The Coming Financial Time Bomb

Never, ever, think about something else when you should be thinking about the power of incentives. -- Charlie Munger

Maybe you've heard this popular myth: A major cause of the financial crisis was boneheaded Wall Street compensation packages unaligned with shareholder interests.

Before I can tell you why that story is so misleading, please ask yourself this:

Am I an investor, or am I a speculator?
During his recent visit to Fool HQ, business legend John Bogle argued that this is the very first question you must ask yourself.
The distinction is simple but powerful: Investors buy shares of businesses and prosper over time as the company grows profits. Speculators, on the other hand, trade wiggles on a stock chart, hoping to sell shares at a higher price to other speculators within a few quarters.

Back to the myth
Sadly, shortsighted compensation plans and business strategies are aligned with the time horizons of the vast majority of shareholders. After all, at year-end 2007 (the most recent statistical set), some 80% of all shares were held by financial institutions. And the evidence shows that financial institutions are, by and large, speculators.

Given the explosion of mutual funds, 401(k)s, endowments, and the like, it makes sense that institutional ownership has steadily risen over the years. As institutional ownership has grown, however, the average holding period of stocks has shrunk:

Year

NYSE Turnover

Holding Period

2009 (year-to-date)

145%

8 months

2000

88%

14 months

1990

46%

26 months

1980

36%

33 months

1970

19%

63 months

1960

12%

100 months

Source: NYSE Group Factbook. Turnover = number of shares traded as a percentage of total shares outstanding.

It gets even worse when we look at the overall stock market, according to Bogle. Inclusive of exchange-traded funds, the overall market turned over at 284% in 2007. That means the average holding period for stocks and ETFs was four months!

OK, but how does this speculative frenzy affect you?

Wall Street's very dirty secret
Simply put, when an institutional shareholder has a time horizon of four months, they should want management to pull out the stops right now to hit quarterly earnings targets. If they're not going to own the stock in five years, why would they concern themselves with the long-term effects of today's business decisions?

Consider the average holding period of these stocks in 2007 -- the year before the volatility-inducing financial meltdown:

Company

Holding Period

Bank of America

9.4 months

AIG

9.3 months

Citigroup

5.8 months

Morgan Stanley

5.0 months

Lehman Brothers

2.5 months

Sources: Yahoo! Finance; Capital IQ, a division of Standard & Poor's; and author's calculations. Turnover calculated as total yearly volume divided by average shares outstanding.

One appalling example
From 2000 until the collapse of the firm, former Lehman Brothers CEO Richard Fuld received approximately $350 million in total compensation. In part, he was rewarded for growing the company's earnings at an annual rate of 18% over that time frame ... except that those returns were produced using 30-to-1 leverage on top of a shoddy asset base.

Since it would only take a roughly 3% decline in the value of Lehman's assets to render the firm insolvent, it seems as if Lehman operated with temporary gains in mind, but no thoughtful strategy for how to avoid blowing up. And on Sept. 14, 2008, it did, in the largest bankruptcy ever.

The shock of Lehman's failure froze credit markets, caused huge derivatives losses, and set off bank runs around the world. In just one month, the TED spread shot up to an all-time high. AIG needed to be rescued by taxpayers because of the billions it lost because of Lehman's collapse.

The run on Washington Mutual, which began the day of Lehman's collapse, led to the largest bank failure in U.S. history in mere weeks. One Wells Fargo senior economist estimated the employment fallout from Lehman's bankruptcy at two million job losses. Even strong companies unrelated to the financial industry are suffering from the economic fallout of this crisis -- Medtronic (NYSE: MDT  ) , eBay (Nasdaq: EBAY  ) , Wal-Mart (NYSE: WMT  ) , and Verizon (NYSE: VZ  ) , for example, have been forced to announce layoffs.

No one disputes that the outrageous risks taken at Lehman Brothers and similar institutions have had terrible effects on our economy. But consider this: Despite Lehman's epic collapse, it's probable that most shareholders benefited from Lehman's more than 200% rise over eight years. Refer back to the chart above -- the average holding period of Lehman stocks was less than three months!

Frankly, this upsets me. And I can't blame you if it makes you mad, too. The fact that a majority of business owners' interests are unaligned with the health of their own businesses runs completely counter to the well-being of our economy and the basic tenets of capitalism.

If capitalism is going to work, this ridiculousness needs to change.

Here's my plan
One market-oriented mechanism would be a tax increase on speculation, combined with a tax decrease on investing. If it became less profitable for institutional shareholders to speculate on short-term price movements, and more profitable to invest for the long term, their holding periods might increase, and they'd likely care more about the financial health and compensation structures of the businesses they own.

This could take the form of a graduated 60% speculation tax on stocks and equity-based derivatives held for less than one year, which tapered down to, say, 5% after a few years.

I'm not the only investor who has thought of such a plan. Warren Buffett (perhaps facetiously) once suggested a 100% short-term capital gains tax, while John Bogle has advocated a 50% rate. Former IBM CEO Louis Gerstner recently suggested a similar plan.

Such a move to align institutional shareholders with the long-term health of the companies they own is a necessary step to preventing the next financial time bomb. Without such a shift in incentives, they would have limited reason to demand responsible management, and a crisis like this one would be more likely happen again.

The silver lining ...
To be fair, not every corporation fits the Lehman mold. Berkshire Hathaway's shareholders are owners for more than 30 years on average; they must be happy with Warren Buffett's relatively meager compensation, large stock ownership, and long-term focus.

Nucor's (NYSE: NUE  ) Daniel DiMicco, Amazon's (Nasdaq: AMZN  ) Jeff Bezos, and UPS's (NYSE: UPS  ) Scott Davis have compensation structures that look much more like Buffett's than many of their CEO counterparts.

Just as we saw a number of disasters in the past year, I expect -- and history confirms -- that we will begin to see other companies benefit from their missteps. With stocks so cheap, making money now becomes a matter of examining every facet of a company -- including the competency of its management team, rewards and incentives, business strategy, and market environment.

These are just some of the factors we examine at Motley Fool Inside Value to identify the best bargains in this market. Click here if you're interested in reading more about our favorite stock ideas, free for the next 30 days.

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This article was originally published under the headline "Why You Should Love Higher Taxes" on April 17, 2009. It has been updated.

Ilan Moscovitz owns shares of Berkshire Hathaway, which, along with eBay and Wal-Mart, is an Inside Value pick. Berkshire, eBay, and Amazon are Stock Advisor selections. UPS is an Income Investor pick. The Fool owns shares of Berkshire and Medtronic. The Motley Fool is investors writing for investors.


Read/Post Comments (4) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 16, 2009, at 4:59 PM, DennisMack wrote:

    This is an interesting idea, but it does not reflect the fact that much institutional money, including money run by hedge funds, is exempt from income taxation. Your proposal needs to addresss this.

    I can appreciate a suggestion to treat positions held for less than one year and the income earned from renting out proxy voting rights and other ways speculators make money with shares like the UBT, and then make the earnings subject to income tax Federally and in the state where the principal office of the investor or its advisor is located.

    However, you propose to reduce the tax rate on people who hold for a longer term. There is some point, perhaps earlier than the phase out of the tax, where the tax exempt organization should be free of the tax.

    The problem with the reduced gains tax on a longer holding period will create a dilemma for those deciding whether to put money in a retirement account when their buy and hold strategy outside the retirement might result in lower income taxes. And why would a person pay the income taxes today on his Roth contribution or conversion if the gains on the positions held for less than a few years will be taxable in any event.

    Can you imagine the added tax-accounting complexity you will be adding to the annual tax filings of Joe Average. Right now, he can largely ignore things like basis. Under this proposal, he might have to keep track of many different facts.

    Since most people do not trade much in their 401(k) accounts, perhaps there should be an exemption from such a rule for retirement accounts in a group that aggregate less than some amount for a single person.

  • Report this Comment On August 17, 2009, at 11:06 AM, kkolbye wrote:

    Although an interesting concept to try to resolve the problem, I don't think you are going to change wall street, but, what you will do is punish the small investor more. I like to swing trade some in addition to long term buy and hold.

    Morally, I think taxes are unjustified for the most part. I think what would spark the economy would be less taxation and government interference. Let the cards fall where they may from free markets. Now, I'm realize there has to be some and hopefully minimal regulation in some markets to keep it orderly. Think what we could do for our retirements if we had less taxation period? That to me is the most interesting concept out there. We would be able to keep more of what we earn and depend less on government controlled entitlements for our retirement.

    Anyways, thanks for letting me voice my 2 cents worth.

    Yours truely.

    a fool fan since the beginning.

  • Report this Comment On August 18, 2009, at 12:16 PM, sTUTTIG wrote:

    The basic recommendation of the Motley Fool is good. However it lacks as a well as the comments lack the area of danger.There exists in the mathmatical world Progressive and regressive means of judging how far out on a limb the current economy is. With the proper consenses in place and the areas or limits os safety extablished the SEC or a like organization could keep a mathmatical model current showing the result of speculation of this type. When the flag is raised sombody should be forced to act.

  • Report this Comment On September 02, 2009, at 2:59 AM, TMFDiogenes wrote:

    Thanks everyone for the fantastic comments. Dennis, you're right -- there would need to be a way to address tax-exempt accounts and institutions. When Buffett, for example, advocacted a 100% short term capital gains tax, he specified that it should apply to tax exempt institutions as well. On a related note, it would be important for funds, rather than fund investors, to pay capital gains taxes, so that fund managers can't simply pass off these transactional costs to his/her investors.

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