Archive for the ‘Corporate America’ Category

Your Cheating Heart

We live in a society which presumes that everybody is being completely honest with each other and that everybody is doing the right thing all the time.  We have the presumption of innocence in matters of law, for example.  Of course, when the rubber meets the road, not everybody is completely honest about everything.  In some cases, this is beneficial, while in others it is not.

I have a health savings account (HSA), and as a result, I tend to view the medical establishment with a degree of caution.  That is, I’m keenly aware of what medical procedures and prescriptions cost, even though, in many cases, the doctors don’t know what things cost.  And I know that there is a complex financial relationship between my health and what it costs to keep me healthy.

I suppose that this is an example of the Stockholm Syndrome, but also I tend to view the health insurance carriers as being on my side.  In the end, their vigilance over medical costs is what keeps my insurance premiums reasonable.  Yes, of course, I would like the rates to be lower, but I also recognize that there are financial aspects to my relationship with my doctor, the hospitals and my health insurance company.

The insurance carriers have always been the subject of criticism from all sorts of people and “advocacy” groups.  And not all of it is undeserved.  Yet, from time to time, the politicians decide to play to the electorate with what can only be considered to be ill-advised legislation.  The latest in this cavalcade of political pandering comes to us in the current session of the Georgia General Assembly.

Rescission: (to rescind or set aside a contract) has generally been defined as the unmaking of a contract between parties.

State Senator Preston Smith, a Republican from Rome, Georgia, has introduced SB330, which deals with an insurance industry practice called “rescission”.  To quote:  At the core of SB 330, Smith said, is rescissions, or the cancellation of health insurance polices. Smith said Georgia is one of the few states that allows rescissions, particularly those based on errors, omissions and misstatements.

As with so much else, it is presumed that when you file an application for health insurance, you are being truthful. To continue quoting Senator Smith, his bill would: “Prevent insurers from canceling policies and refusing claims based on contract misstatements or innocent omissions.”  Of course, your “innocent omission” can be a deal breaker for the insurance carrier when you fail to reveal your two-pack a day relationship with Marlboro cigarettes, for instance.

As pointed out by a representative of the health insurance industry: “If I don’t know what the risks are, I charge you more...”  The insurance industry has legions of actuaries whose sole job is to assess risk and to price things accordingly.  If they don’t know what the risks are, their pricing has to reflect this lack of knowledge.

And, in a parallel example, our own governments rely upon us to be honest and truthful in reporting our incomes for tax purposes.  When you sign that tax form, you are attesting that the information which you have given is an honest report.  They give you some latitude for “innocent omission”, but when it becomes apparent that you have not been truthful, the penalties and interest have a way of reminding you that you shouldn’t do that sort of thing.  Why should insurance applications be any different?

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The Wall Street Journal recently had a very small article about the latest chapter of a conflict, buried down in the Money & Investing section of the paper. For those who understand railroads, this should have been front page news.  The heart of the story is the ending of a contentious relationship between CSX Transportation, a major United States railroad, and The Children’s Investment Fund (TCI), a hedge fund which was started in 2004.

The basic elements of the story were: TCI and another fund, 3G Capital Partners, last year lobbied other shareholders for proxies to install a five-person board slate, which included the heads of both funds plus nominees with transportation sector experience and some who specialized in freight rail operations. They argued that CSX Transportation had underperformed in its rail operations and could generate more value to customers and investors. For more details, please see here.

Put another way, the railroad operators viewed their mission as running a successful railroad that yields returns on the stockholders’ investments. The hedge fund viewed the railroad as an investment that returns profits from the operation of the railroad. A dynamic had developed between the railroad managers and the hedge fund managers, one that boiled down to a question of how to run the railroad. Which is to say, how to spend the money which the railroad was bringing in as revenues. Of course, with the fall of revenues, the possibility of peeling off dividends becomes less of a possibility, thus the exit of the Children’s Fund.

Many were concerned about the effect of a hedge fund, which had the goal of maximizing financial returns, being in control of an entity that served the public good. And, the railroad is an entity which could wreak havoc on local communities if a train derailed. Or if goods could not be delivered in a timely fashion. In short, the railroads are institutions which our country relies upon to support the public good, but are, at the same time, privately financed institutions.

At the core of this dissonance is maintenance, the regular and routine activities performed by the railroad to make sure that it can continue its mission of moving freight. This specifically includes track maintenance, which is the regular replacement of crossties, leveling and alignment of the track and related activities. Maintenance is a big item for a railroad, and one way to improve financial performance in the short term is to defer maintenance. It works in the short term because instead of spending the money to keep the track in shape, you spend the money on other things, such as dividends to the investors. And it is the track which is the heart and soul of a railroad; without good track, the railroad cannot perform.

Deferred maintenance is a slow and pernicious process, and even in this era when everything is a crisis, deferred railroad maintenance would likely slip under the radar until things were really bad. Recovery from the effects of deferred maintenance are expensive and equally slow. I’m old enough to remember when the railroads of the United States were on their collective knees. World War II had been the railroads’ greatest hour, when they hauled soldiers and war materiel, giving the extra effort to win a war against tyranny. During World War II, maintenance had been largely deferred, and in the wake of the war, there was a period of financial recovery that led to a significant decline in railroad revenues. Something had to give; it would be the railroads’ infrastructure that took the hit. And as the track deteriorated, train operations deteriorated in tandem. As the trains slowed down, freight customers found other modes of delivering their goods.

Additionally, the railroads were regulated by the Interstate Commerce Commission. The nature of the ICC was covered well in an article in the Wall Street Journal, August 14, 2001. In a review of John Steel Gordon’s book “The Business of America”, reviewer John Lilly states: More typical is Mr. Gordon’s evident enthusiasm for free and fair markets. In “R.I.P, ICC” he presents an unflattering obituary of the Interstate Commerce Commission, which ended its days in 1995, having “outlived the problem it was created to manage by several decades.”

The net effect was that the railroads had reached a point when they could no longer operate trains at the speed necessary to attract freight customers, and were regulated in such a way that they could not easily shed losing operations. The ICC should stand as an example of unintended consequences to those who seek to use Federal government to govern private enterprise. It would be the Staggers Rail Act of 1980 that freed the railroads of their burden.

Railroads are, by their nature, unique and conservative institutions. Unlike other transportation modes, railroads usually own their own rights of way, maintain their own facilities and pay taxes upon those assets. Because their tracks cannot be easily moved, railroads are in it for the long haul, so to speak. You just don’t pick up the tracks, signals and structures and move them to another location if the business environment offers a new opportunity. If a new business opportunity becomes available, it has to be a big one for the railroad to commit to making the substantial investment necessary to reach that opportunity.

Compare this to a trucking line, for example, which simply routes its vehicles over public roads. Or an airline, which simply directs their aircraft to the new destination, to an airport maintained by a municipality under the direction of Federally paid controllers. While both trucking companies and airlines pay taxes and user fees, ultimately it is the taxpayers who support their business models in the notion of “The public good”. Most railroads, on the other hand, still pay for much of their own costs; this has changed somewhat in recent years with the states realizing that a good railroad can remove truck traffic from their highways. Which brings us to CSX, which has an advertising campaign that points out that the railroad can haul a ton of freight over 400 miles on a gallon of fuel. Efficiency.

The departure of Childrens Investment Fund Management, an aggressive hedge fund, from CSX signals an end to a quietly growing dilemma. Although this matter is over and done for the moment, there still remains the question of how the railroad operates in our society. Railroads in the United States are largely private entities that serve the public good. Past experiences with government operation of railroads have proven to be expensive, sometimes wildly so. People often point to the European passenger train as a successful model that the United States should follow. What is not seen are the costs of such an operation.

The railroad is, first and foremost, a financial entity. It is not a children’s toy.

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