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, in hopes of selling 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)

141%

9 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 institutional shareholders have 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 its collapse, 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 take only a roughly 3% decline in the value of Lehman's assets to render the company 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 blow up, 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 2 million job losses. Even strong companies unrelated to the financial industry are suffering from the economic fallout of this crisis -- Coach (NYSE: COH  ) , Best Buy (NYSE: BBY  ) , and Chevron (NYSE: CVX  ) , for example, were forced to announce layoffs earlier in the year.

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 rise of more than 200% 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 probably 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. Just this month, Buffett, Bogle, and former Goldman Sachs (NYSE: GS  ) Chairman John Whitehead joined 25 other highly respected signatories in endorsing a similar proposal by the Aspen Institute.

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 to 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 Buffett's relatively meager compensation, large stock ownership, and long-term focus.

AMR's (NYSE: AMR  ) Gerard Arpey, Duke Energy's (NYSE: DUK  ) James Rogers, and Southern Copper's (NYSE: PCU  ) Oscar Gonzalez Rocha 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 competence 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.

Already a subscriber to Inside Value? Log in at the top of this page.

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 Best Buy and Coach, is a Stock Advisor pick. Berkshire and Best Buy are also Inside Value recommendations. Duke Energy is an Income Investor selection. The Fool owns shares of Berkshire. The Motley Fool is investors writing for investors.


Read/Post Comments (9) | Recommend This Article (23)

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 September 19, 2009, at 8:36 AM, RLAprof wrote:

    As I understand it, next year a lot of boomers that make over $100,000 will be able to roll their 401s and traditional IRAs into Roths. That will give them access to lots of money that they can use for short-term trading, and pay NO taxes on the gains.

  • Report this Comment On September 19, 2009, at 8:41 AM, sept2749 wrote:

    Really interesting article. 60% tax on short term gains could hurt the "investor"though - especially the individual small investor who lets say, needs money to live and is forced to sell a stock he recently bought. However, if the gov't. were to keep the short term gain tax rate at where it is for individuals but raise the rate for corporations to 60%, if for instance, they were to sell "x" percentage of holdings it could have a positive impact on shareholders in general.

  • Report this Comment On September 19, 2009, at 3:24 PM, AnnaDcc wrote:

    Nice article, but I agree.. a 60% tax would be horrible for the little guy. For many Americans who feel like they're fighting a losing battle in this economy destined for inflation, short-term trading offers both a hobby and a source of hope. It lets individuals take their retirement future into their own hands, rather than entrusting even more of their destiny to others.

    If you tax the little guy trying to build a chance for a retirement before death 60% on capital gains through short-term trading (the only kind of trading that is safe in this corrupt financial system), you'll take away not only chances of success, but also any enjoyment of trading in the process.

    Maybe this 60% tax on short-term holding would be a good idea for mutual funds and hedge funds, to keep the market safer for the small investor. Taxing the little guy who has no real control over price fluctuations due to large hedge bets, though, would just be kicking someone when they're already down.

  • Report this Comment On September 19, 2009, at 3:39 PM, 026463 wrote:

    Let me get this straight..........you want another tax? we are taxed beyond the grave now. The government will come up with this idea shortly, please do not help them. Tax smokers, tax pet owner, tax people that mow their grass.

  • Report this Comment On September 19, 2009, at 11:08 PM, PsychPlayer wrote:

    This is a dreadfully naive idea. It won't have its intended effect, instead it will only drive capital to other markets. Similar to the way Sarbanes-Oxley drove the IPO market to London and out of New York.

    This is an age of global capital flows at the speed of electronic information. Short term traders are not creating market instability, that role goes to the Federal Reserve and to Investment Banks operating at 30 to 1 leverage, and to Fannie Mae doing the same thing.

    Let me guess, next you'll be proposing to outlaw short selling.

    This "tax people I don't like" strategy subconsciously implies that Buy and Hold investing works. It doesn't. Anybody with a brain knows the Ibbotson study is a fabrication of the brokerage industry. The Dow is actually down from 9/1999, 10 years ago. Not by much, but it is down.

    Folks, even in those good old days before 1987 when Alan Greenspan single handedly removed morality from equity markets for the next 20 years, markets have always been treacherous. Governments fiddle with currencies (1985 Plaza Accord, 1987 Louvre Accord) crashed Japan in 1989 and it never recovered because of history, demographics, and government policy in banking. Not because short term trading was a problem.

    Why not complain about the low ethical standards for IPOs courtesy of Goldman Sachs starting with the Internet age. Or the complete failure of the SEC/CFTC to regulate large financial institutions. Or the corruptness that bails out selected large financial players.

    Oh long term investor, it is the central banks and the western marxist governments you should abhor, not the free exercise of using the internet to process information faster, and the deregulation of global capital flows to put money in China or take it out as the political winds blow on creating a stable economic powerhouse over the next 20 years.

    Bad, bad idea that "sin tax" on trading. You'll only reward the slow witted and foreign markets as America continues its economic decline in the world as it fails to innovate successfully in its economy. Or it fails due to global corporatism, take your pick.

  • Report this Comment On September 20, 2009, at 12:24 PM, feigmo wrote:

    Once again to the point of blatant redundency , an imposed Tax ( and lets get serious - it is really a FINE ) will just solve everything according to the illiterata. People are trying to recover losses via a BEARISH market so lets take even that away from them.

  • Report this Comment On September 20, 2009, at 2:38 PM, wasteofair wrote:

    This could be done as easily with a tax rebate as a tax increase, or a combination of the two that is revenue neutral. This is all about realizing that more wealth is created and shared by more people by shifting the focus away from short-term investing. It is not good for the economy as a whole to have such a large part of corporate equity owned by short-term traders and it's particularly bad for wage earners. This in no way changes the important economic function that short-term trading performs, only that it does harm when it becomes dominant.

  • Report this Comment On September 20, 2009, at 4:32 PM, deadlysaber wrote:

    Now we understand that taxes are necessary to ensure better lives for everyone, but that does not mean it doesn't hurt to pay taxes. Capital gains taxes can be particularly difficult, since one may feel that they are entitled to the whole amount. There is a way to avoid capital gains taxes though, called a 1031 exchange. This refers to provisions made possible via the Internal Revenue Code section 1031, which specifies how capital gains and associated taxes can be deferred.

    The gist of it is that you do not "sell" your assets, but instead "exchange" them for something else. There is a fundamental difference there, and that is why 1031 exchanges can help you get the max out of your investment's growth. To illustrate, perhaps an example is in order.

    Say you own stocks in a mining company. That mining company has performed well for the past years, and has seen its value rise. Your stocks in turn grow to about 1.2 times the original size. Now, if you were to sell those stocks and cash out so to speak, you would lose some amount to taxes and not get the total 120% return of investment you wanted. Instead, you can reinvest that amount by exchanging your current stocks with stocks totaling a higher value from another mining company. This will not garner any capital gain, since no sale was made and so no tax could be placed against it. You retain your 120% return of investment fully, although it remains in stocks form and not cash. If you planned to invest the money anyway, then this is definitely worth a shot. This exchange of assets with no loss constitutes a 1031 exchange.

    The application for a 1031 exchange is rather complicated, as is anything that has to do with finance and taxation. There are rules which identify eligibility to apply, as well as conditions to be satisfied for it to be considered legal. It would be best to turn to a qualified professional for advice, or to a Qualified Intermediary to actualize it.

    ----------------------------------

    Money without intelligence is like a car without a road.

    http://www.intelligentinvestingtips.com

  • Report this Comment On September 21, 2009, at 3:48 PM, operacat wrote:

    Isn't a law like this already in use? If one holds a

    stock for at least a year and a day, the 15% capital

    gains tax applies. But if one sells the stock sooner

    than that, the old 28% tax applies.

    As a PCU investor, I am glad to read that The Fool

    is "Bullish"; and that execs. are not compensated to

    vulgar extremes I was encouraged to read that the

    CEO recently bought 112,000 shares. How long will

    he hold them will be of interest.

    But in general, the mentality that this tax or that tax

    should be used to fix things, or for punitive purposes, is a bit scary.

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