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:

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:

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.

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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 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.