Moral Hazard and Free Agents

Keith Law of ESPN writes on how GM moral hazard may have contributed to the size, length, and structure of free agent contracts this offseason.

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.

Keith kindly asked me to comment on some potential ways that owners might try to limit this type of behavior.

Solving this problem is not easy, and it’s one that plagues owners of all kinds of businesses. Professor J.C. Bradbury of Kennesaw State University, the author of the upcoming book “The Baseball Economist” and the man behind the Sabernomics blog, points out how difficult it is to overcome the moral hazard issues inherent in the GM role:

“Whether it’s through tying bonuses to stock options or hiring outside auditors, it’s something that owners can only hope to mitigate, not solve. I wouldn’t be surprised if owners began to give bonuses that are good even if you’re fired. If you sign a free agent or draft a certain player who reaches a certain level, you get a share of that, whether you are with the team or not. This would encourage the GM to focus on the long-term.”

Some teams could choose to give their GMs ownership stakes, as Oakland has done with Billy Beane, but doing so also represents a much more firm commitment to the GM than most teams are willing to make.

Because it’s an Insider article I don’t want to quote too much, but Law discusses the specific clauses of several contracts that may be influenced by the win-now-or-be-fired attitude of some GMs.

8 Responses “Moral Hazard and Free Agents”

  1. J. Choe says:

    Hi JC,

    I had an opportunity to talk with a highly regarded Bay-Area GM a few weeks ago and I brought up the moral hazard issue. (I actually didn’t come out and use the term “moral hazard” b/c I didn’t want to run the risk of having people roll their eyes at me.) Anyway, I specifically pointed out the Hendry/Cubs-Soriano deal. This GM that I was speaking with discounted the moral hazard issue a bit b/c he said that that most owners have a final say in the end before a GM takes on a big financial commitment. If this actually is the case, then the moral hazard issue is tempered a bit, as an owner could veto a deal if a GM was too self-serving. But this is assuming that 1. the owner is involved and knowledgeable enough about the baseball market and the specific situation to take a stand and 2. the GM wasn’t fired before an owner would have to make a veto. Off the top of my head, I can’t think of any deals vetoed in this manner that have been discussed publicly, though I’m sure that there are some around. And I am not sure that ownership is the answer, because if you give a bad decision-makin’ GM an ownership stake, then it’s even harder to get rid of him. You’d be introducing the “bad-professor-but-s/he-has-tenure problem.”

    Digression: And instead of solely blaming a GM and his incentive problems for a lot of bad decisions, share some blame w/ the owner and/or the President/day-to-day operator of the team for not setting up a better organizational structure to oversee big financial decisions. I’m stretching here, but fully blaming a GM for making bad deals perhaps b/c they are in his/her best self interest is as inaccurate as blaming a CEO for having a lucrative pay package. In the latter case, one should instead be blaming the Board of Directors for a CEO’s lucrative pay package b/c Boards often have to overpay people to become its company’s CEOs b/c these Boards didn’t do their jobs by already having candidates lined up before their CEO position becomes open. Alright, this digression is a stretch, but my point is: don’t *just* blame the GMs/CEOs…instead share some of the blame with poor organizational planning!

    I really enjoy your site. Thanks.

    Best, J. Choe

  2. JC says:

    Interesting.

    Just to be clear, both Keith and I feel that moral hazard is way down on the list of contributors to this season’s growth in salaries. But, I do think it’s an issue that may influence the structure of some deals. And, most certainly, owners are aware of the problem, and there is no sure-fire remedy.

  3. tangotiger says:

    I disagree with Keith on adding Wells in the list of backloaded deals. As I said on my blog:
    “With all the deferments and signing bonuses, I estimate Wells contract would be the equivalent of him having signed next year as 7/125. That is, they pretty much worked it out that instead of getting 18 MM in each of 2008 through 2014, that it’s the same thing as getting 8.5 MM signing bonus in 2007, 08, 09, salaries of 0.5 in 08, 1.5 in 09, 12.5 in 2010, 23 in 2011, 21 in 2012-2104. ”

    Soriano as well is not that bad in terms of backloaded, as I estimate it as a regular 8/132 (no signing bonus or deferred payments) deal as opposed to his actual 8/136.

  4. Eli says:

    Wow I’m talking with elite company. I just found your blog and its exactly in my interest area. I’ll take a look at your book…

    This is an interesting issue. How could owners leave so much responsibility with their money to a guy making only 0.5 million per year, or perhaps 1-2 million? A good solution would be to have an owner who knows what’s going on, like in the Red Sox ownership or Mark Cuban. But my favourite team, the Blue Jays, have an owner who doesn’t really know a lot about the game and is busy running his 3 billion dollar media corporation to spend time worrying about 7 year contracts. Perhaps there needs to be more scrutinized selection criteria, perhaps one decided by with some say from all organizations, on who the GM will be. This is not a very realistic idea, but every GM’s actions affect every other GM’s actions, by inflating the market, etc. I guess the problem with this is what outlines the very thing that gives the game its flavour: the fact that some GM’s love veterans, some are all about youth, some have 90-year-old owners that are penny pinchers and others that want their money spent.

  5. Eli says:

    Or a GM school could be helpful. I find the problem with 7 year contracts is that most of the time its not because the owner wants to give it because they want to keep the player for as long as possible, but because that is what the player automatically can get if he so desires because someone on the market will be willing to give that luxury. And collusion can’t stop this. You could look at almost every contract at a (much) higher AAV with less years, as in Jason Schmidt. I guess what goes through the GM’s head is “well, if we cut him in the last two years, then that’s overpaying by 40 million, but spread over the contract that means we’re paying him only 24 million for his prime years…”

  6. Eli says:

    Alternatively, GM’s could be given very little job security. Then, just like HOF voting and the defensive awards, you could have a panel vote on how utterly stupid a move is and if you rank poorly on certain indexes, then it puts your job in jeoapardy. Might I add that to this framework, GM’s get only 1 year long contracts and make much more than they do now, something like $3 milloin on average.

  7. JC says:

    Thanks Eli! Glad you like it here.

  8. Eli says:

    Another idea I had is if long-term contracts took on an incentive based position later in the contract incase of injury, kind of like the Cliff Floyd arrangement with the Cubs. It seems more fashionable amongst contracts lately. Ah, I guess it’ll never work.