NBA Franchises, Revenue Sharing, and What the League Could Learn From the U.S. Housing Collapse

I always read with great interest anything that combines professional sports with business. I enjoy learning about the collision between the two because professional sports leagues have chosen to operate outside the confines of normal American capitalism. Franchises, together with unions, have chosen a path where the two parties must work together to create a successful mixture of (in some order): 1) profitability, 2) competitiveness, and 3) survivability.

Earlier this week, SB Nation's very own Andrew Feinstein penned a piece that takes a look at what a revamped revenue sharing model could mean for the NBA's future.

Mark Cuban, Wellington Mara, and the NBA's Broken Revenue Sharing System

It will do you great benefit to read the article in its entirety; for my own purposes, I will try to summarize his thesis:

• The revenue sharing model that the NBA employs is a big part of what ails the league's financial structure.
• A revamped model is necessary to increase the overall level of competition across the board, so that the "haves" and "have-nots" are not so far apart.
• The NFL should be used as a template, and the NBA needs an owner like the Giants' Wellington Mara to help bring the sides together.
• Mark Cuban could be that kind of guy.

My goal is not so much as to offer a rebuttal to his proposal about whether we need a Wellington Mara for the NBA, but to offer a different point of view on the topic and ask this question:

Are we asking the right question?

1. Financial History Lesson

(History teaches us many things, including cool phrases that show up in movies. It is best to heed it well)

Unless you've been living in a bubble for the past three years, you're probably aware of what has happened to the US housing market.  As the economy has darkened, real estate and all of its connected statistics have fallen with it. Here is a brief summary as to how it happened:

1. The federal government, furthering the idea that homeownership is the cornerstone of success, came up with the brilliant idea that if home ownership was so great for the individual and the economy, then more people should be homeowners.
2. The government accomplished this discovery of iron logic by forcing lending institutions to lower their borrowing standards. More loans = more home owners = profits for everyone! (Not a far cry from the Underpants Gnome Theory of Economics) The lenders then split up and sold off these mortgages to other institutions that were willing to accept the risk. Ergo, the lenders were able to write massive loans and bear none of the risk.
3. Millions of people were now in very large mortgages that they could never before afford; as long as the economy continued to grow, they could continue to afford the mortgage payments, watch their net worth grow, and the upward trend could continue.
4. Fast forward to 2008. The economy stopped growing.
5. The tidal wave of all of these risky loans force people into delinquency and foreclosure. Freddie and Fannie fall apart and some of the nation's biggest banks face the fear of going under. Century old banks such as Bear, Stearns and Lehman Brothers did.
6. Government to the rescue! In the form of the Troubled Asset Relief Program (TARP), the government used taxpayer money to bolster the failing banks. Banks that played the game conservatively are penalized while banks that played the game recklessly were rewarded.
7. The giant banks and the government were duly chastened, and began to tighten the reins on the mortgage market.
8. Just kidding.
9. FHA loans take the place of Freddie and Fannie, reverting back to the risky lending practices that helped sink the market before. Once again, here come the high risk NINJA loans (No Income, No Job or Assets).
10. People who can get these loans do get these loans, and the parties who have skirted the capitalist system of risk and reward continue playing the game, knowing that someone else is bearing the risk while they profit.

The point of rehashing the real estate crisis is not merely to show how I went from living in luxury to living in squalor. Rather it is to demonstrate a pattern of decision-making that develops when the proper amount of risk is not assumed when making choices.

2. The Problem with Moral Hazard

I do have a point.

My purpose for rehashing the real estate meltdown is to hone in on what actually enabled it - a concept called moral hazard. What is this strange term?

"Any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly." - Paul Krugman, Nobel Prize in Economics, 2008

In the above scenario, there were two parties that assumed risk: the lenders, and the borrowers. However, only one of those parties kept the risk - the borrowers. If they didn't pay their mortgage, they lost their home. The lenders, the controllers of the money, did not have this same risk. If they were to issue a bad loan, so what? First, they sold off the risky parts of the loan to some other dope. Second, they were bailed out by TARP. Freddie and Fannie, who backed many of those bad loans, got their own little slice of the bailout pies, also from taxpayer funds. In short, the lending institutions did not face the risk that was inherent in the activities they undertook; they transferred it to those who didn't actually have any vested interest in the game - the other banks and the taxpayers. Since they did not keep the risk and bear the cost of bad decisions, they have no motivation to change their lending habits.  As long as lenders aren't penalized for doing stupid things, they will go on doing stupid things. It is the "dues ex machina" approach to decision making - no matter how bad our decisions may be, always count on that miracle happening.

Now that we have a framework for how bad decisions get perpetuated, let's take a look at the NBA. Does any moral hazard exist in the NBA right now? Yes, it does, although not in the place you might think. Malcolm Gladwell, take it away please (emphasis mine):

I think, for example, that the idea of ranking draft picks in reverse order of finish -- as much as it sounds "fair" -- does untold damage to the game. You simply cannot have a system that rewards anyone, ever, for losing. Economists worry about this all the time, when they talk about "moral hazard."

...No economist in his right mind would ever endorse the football and basketball drafts the way they are structured now. They are a moral hazard in spades. If you give me a lottery pick for being an atrocious GM, where's my incentive not to be an atrocious GM?

...If the reverse-order draft is such a great leveler, then why are the same teams at the bottom of both the NFL and NBA year after year? The current system perpetuates the myth that access to top picks is the primary determinant of competitiveness in pro sports, and that's simply not true. Success is a function of the quality of the organization.

Another more radical idea is that you do a full lottery only every second year, or three out of four years, and in the off year make draft position in order of finish. Best teams pick first. How fun would that be? Every meaningless end-of-season game now becomes instantly meaningful. If you were the Minnesota Timberwolves, you would realize that unless you did something really drastic...you would never climb out of the cellar again. And in a year with a can't-miss No. 1 pick, having the best record in the regular season becomes hugely important.

Taken from ESPN Transcript, 5/13/09

As you can glean from Gladwell's comments, currently the reverse order drafting scenario actually operates as a moral hazard. As long as organizations perceive a benefit to not playing hard (i.e. tanking down the stretch to improve draft position) and bear no risk in losing out on top level talent in the draft, they will continue to intentionally lose.

(There are exceptions to this rule. The Spurs were rewarded with Tim Duncan by tanking, and in the most recent aggressive tank-fest, the Cavs were rewarded with LeBron James. Although you could potentially argue that there were karmic consequences to such an approach)

In summation, when the risk-reward dynamic is interrupted with moral hazard, decisions become sub-optimal because the decision-makers do not have commensurate skin in the game. If they don't stand to lose the most, then the decisions bear less weight on their desire to get them right. Not only that, but the risk does get transferred elsewhere - it is like the law of conservation of energy in that regard. In the case of the NBA draft, the risk of picking the wrong guy isn't completely attached to the GM because, hey, we could get another one next year, and fans will still come to games, right? Rather, you could argue that the risk is transferred onto the fans. The fans now bear the risk and cost of paying for a ticket or for merchandise, not knowing whether the franchise will in fact attempt to do the one thing it is created to do - to try and win games.

3. The Revenue Sharing Proposal

Now that we can see that moral hazard exists on some level in the NBA, the logical question is, "So what? Isn't it good that poor teams get better players? Won't it make poor teams better?"

My question for you is: why do we keep seeing the same teams show up in the lottery year after year?

If you're inclined to disagree with my assertion, I think we can at least conclude that the cause-effect relationship between high draft picks for lottery teams and future success on the court is tenuous at best.

Let's circle back to the concept of revenue sharing. The premise of revenue sharing is that the league takes some of the surplus of profit the more successful teams earn and redistribute it to the less successful teams. The transfer of wealth provides those lesser revenue teams with more assets to try to forge ahead and build something meaningful in order to even out the level of competition. If this concept seems foreign to the entrepreneurial spirit, well, it is. The idea of revenue sharing is itself anti-capitalistic, since it effectively taxes the successful and subsidizes the unsuccessful, at least on a purely monetary plane. It is not a problem necessarily that revenue sharing is anti-capitalism; the fact is, the very concept of a professional sports league, with the parts existing to bolster the greater whole, is the very definition of collectivism.

The collective, i.e. the league, seeks to maximize itself economically. How to do this? The view, and the very alluring promise of revenue sharing itself, is that the league as a whole is best able to maximize its value if a majority of teams are competitive from year to year. Here is a little progression chart for you:

The formula is thus: by increasing revenue sharing, more teams will have more money to build their team. With more assets to build their team, each team will become better, which will raise the overall level of competition. An overall increase in the quality of competition will therefore cause the NBA and its teams to grow in popularity. A growth in popularity will allow the NBA to grow in net worth. Ergo, revenue sharing is a powerful and realistic means to increase the overall pie.

Is there precedent for this revenue sharing philosophy?

Now the past collides with the present. The NFL is the shiny beacon of light, since it is currently the model and money-printing megalith. As Feinstein mentioned, the NFL first instituted the concept back in the 1960's using a philosophy they called "League Think." Out of this philosophy, as Feinstein notes, powerful owners such as Wellington Mara acquiesced to the commissioner's motion to share revenue for the good of the league as a whole; for owners to think of themselves as partners rather than individual going concerns. In the1960's, the proposal held merit. Dozens of teams had folded or relocated in the prior decades, and so the commissioner at the time, Pete Rozelle, was faced with a very large dilemma: how was he going to shape the league so it would survive for the long term? Revenue sharing was the best possible way to solidify an entire league to ensure some level of both profitability and competitiveness.

However, as owners and teams have grown in wealth, the capitalist spirit has begun to poke its head up from the dirt once more.  The collective bubble of the NFL is fighting the capitalism that floats and swirls around it. Franchises do not always want to be thought of as part of the collective (see: Jones, Jerry), and there is now court precedent* signifying the way things will be moving. As much as the NFL would like to always bargain as a single entity, legally they cannot force a team to join in. Besides, I am hard pressed to be convinced that revenue sharing is still about survival for the league or for teams; instead, it is about trying to retain the remnants of a league that existed very long ago and to shoehorn an economic model that stretches against the capitalistic spirit that defines virtually every owner. If you take a look at the profitability of NFL franchises, you can see that only the Miami Dolphins and Detroit Lions had operating losses in 2010. The Lions are an easy case study as to why neither profit sharing nor a draft is any guarantee for future success. Also, take a look at the top team on the list in terms of operating revenue - the Dallas Cowboys haul in the motherlode and yet have not won a playoff game since 1996. Conversely, Indianapolis, a so-called "small market team," is eighth in operating revenue. Revenue sharing may pad the team's coffers, but I don't think it plays a material role in the current age as to which teams are competitive on a year to year basis. Team success has more to do with sound drafting, offering reasonable contracts, and front office management. What the NFL has now is a virtual fool-proof business to poor decision making, at least from a financial standpoint.

(*I actually wrote about this court precedent for the outstanding blog "The Baltimore Sports Report." Take a look if you are so inclined.)

4. The Effectiveness of Revenue Sharing

A revenue sharing proposal is based on the equation above: more money = better players which leads to better teams. However, this theory is based on a hidden presumption that having more money necessarily leads to having better players. Is this true?

Revenue Sharing Won't Solve the NBA's Small Market Problems | Business Insider

If you take a look at this article, you can begin to see that this presumption does not necessarily hold true. Consider the Indiana Pacers and the Milwaukee Bucks. According to Business Insider's data, each of these metropolises have under 2 million people, so they classify as "small market" teams. The Pacers and Bucks have spent over $69 million and 64 million on average from 2004-09, respectively. The Pacers suffered an operating loss of over $26 million, and the Bucks barely squeezed out a $1 million profit over that time period. These expenses and losses have yielded on average 38.4 and 33.6 wins per year. Clearly, these two teams would be prime candidates to benefit from revenue sharing.

Then you see the Utah Jazz. The Jazz have a smaller population than both, and a smaller TV audience than the Pacers. Never the less, the Jazz have turned an operating profit of $33 million while spending only $62.6 million on their players, and yet their average win total is 44 games per year. The Spurs are an even more drastic comparison. Yes, their metropolitan area is slightly larger, but they are still considered a "small market team." With their front office acumen, they have won an average of 58 games per year while spending less on their players than either the Pacers or the Bucks, and the combination has yielded an operating profit of $80 million.

Also, another statistical outlier is the man that Feinstein thinks might be capable of bridging the gap, Mark Cuban. He may be right in his assertion; I don't see any other owner in the league right now who has the same cache as Cubes. However, if you look at his own work in Dallas, a metropolis of over 6 million people, you will see that he loses a ton of money every year. Dallas is not a small market team, the owner is highly business savvy, and yet they lose money. Would Dallas be bolstered by revenue sharing? In fact, the only team that is losing more is the Portland Trailblazers, who may classify as a small market team with only 2.2 million people there. They too have let player costs spiral to pursue wins. Would revenue sharing help them at all? Remember, their owner is Paul Allen, currently worth $12.7 billion and is the 37th richest man in the world.

5. Revenue Sharing and Moral Hazard

Let's try to bring this mess back together. Based on above analysis, we can conclude that moral hazard is the enemy of good decision making, be it in real estate or in an NBA draft. We can also question the premise that a redistribution of wealth would automatically equate to more wins and more competitiveness, because there doesn't seem to be any correlation between a team's profit margin and how many wins they put on the board.

Can we take this in the opposite direction? Given the confluence of the two natures of moral hazard and revenue sharing, can an argument be made that not only would revenue sharing not help the league, but could it actually hurt the league?

Remember, moral hazard is what happens when decision-makers decide how much risk to take, but other people bear the cost if their decision doesn't pan out. As long as their insurance against bad judgment is in place, the decision-maker is not going to be motivated to care either way. A perfect example of this mindset is the Clippers' owner Donald Sterling. His insurance isn't revenue sharing, but is actually the fact that he had the good fortune to buy a team in Los Angeles. His team's financial success doesn't have anything to do with Sterling's ability to hire good executives, develop young talent, or bring good free agents to the team. In fact, those activities are purely incidental to his business approach. Put simply, Sterling is a real estate speculator and the franchise is his revenue stream. He will always be insulated from bad decision-making because his insurance policy, the Los Angeles market, will always be available to absorb the costs when his decisions fail. In fact, he actually has an impetus to NOT change the way he approaches things. If he were to take on additional risk by, for example, pursuing top flight coaches and free agents and they didn't pan out, these bad decisions would hurt his bottom line.  Ergo, he will not change the way he does his business.

My biggest fear is, just like the negative consequences of the draft described above, revenue sharing would create moral hazard for poorly run teams, reinforcing their bad patterns of poor decision-making. If they can stay where they are but turn a profit because more successful teams are forced to subsidize them, they are effectively being rewarded for failure. As Gladwell pointed out above, you can never award someone for losing.

6. A Better Question

First, an anecdote: LeBron James, the #1 pick in 2004, carried the Cavaliers to the playoffs five out of the seven years he was there. In 2011, the Cavs will once again be competing for a lottery draft pick, and I'd be willing to wager, the year after that as well. We can conclude two basic things: 1) LeBron James is a once in a generation franchise-altering talent; and 2) the Cavs organization learned essentially nothing as for how to build a successful franchise even as they existed AS a successful franchise.

In other words, for Cleveland, being both more competitive AND more profitable seems to have had minimal benefit on the franchise's ability to make better decisions.

What we have now is a system and a negotiation table that is seeking to further minimize the sting bad of decisions rather than reward good ones. Underpinning this system is the idea that franchises who are given more money will make better decisions with that money. To the contrary, I believe that being given more unearned money does not embolden better decisions, but rather because of moral hazard actually creates a tolerance for more poor decisions.

Hopefully we can explore some of those ideas down the road.

(NBA GM's feel free to contact me at dogburt21@gmail.com if you are looking for advice from a blogger whose online moniker is that of a cartoon)