12 November 2008

The Ownership Of Enterprise

One of my all time favorite non-fiction books, written by law professor Henry Hansmann, now teaching at Yale Law School, and published in 1996, has the same title as this post. Unlike most books on choice of entity, his book is largely empirical. He looks at what businesses are organized in which way and then asks what purpose this serves. By doing so, he deduces what factors are really important.

One of the most trenchant observations of the book, which spends quite a bit of time looking at cooperatives, employee ownership and non-profit organizations, in addition to more traditional shareholder ownership, concerns the pre-FDIC banking industry. Historically, the officers of shareholder owned banks consistently took big risks with other people's money. This paid handsomely when the risks paid off, and left somebody else holding the bag when the risks went south.

But, historically, not all companies behaved in this fashion. Credit unions and their counterparts, mutual insurance companies, both of which are customer owned cooperatives, were more cautious. Directors genuinely accountable to people who face serious down side risks make more conservative risk choices and are less prone to catastrophic collapse.

The FDIC ended this cycle for commercial banks. By imposing reserve requirements sufficient to make its insurance benefits mostly irrelevant, it became as safe to put your money in a bank as it was to invest in the safest investment in the marketplace, Treasuries. Free of the need of depositors to fear deposit threatening bankruptcy, shareholder owned commercial banks went on to thrive and become the dominant form of organization for the banking industry, although lightly regulated credit unions remained.

The state regulatory framework came later and less consistently to the insurance industry, and as a result, many significant insurance companies, like Northwestern Mutual and Amica, continue to be organized as consumer cooperatives.

This provides some context for some of the closing words of Michael Lewis, the author of Liar's Poker, discussing the collapse of major Wall Street financial institutions he'd assumed would happen a couple of decades earlier. He is discussing the collapse of an investment bank that changed its form of organization from an employee owed partnership to a publicly held corporation with the man who took it public.

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?

Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.

Investment banks are doing precisely what killed pre-FDIC commercial banks in wave after wave of financial panics. They are taking excessive risks with other people's money because they have upside risk, but not downside risk.

The defining executive compensation tools of the quarter century "Wall Street era," from the start of the 1980s boom around 1983 through the 2008 financial crisis, have been the stock option and the profit sharing bonus. A stock option rewards executives for increases in stock prices but is merely worthless if stock prices fall. A profit sharing bonus gives senior employees a fat check if the company is doing well, but asks no one to give anything up if the company does poorly. These compensation methods exemplify this bias in favor of the upside without due regard to the downside that exists on Wall Street.

Stock options are strongly encouraged by our tax code, which explains why the lion's share of senior executive compensation in publicly held companies is structured in this way. Stock options defer taxation, while ordinary pay must be taxed immediately. Stock options also convert compensation for services ordinarily taxable at the highest individual income tax rates and in addition 1.45% of FICA taxation for both employer and employee (for a combined 37.9% marginal tax rate), into capital gains taxable at a mere 15% tax rate with no social insurance taxation.

You can't simply prohibit "excessive risk taking." Excessive is too malleable to operationalize without more context.

But, you can create incentives that require management to better weigh the relative upside and downside risks associated with business decisions like compensating them with shares of stock that have both an upside and a downside, instead of stock options. You can change the tax code so that it doesn't have a bias in favor of debt over equity financing for big businesses and people's personal lives. You can create director selection methods that make management more accountable to shareholders, and hence less prone to expose companies to risks that are excessive in the eyes of shareholders.

One could, for exmaple, require that firms that invest other people's money as a principal, the way that a mutual fund or private equity fund does, be investor owned, and that such firms be segregated from firms that provide investment services to others but do not invest their own funds, like investment advisors, retail brokerages and firms the underwrite initial public offerings.

One doesn't have to create incentives. One can opt instead for the road that commercial banking took. Whole industries can be prohibited from engaging in practices known to be risky for investors, like excessive leveraging, beyond a certain point defined by government regulation. Companies could be limited in the volume of guarantees that they are allowed to undertake.

Furthermore, while there is compelling evidence that allowing markets to set prices advances economic growth, the evidence that forcing the market to fit its offerings into one of a wide range of governmentally standardized products with only a few "moving parts" causes any economic harm is far less persausive. This may have costs at the margins, where innovative opportunities are lost. But these costs may come in exchange for the benefit of creating a market that participants in it actually understand, and thus are more likely to behave rationally within.

Perhaps new financial products ought to be treated the way the FDA treats new drugs. They would have to be tested under close supervision with people who know they are guinea pigs, and approved as safe and effective, before they are unleashed on the wider marketplace.

Ultimately, this particular post isn't about a solution. It is simply about identifying one of the central problems that created the financial crisis, which is that some of the key players had the wrong incentives. In another part of the conversation quoted above, Lewis notes that:

He thought the cause of the financial crisis was “simple. Greed on both sides—greed of investors and the greed of the bankers.” I thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.

I agree with Lewis.

Hat tip to NewMexiKen.


Anonymous said...

Hi Andrew, I was hoping to send you a heads up on an event tomorrow at the State House about immigration law reform I thought might interest you, from DU, what's the best way to email you? You can zap me a note if you don't want to post it at chase.squires(xat)du.edu

Thanks, Chase

Andrew Oh-Willeke said...

The first part of the e-mail address is ohwilleke and the e-mail provider is hotmail.com