## Sunday, January 14, 2007

### Why don't teams and GMs care about the long term?

Would you pay an interest rate of 174% for a loan? Apparently, football GMs do. In their study of the NFL draft (previously reviewed here), Cade Massey and Richard Thaler looked at trades that involved only draft choices, and discovered, based on the value of the draft choices, that the average implied discount rate on those trades was 173.8%.

For instance, the authors write,

“... teams seem to have adopted a rule of thumb indicating that ... for example, a team trading this year’s 3rd-round pick for a pick in next year’s draft would expect to receive a 2nd-round pick in that draft.”

According to NFL teams’ own internal charts of draft choice values, a mid-second-round pick is worth “420,” while a third-round pick is “190”. Receiving 190 this year, in exchange for 420 next year, calculates to an interest rate of 121%. (Presumably, to get from 121% up to the average of 174%, there must be other trades with an interest rate in the 200s!)

In real life, if the market sets an interest rate of 121%, that would suggest at least a 50/50 chance of the borrower going bankrupt and the creditor not getting any money back at all. But, in the NFL, there’s no doubt that the creditor team will make good on its promise of the second round choice – the league offices will see to that. So why would a team think of paying 121%?

It could be the incentives its management faces. Every GM knows that he could be out of a job at any time, which gives them an urgent incentive to show improvement right now, before they get fired. If the GM is thinking only of himself, and not the team, the high discount rate might be perfectly appropriate – a 50% chance of getting fired is roughly equivalent to a 50% chance of going bankrupt. Either way, the party choosing to defer the possible benefits has a only a one-in-two chance of reaping them.

This is the argument that
J. C. Bradbury and Keith Law are making (in the Sabernomics blog) for a slightly different situation – the question of why baseball teams pay so much for players who are demonstrably not worth it, and why they continue to issue long-term contracts to players in their declining years.

Law writes,

“The problem is that the best way to keep a GM job when you know you’re in danger of losing it is to produce results in the short term, sometimes in the very short term. This idea of trading a dollar in the future for 10 cents in the present often manifests itself in moves like trading prospects or young players for “proven” veterans, signing well-known free agents whose name value exceeds their on-field value, and backloading deals to maximize disposable payroll in the current year without regard to the payroll consequences for future years.”

While I think that this argument is certainly a part of the answer, I don’t believe it’s even close to the entire answer. In the football case, the 173% discount rate is more than just an unwritten rule of thumb – it’s literally accepted, in writing, in the form of 30 teams’ similar draft value charts. If thirty general managers were conspiring – in writing! -- against thirty team owners, in an effort to keep their positions, all it would take is for a few owners to tear up the draft value chart and present the GM with a better one along with orders to use it. Or for one GM to start aggressively trading current draft choices for future ones. At a 100% discount rate, one choice today would be worth 32 choices five years from now. That seems like a good way to for a GM to attract attention as a genius (or at least attract attention as something).

More practically, a team could trade this year’s draft choices and receive double draft choices forever! To do that, trade this year’s choices for two choices next year – in addition to the “regular” choice next year, that gives you three. Next year, trade one of those three for two again the next year. Repeat, and you’ll have two draft choices instead of one, every year, forever. If you were a GM, wouldn’t you think a deal like that would impress your ownership?

In the baseball case, if it’s against the better interests of the team for the GM to offer the contracts he does, that would imply that not offering those contracts would make the team better off. But if 29 GMs are offering too much money to free agents, the (rational and ethical) thirtieth GM does not have the option of paying less – he only has the option of not paying at all. That would put his team in the basement, and that’s not clearly in the interests of the team. I think a better explanation of out-of-control contracts is a model where some owners are willing to lose money for
the pride of having a winning team. Their overspending forces other teams to also overspend, even teams that want to maximize profits rather than wins, and the result is a salary spiral.

In any case, Bradbury has what I think is an excellent idea for how owners can bring rationality back to the executive office. His suggestion is to offer the GM a bonus for how well draft choices turn out – even if the GM has since been fired. (This doesn’t mean GMs would necessarily make more money overall, since their base salaries could drop by the expected amount of the bonuses.) The same calculation could work for trades – GMs could be credited (or debited) based on the performances of the traded players in subsquent years.

It seems like this extra incentive would work very well. A early draft choice next year would earn more money overall for the GM than a later draft choice this year. Once every GM starts realizing this – which would probably take about fifteen seconds -- the market price would immediately adjust. It won’t adjust perfectly, because the GM will receive only part of the value of the draft choice. If a second round choice is worth a million dollars more than the third round choice, but the GM only gets to keep 1% of that, he might be willing to sacrifice \$10,000 in bonuses to show results this year and keep his job.

And on the flip side, the incentive structure needs to be considered carefully, because sometimes you absolutely need to make a “bad” trade for a short-term need. In 1992, the Blue Jays traded Jeff Kent and Ryan Thompson for two months’ worth of David Cone. In raw long-term value, the trade looks like a disaster. But Cone helped the Jays win the World Series, and GM Pat Gillick probably has no regrets. But would he have made that same trade if it would have cost him thousands of dollars personally?

Still, it seems like the right set of incentives could work to correct whatever anomalies ownership is concerned about. If GMs received part of the profit from a
Nolan-Ryan-for-Jim-Fregosi trade, they they’d at least be thinking a little more about long term benefits. And if they had to take a loss for trading a draft choice that turns into a superstar, they'd suddenly realize that part of the 121% interest rate they’re paying would be on their own money.

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