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Required Reading for the Healthcare Debate March 27, 2007

Posted by David Bookstaber in Healthcare.
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I just stumbled across Phillip Longman’s essay, “The Health of Nations,” from 4 years ago.

A More Reasonable Hedge Fund Fee Structure March 21, 2007

Posted by David Bookstaber in Finance.

Hedge funds are a legitimate financial industry, distinct from the retail industry of tax-efficient diversified mutual funds geared towards small investors and individual savers. However, the hedge fund industry maintains a fee structure that embeds an unusual moral hazard. The industry is ripe for an evolution in fee structure, but it may take a major and somewhat altruistic player to effect that evolution.

The Status Quo

Typically a hedge fund manager will collect a 2% management fee and on top of that will take 20% of any profits generated. This emphasis on performance incentives is a hallmark of the industry. But the incentive is almost always implemented with a peculiar feature: The fund manager gets to lock in performance fees at the end of each calendar year. He will keep this money even if he subsequently loses investor capital.
This fee structure creates perverse incentives. Because the manager shares directly in the upside, but risks nothing material on the downside, he has every reason to take excessive risks. In effect he is gambling with other people’s money. The annual lock-in produces a behavior known as the Wealth Effect: Managers who have accumulated large profits tend to reduce the risk they take towards the end of a calendar year in order to protect their impending payout. In contrast, managers who have lost tend to “double-down” and take excessive risks, in hopes of recovering and turning a profit they can harvest at year end. In each case the manager’s incentives are not aligned with those of the investors, who want to take exactly the appropriate level of risk regardless of how much has been made or where they are in the calendar.
A common fix to this problem is to establish a “high water mark” so that managers do not earn any incentives until they have entirely recouped losses.  The perverse result of this is that as soon as their performance draws down too much they tend to close up shop rather than stay in the game to recoup their investor’s losses.  After all, they do not earn anything extra by making money back.  The problem again is that they have still locked in past performance fees.  Often it is easier to take their past winnings and start from scratch somewhere else, where once again they are “above water” and immediately share in profits.  (This tendency for losers to quit has resulted in a notoriously large “performance selection bias” in the hedge fund industry.)
These hazards were on spectacular display at Amaranth Advisors where Brian Hunter, an energy fund manager, accumulated enormous paper profits in 2005.  He personally took home an estimated $75 million at the end of the year based on that performance.  However, he earned that money by taking huge risks, and just a few months into 2006 his positions collapsed.  Investors lost more than half of their money, and the firm promptly closed, but Brian Hunter kept his millions.
The Fix 

The industry is ripe for an evolution in incentive structures:  It is obvious that this needs to involve delayed vesting of performance fees.  Performance fees should be kept in escrow with a vesting period much longer than one calendar year.  Just as the exact performance share varies from fund to fund, the vesting period could vary; a reasonable period might be at least five years.
So long as investor money is at risk, performance fees should be at risk.  Granted, fund managers have to feed their families, so they would lock in their fees gradually over the vesting period.  But delayed vesting will keep their skin in the game even if they have a big drawdown.
To see how this would ameliorate all of the moral hazard inherent in the current incentive standard, imagine a hedge fund named Zamaranth funded by two equal investors, A and B.  During 2005 Zamaranth doubles its investors’ money, and the manager gets $100 million in incentive fees escrowed, vesting over five years.  Beginning 2006 the manager is earning $1.67 million each month from escrow – an ample payout from his stellar performance.  Soon investor A cashes out, and since that investor’s money is no longer at risk, the manager immediately banks $50 million from escrow.  A few months later, Zamaranth’s remaining positions collapse, losing all of the value they accumulated during 2005.  Investor B, having lost all his gains, recoups all of the performance money remaining in escrow.  The Zamaranth manager took a big risk, and he shared in the consequences.  But he is still incentivized to work for his investor, because he is not “below water,” so any profits he earns will immediately accumulate in his escrow account.

In Support of “Separation of Church and State” March 20, 2007

Posted by David Bookstaber in Government.

Our Constitution erects no “Wall of separation between Church and State,” but I would be happy to respect one if the liberals who so adamantly agitate for it would respect it themselves.

After all, New Deal liberals have manipulated our federal government into a tool for coercing all Americans to follow their moral programs for intervening in almost every facet of American life.  The fact that theirs is a godless religion does not make it any less of an establishment.  Their clerics exhort them from the halls of academia and the pulpits of the mainstream media.  Their politician-priests compel even the unbelievers to pay taxes for non-Constitutional government activities — regardless of whether an individual agrees with their purpose or means.

John Marini has an eloquent summary of this conflict:

Indeed, they resemble the religious quarrels that once convulsed western society. The progressive defenders of the bureaucratic state see government as the source of benevolence, the moral embodiment of the collective desire to bring about social justice as a practical reality. They believe that only mean-spirited reactionaries can object to a government whose purpose is to bring about this good end. Defenders of the older constitutionalism, meanwhile, see the bureaucratic state as increasingly tyrannical and destructive of inalienable rights.

Ironically, the American regime was the first to solve the problem of religion in politics. Religion, too, had sought to establish the just or good society—the city of God—upon earth. But as the Founders knew, this attempt had simply led to various forms of clerical tyranny. Under the American Constitution, individuals would have religious liberty but churches would not have the power to enforce their claims on behalf of the good life. Today, with the replacement of limited government constitutionalism by an administrative state, we see the emergence of a new form of elite, seeking to establish a new form of perfect justice. But as the Founders and Reagan understood, in the absence of angels governing men, or men becoming angels, limited government remains the most reasonable and just form of human government.

Time for the Old Deal March 20, 2007

Posted by David Bookstaber in Government.
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Perhaps one shortcoming of our Constitution is that it has no circuit-breaker to allow for its temporary suspension during crisis.  In emergencies our government often stretches against its bounds and, since a constitution is not supposed to be elastic, things never really return to their original shape when the crisis is over.  We could take a page from the ancient Roman Republic and allow for government to assume dictatorial powers for limited periods during circumstances that threaten the nation.

During the Great Depression the United States were overwhelmed by temporary economic dislocations.  The desperate masses acquiesced to Roosevelt’s New Deal, which replaced “the revolutionary notion that the people grant government its rights, and not the other way around” (that’s Reagan’s description of the Constitution, in his final State of the Union).  John Marini has an excellent essay in this month’s Imprimis that illuminates the philosophical basis of Roosevelt’s New Deal — and Reagan’s attempt to roll that back.

Roosevelt had made it clear, even before he was elected president, that government had a new and different role to play in American life than that assigned to it by the Constitution. In an October 1932 radio address, he stated: “…I have…described the spirit of my program as a ‘new deal,’ which is plain English for a changed concept of the duty and responsibility of Government toward economic life.” In his view, selfish behavior on the part of individuals and corporations must give way to rational social action informed by a benevolent government and the organized intelligence of the bureaucracy. Consequently, the role of government was no longer the protection of the natural or political rights of individuals. The old constitutional distinction between government and society—or between the public and private spheres—as the ground of liberalism and a bulwark against political tyranny had created, in Roosevelt’s view, economic tyranny. To solve this, government itself would become a tool of benevolence working on behalf of the people.

The New Deal was essentially a fascist compact.  Its purpose was not to preserve individual liberty, but rather to preserve the moral ideals of a society: Everyone would be compelled to sacrifice so that nobody would suffer too much.  This may well have been the only way to weather the Great Depression.  But it is fundamentally at odds with the United States Constitution, as Reagan explained when he began trying to undo it a generation later:

“[T]he full power of centralized government” was the very thing the Founding Fathers sought to minimize. They knew that governments don’t control things. A government can’t control the economy without controlling people. And they knew when a government sets out to do that, it must use force and coercion to achieve its purpose. They also knew, those Founding Fathers, that outside of its legitimate functions, government does nothing as well or as economically as the private sector of the economy.  (1964, “A Time for Choosing“)

Unlocking the Organ Supply March 16, 2007

Posted by David Bookstaber in Healthcare, Human Markets, Regulation.

Sally Satel makes the easy case that allowing incentives for donation will increase the currently scarce supply of human organs. She misses the other significant damper on organ supply: discretion.

Why do many people decline to donate their organs after death? A 2005 Gallup survey turned up two interesting results: 21% of people agreed with the statement “Transplants often go to undeserving people” (my emphasis), and 79% agreed that “Discrimination prevents minority patients from receiving the organ transplants they need.”

Many people are hesitant to dump their body parts into the labyrinth of rules devised by the United Network for Organ Sharing and hope that their own values are considered. What if they don’t want an elderly alcoholic to get their liver just because he has been on a waiting list longer than a young diabetic? Or what if they don’t believe a mother should be in line behind a violent felon to receive their heart?

Individual incentives and discretion are both keys to unlocking the supply of human organs.

Confused Environmentalists For Speed Limits March 13, 2007

Posted by David Bookstaber in Energy, Regulation, Transportation.
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As far as I’m concerned Germany’s Autobahn is one of its greatest tourist attractions: Immaculately maintained highways teeming with some of the world’s best cars and best drivers, compounded by long stretches with no speed limit.  Among my fondest travel memories is blasting through the scenic German countryside at 140mph in a rented Audi turbodiesel.

So here come environmentalists to crash that party: No less than the EU “Commissioner for Environment” suggested it’s inappropriate to let people drive that fast because cars consume more gas at higher speeds.

This is a typical environmentalist maneuver: Attack a high-visibility target without regard to its value.  There’s no consideration of the benefits of speedy highway travel.  Meanwhile, how much could a speed limit benefit the environment?  “A spokesman for the Transport Ministry, Dirk Inger, said a study by a federal agency had found that an overall autobahn limit of 100 kilometers per hour — or 62 mph — would reduce carbon dioxide emissions by only 0.6 percent.”

I have a number of ideas that would have a far greater impact on carbon emissions:

  • Require every European to live within walking distance of his place of employment.
  • Ban leisure travel more than 10 kilometers from a European’s place of residence.
  • Ban residences that are larger than 500 square feet per occupant.
  • Ban recreational energy consumption: No more sporting events, theme parks, etc.
  • Ban fossil-fueled power plants.

Strangely, the Greek EU Environment Commissioner has not proposed any of these initiatives.  I guess it’s easier to tell someone else (in another country, no less) to change than to propose changes that could strike closer to home. 

Fortunately, a group representing the German auto industry said it needed “no coaching on efficient climate protection from Brussels.”

An Inconvenient Truth on “Carbon Offsets” March 2, 2007

Posted by David Bookstaber in Energy.
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The basis for carbon offsets to absolve eco-sinners of guilt is bogus.

Carbon offsets consist of either paying someone to expend resources sequestering atmospheric carbon that would otherwise roam free (presumably trapping heat and warming the climate), or else paying someone to not emit carbon into the atmosphere that they otherwise would – typically by paying to replace a fossil-fuel energy source with a “green” energy source.

The problem with the latter “replacement” scenario is precisely that it immediately reduces consumption of fossil fuels … which reduces demand, makes them cheaper, and thereby incentivizes someone who could not afford them before to come along and burn them after all. Fossil fuels will continue to be burned until cheaper and more portable stores of energy are developed. There is no short-term penance that can change that equation.

Spending resources to capture carbon that has already been released is also dubious. The workers who are planting trees will be burning refined oil as they go about that business. Carbon injection factories will be built with metal smelted with coal and powered perhaps by natural gas. So long as our economy is powered in part by fossil fuel, you are at least indirectly burning fossil fuels anytime you consume or spend anything. In theory it may be possible to undertake net-positive carbon sequestration, but nobody has offered a calculus that fully considers the carbon emissions of every input to a practical sequestration effort.

So before we absolve our eco-upper-class of hypocrisy, we should consider that buying indulgences for eco-sin is not as easy as they would like to believe.