself up off the floor and find a job with another firm.  It happens all the time.  Shareholders get screwed and have lost everything, while the person responsible is back doing the same thing, taking the same risks, jeapordizing a different set of shareholders' capital, somewhere else.  The downside risk of failure for the individual is completely disproportionate to the reward for success: fail and you have to find another job, succeed and you can make more money than you could ever dream of in the time it takes to finish an associate's degree at a community college.  The risk to the shareholder is having all of your capital completely wiped out. 

And as we've seen recently, the downside to the individual for failure is often not even that great.  Witness the billions of dollars of bonuses planned for this year from Goldman Sachs, JP Morgan, and others, in many cases with bonus compensation actually outstripping annual earnings.  If I were a shareholder of any of these firms, I would be positively beside myself at this. 

Less than 12 months ago, most of these firms needed billions of dollars of government bailout money to continue to exist.  They took advantage of taxpayer funds, as well as government guarantees of debt (lowering their cost of doing business through lower interest rate expense).  Had that money not been available, most of these firms would no longer exist.  Now that the system has stablized, they've decided to slap shareholders (and taxpayers) in the face by paying more to their employees than to their shareholders.  Management decisions at each of these firms (being too highly leveraged, being too dependent on capital markets for near-term cash for operations, etc.) nearly drove them to collapse.  And the reward for this failure of judgment is a bailout at the expense of the US taxpayer and possible record bonuses at some firms (you know who you are). 

So I'll ask you, if you were a trader or manager at one of these firms, what possible incentive could you have right now NOT to take as much risk as humanly possible?  We've just been through possibly the most tumultous period in the history of Wall Street, and not only do you still have a job, but you're about to get the largest bonus of your life.  Why would you do anything other than continue to shoot for the moon when the consequences for failure are so small?

And finally, I want to comment on the unlimited upside potential of incentive compensation, especially on Wall Street.  I believe that this type of compensation structure is antisocial (detrimental to social order or the principles on which society is constituted). 

I don't begrudge anyone the opportunity to earn as much money as they can, however they can, within the ethics of society and the law of the land.  That having been said, nothing good comes of $100 million bonuses to heads of trading desks and billions of dollars of annual compensation to hedge fund managers.  There comes a point where the money is just a tool to keep score, to feed your ego, and to make you feel like you're better than everyone else.  No one can seriously tell me that Jim Simons needs to make another $2 billion next year.  Nor can Mr. Simons honestly look someone in the face and say that he would be disincentivized to perform to the best of his ability if he could only make $1 billion rather than $2 billion next year. 

These outlandish sums of money going to individual are a mockery to capitalism itself and destablizing to society.  Capitalism rewards risk taking.  The person who starts a business with seed money from friends and family, for example- these are people working for the betterment of themselves, taking great risk for great reward.  They take the risk of losing everything if they fail.  For that risk, they can be amply rewarded.  The entrepreneur who creates a new business is benefiting society because this new business has the potential to create new jobs and new products that did not previously exist.

Heads of trading desks, hedge fund managers and the like are not adding value to society.  They're not creating great new consumer products, finding cures for disease, building the proverbial better mousetrap, or even providing primary capital to burgeoning entrepreneurs to start a business.  They are using their formidable intelligence (and social connections) to leach off the capital markets like intermediary vampires.  The more money they make, the more polarized society becomes because it concentrates that much more money into fewer and fewer hands.  Every dollar they make is actually draining capital from other parts of society that could be used for valuable, societally enhancing endeavours (such as the examples above).  The fact that the numbers are so outlandish, and the fact that these figures are publicized, simply serves to create populist rage and destablize society.  That's $2 billion less money going to small business startups, the lifeblood of the American economy and the only real engine of net job growth for the last 20 years.

And therein lies the problem with incentive compensation on Wall Street.  It incentivizes too much risk taking by systemically important entities at the expense of shareholders (and now taxpayers) with little downside to the individual for failure and significant downside to society for success. 

In an upcoming post, I'll comment on what I think are some possible solutions for reforming incentive compensation, both on and off Wall Street, to realign risk and reward. 

Disclosure: No positions in any individual stocks at this time.  Positions may change at any time without notice.

Capitalism is not inherently evil.  I maintain that the way to have stopped this economic mess in the first place, as well as the way to stop it in the future, is quite simple: 

1.  Capitalism has "natural" boom and bust cycles, which create great riches as well as tremendous havoc and upheaval.  We need to let those cycles take their course, with appropriate governmental safety nets in place for the affected individuals AFTER all other channels have been exhausted (including bankruptcy).  Without the real threat of liquidation and wealth destruction, individuals and business will not consider the potential consequences of their actions.  They will simply risk everything they can in order to make more money, knowing that there is no real consequence for failure.  There should be no bailouts of organizations or individuals.  Many people don't seem to realize that the outrage over $165 million in AIG bonuses could never have happened if the government hadn't stepped in and bailed AIG out in the first place (because AIG would have gone into bankruptcy, causing all of these individuals to lose their jobs and simply be general creditors standing in line with all other creditors for proceeds post-liquidation).

2.  This is the more important, and controversial, point: everyone who handles, manages, or is ultimately professionally responsible for financial assets, physically or electronically, should be deemed a fiduciary under the law- from the bank teller all the way up to the CEO of exchanges, banks, and brokerages, along with real estate agents, mortgage brokers, etc. 

From Dictionary.com:

fi⋅du⋅ci⋅ar⋅y
   /fɪˈduʃiˌɛri, -ˈdyu-/
–noun
1.     Law. a person to whom property or power is entrusted for the benefit of another.
–adjective
2.     Law. of or pertaining to the relation between a fiduciary and his or her principal: a fiduciary capacity; a fiduciary duty.
3.     of, based on, or in the nature of trust and confidence, as in public affairs: a fiduciary obligation of government employees.
4.     depending on public confidence for value or currency, as fiat money.

A fiduciary duty is the highest standard of care in Western law. A fiduciary must not put his personal interests before the duty, and must not profit from his position as a fiduciary, unless the principal (client) consents. The word itself comes originally from the Latin fides, meaning faith, and fiducia, trust.

By making individuals who handle financial assets of any kind fiduciaries, it eliminates the ability for these individuals to put themselves and their personal profit before the interests of the client.  Violation of fiduciary responsibility carries with it rather severe penalties in Western law, including regurgitation of all related profits, compensatory damages to the client, and possible criminal penalties (including possible prison time). 

One example to note is the trustees of company-sponsored retirement plans.  One of the reasons you never see crimes like embezzlement and fraud being committed by trustees of retirement plans is because they are legal fiduciaries of the plan.  And such malfeasance can result in any combination of regurgitation of profits, large compensatory damages being awarded by a court, personal liability for damages, or possible jail time for any or all of the trustees. 

If CEOs, heads of Wall Street trading desks, bank mortgage underwriters and mortgage brokers were fiduciaries to their respective clients, you never would have seen any of this.  Think any of those 1-year interest-only negative amortization ARM loans would have been written by mortgage brokers (or created by banks) if the brokers were fiducially responsible for the well being of the client on the other end of those loans?  I think not.

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