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 is so misleading, please ask yourself one question.

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's 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

129%

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. Including exchange-traded funds, the overall market turned over at 250% in 2009. That means the average holding period for stocks is less than five 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 five 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

JPMorgan Chase

8.6 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 his company's collapse, former Lehman Brothers CEO Richard Fuld received about $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 have taken 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 -- an indicator of credit risk in the economy -- shot up to an all-time high. AIG needed to be rescued by taxpayers because of the billions it lost thanks to 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.

All told, the economy has shed 8 million jobs, and public debt as a percentage of GDP is expected to be triple what it otherwise would have been as a result of the crisis. Even strong companies unrelated to the financial industry continue to suffer from the economic fallout -- over the past month or so, IBM (NYSE: IBM  ) , Caterpillar (NYSE: CAT  ) , and Chevron (NYSE: CVX  ) , for example, have been forced to lay off thousands of employees in their server, backhoe loader, and crude oil refining areas, respectively.

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 once suggested (perhaps facetiously) a 100% short-term capital gains tax, while John Bogle has advocated a 50% rate. In September, Buffett and Bogle joined 26 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 toward 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 (NYSE: BRK-A  ) 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, Microsoft's (Nasdaq: MSFT  ) Steve Ballmer, and Whole Foods' (Nasdaq: WFMI  ) John Mackey all have compensation structures that look much more like Buffett's than many of their CEO counterparts.

Just as we saw a number of disasters over the past two years, I expect -- and history confirms -- that we will begin to see other companies benefit from those missteps. In this market, 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.

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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 Whole Foods and Berkshire Hathaway. Whole Foods and Berkshire are Stock Advisor selections. Motley Fool Options has recommended a diagonal call on Microsoft. Microsoft and Berkshire are Inside Value selections. The Fool owns shares of Berkshire. The Motley Fool is investors writing for investors.


Read/Post Comments (4) | Recommend This Article (14)

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 April 14, 2010, at 9:16 AM, Vandy1961 wrote:

    Me personally I think this is a bad idea. I invest but I now set stop limits to protect myself from loss on bad news. I have sold shares of stocks, not so I can reinvest in other companies and take a profit but to prevent the loss. Throwing a huge tax at me for doing that is rediculous. Some of my picks have had huge drops in value prior to stting up my stops and now I am stuck with them until they recover if they recover. Punishing a good investor for protecting himself is just another way to ensure he/she takes a loss either by making him/her ride the stock down or through taxation. Either way they get to take a loss.

  • Report this Comment On April 14, 2010, at 10:45 AM, Grongo wrote:

    While I agree that short-term investment and management is a real problem, there is an error in the article's supporting facts. In the case of IBM, the layoffs were a nakedly opportunistic move of jobs from the United States to the Third World, under the protective cover of the recession.

  • Report this Comment On April 14, 2010, at 11:04 AM, goballstate wrote:

    No one has ever stated that stock ownership is safe or protected. Saying that a system to improve investments for everyone can't be enacted because you are afraid of losing money on a bad bet is ridiculous. And the article has a very valid point. If the system isn't stabilized and made better, then more and more we'll see bad news, poor corporate management, and major market losses (very likely anyway). This is a very valid way to fix the problem. It may also, to act on your point, force smaller individual investors to look into company health more actively prior to investing in that company whether they are concerned with short or long term holdings. I don't see any of this as a bad thing.

  • Report this Comment On April 14, 2010, at 11:19 AM, millsbob wrote:

    Vandy, this is not net sarcasm, but an honest appraisal.

    if you use "stop-loss" and "investor" in the same sentence, there should be a "not" involved somewhere.

    are you Really an "investor"?

    think about it.

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