Wall Street actions are a result of incentives

How can the financial crisis be a result of anything other than the incentives created by incomplete regulation and incorrect company structure?

People will always respond to the strongest incentives they see and are able to take on. The strongest incentives are so far-reaching across financial firms and the government:

  • Complete lack of either oversight or transparency of the derivatives market creates the incentive to build supposedly market-neutral bets that are orders of magnitudes larger than what capital reserve requirements dictate
  • Compensation packages that pay bonuses now on trades that can blow up later creates incentives for employees to take risks now; if the house falls down, they will be laid off, but will also be much wealthier.
  • The tacit understanding that the largest banks and hedge funds will be rescued no matter how stupid the actions that got them there to begin with creates the incentive to take on increasingly risky positions. If you aren’t playing with house money, you will be playing with taxpayer money.
  • The SEC’s inability to regulate Wall Street, because Congress told them not to, because they were told that regulation hampers innovation by a Wall Street lobbyist, creates the incentive to continue doing what you are doing, as no one from the government will bother you.

I am sure I am missing probably 3-4 other causes for these incentives, but to me these are the biggest.

The financial regulation bill reaching Congress today is a step in the right directly, but will likely introduce or leave behind holes. This will create additional incentives that financial firms will rush to fill. I don’t know what those holes are, as I haven’t read any part of the bill, but I know they will be picked apart by the blogs I do read (mentioned below).

Any argument that talks about morals (e.g. “Wall Street is too greedy”) is doomed to fail. Spend five minutes with a trader from one of these firms, and economic morals is generally completely lost on them. They wouldn’t be successful traders if this wasn’t the case, as their jobs are to take advantage of these kinds of inefficiency.

This post was inspired by this summary from Russ Roberts on Marginal Revolution, as well as from two years of reading Naked Capitalism and Marginal Revolution

“1. It isn’t “too big to fail” that’s the problem, it’s the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

2. Shareholder losses do not reduce the problem even when shareholders are the executives making the decisions

3. These incentives allowed execs to justify and fund enormous bonuses until they blew up their firms. Whether they planned on that or not doesn’t matter. The incentives remain as long as creditors get bailed out.

4. Changes in regulations encouraged risk-taking by artificially encouraging the attractiveness of AAA-rated securities.

5. Changes in US housing policy helped inflate the housing bubble, particularly the expansion of Fannie and Freddie into low downpayment loans.

6. The increased demand for housing resulting from Fanne and Freddie’s expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.”

(Side note: I use the term Wall Street quite loosely here. In reality, many firms that contributed are not physically on Wall Street, and many that are on Wall Street did not contribute in meaningful ways.)

Leaving a dentist near you…

UPDATE 4/22/2010: And like that, the ridiculous program requirements that Align Technologies put into place has been removed. Fortunately I did not follow through on that short – the stock is up almost double since this program was announced.

ORIGINAL 7/9/2009:

.. Invisalign.

In what could be the dumbest business decision I’ve heard of in a long time, Align Technologies (NASDAQ: ALGN), makers of Invisalign® has decreed that all dentists offering Invisalign must start 10 cases per year and complete 10 CE credits related to Invisalign per year (copy of letter sent to one dentist here).

What this means for the consumer:

  • The consumer experience will undoubtedly improve. Those who truly want Invisalign will now have a limited set of very experienced dentists to choose from.
  • However, competitive pressure may change that – see notes on ClearCorrect below.

What this means for the dentist:

  • The national average for a case is $5,000/year(source). Convincing 10 patients per year to fork over $5,000/year for a truly elective procedure is very, very hard in the vast majority of markets out there. Only the ones that market heavily and whose business consists of a very high percentage of cosmetic dentistry will make this quota.
  • Every dentist who became certified in the past 5+ years was required to pay $1K-2K to become certified. This, combined with a mandatory reduction in services, is going to lead to a large number of very unhappy dentists at this decision (I know a few myself). And, you can be sure that unhappy dentists across the country will do whatever is in their power to keep a patient in the door. A few choice quotes from the online dental community DentalTown:
    • “Absolute idiots IMHO !!! I wonder if they will be refunding doctors certification costs as they decided to change the rules in the middle of the game?”
    • “While there are many doctors that may not submit many cases to Invisalign, I suspect these same doctors talk alot about invisalign and are a terrific advertising/referral source for high volume invisalign offices or orthodontists. I’m sure many of us won’t have very many nice things to say about Align right now.”

What this means for Align Technologies:

  • I would expect that this knocks out 50-75% of their dentists (by number), but only knocks out 10% of revenue in year 1*. They can align sales/admin costs against this expected reduction in revenue to minimize the impact to net income. This, however, does not include the general softness expected in their business due to offering an expensive, elective procedure during a severe recession, which analysts have already identified.
  • Beyond intentionally cutting revenue during the recession, their timing is poor. Between being found as violating patents by one competitor (Ormco Corporation) and seeing another upstart invade their turf (ClearCorrect), they are leaving dentists with plenty of options that are not Invisalign.

How long will they have until this newfound exclusivity takes a toll on their brand strength and share price? I don’t think their 2Q earnings will reflect the change, as the few fringe dentists are likely pushing Invisalign hard to hit their quota, but I would be surprised if they don’t have to lower guidance again in future quarters, partially as a result of this policy.

Comments? Thoughts?

*These are gut-feel numbers, not based on financial analysis.