Did Shareholders Cause The Crisis?

About a month ago, Atlantic Correspondent Ben W. Heineman, Jr. wrote a fantastic piece about shareholders and their role in the crisis. I have long wondered why more attention hasn't been paid to this topic. After all, it's shareholders' job to control management and keep its risk-taking in check. If shareholders had acted more responsibly, you might argue that we could have avoided this whole mess.

Heineman addresses this explicitly in his piece. It's quite long, but quite good. In particular, I think his explanation of the shift to institutional investors' influence as shareholders in U.S. corporations is very important:

Institutional investors now own approximately 60 percent of U.S. equities (using other people's money). Some observers say, while there are some long-term value holders, many of these investors are driven by the goal of short-term performance in their portfolios, and so they engage in relatively short-term trading strategies and have little interest in corporate creation of long-term economic value by the corporations whose securities they own and trade. (Shares of stock are now held, on average, for far shorter periods than was the case 10 or 20 years ago.)

For funds, I think this is particularly relevant. When many people are looking at funds, they probably aren't as concerned with the 5- or 10-year return, but probably more interested in their 1- to 3-year return. Thus, short-term profits are how funds are often judged too. Is that a failure on the part of those individual fund investors? Sure, but that's reality.

So the assertion that institutional investor shareholders might have contributed to the problem, having had more of a focus on short-term profit, is almost certainly true. But if you're anything like me, then you look at your 401k statement rather hastily, making sure that your funds are doing relatively well and not much more deeply. So the idea that individual fund investors would be able to affect the kinds of companies that funds invest in seems ridiculous. But that most individual fund investors want long-term profit as opposed to significant short-term risk is almost certainly true.

There appears to be a major problem for relying on institutional investors to act as responsible shareholders. But what about that other 40%. Sure, it's less than the majority, but could they help matters? Unfortunately some of those investors might be even less likely to affect change. A fair portion of that likely consists of firm insiders. While it might be nice to think that management cares about long-term profit, the reality is that they probably care a lot more about keeping their annual performance evaluations high.

Then there is the handful of large individual investors. They're the most likely source of long-term care and concern. Unfortunately, they also likely make up a small minority of shareholders for many corporations.

So what's the solution? I'm not really sure. In theory, if shareholders actually want the focus to be on short-term profit, then it's hard to say they're wrong. After all, if it's their company, then they can focus on whatever they want. It's their money to lose. Of course, the rest of the economy could suffer if their firm's failure poses great systemic risk.

A non-bank resolution authority solves this problem. Shareholders are within their right to develop a risky corporation that may very well fail if the tide changes. Yet, within a free market economy, that failure must be possible. Otherwise, shareholders' goals could conflict with the stability of the economy. So you must either force shareholders to adopt the goals of Washington or allow those goals to lead to failure if foolhardy. I prefer the latter option.

Then the problem really is only for small individual fund investors. If they're concerned with long-term investment, then must also consider a fund's behavior as a shareholder. Does it cater to investors who prefer short-term profits or strive for longer-term returns? What I would hope to see is some funds that focus on stable long-term returns, rather than higher short-term gain, becoming more popular. Of course, this change would also result in better shareholders and a more stable economy going forward.