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Optimal Contracting and the Securitization of Human Capital

Professor Jonathan Parker

An interesting new company, Fantex, is securitizing human capital.  They are offering assets whose payouts are determined by a given athlete’s future earnings, in this case both Arian Foster and Vernon Davis, players in the National Football League.  Here is a New York Times article from today, and here is a more complete description from former Goldman Sachs employee and current Grantland writer Katie Baker.  (Before heading out to buy, note that the convertible bonds that the story describes are pretty complex and not just a bond backed by a share-of income.)

This financial innovation could be bad thing, and I expect that sports leagues make this illegal, or at least a violation of the terms of contracts.

Why?  Because private contracts like NFL contracts are typically carefully structured by employers and employees to balance risk-sharing and incentives (and to be consistent with salary cap rules).  On the one hand, employees do not want lots of income volatility.  For a given expected income, people prefer to be paid a certain amount, rather than having to bear uncertainty due to variations in future performance, particularly due to factors that are beyond their control.  On the other hand, employees that get paid more if they do better have an incentive to do better, to train harder, eat right, etc.  Would someone work as hard if they were only getting fifty percent of the money they earned?   In general, economists think not.   This dis-incentive is the source of the economic cost of taxes, why higher taxes mean lower output.  So contracts provide insurance and a safe payment where the effects of monetary incentives are weak or the effects of forces beyond the employee control are large (such as for injuries).  Similarly, contracts provide incentives and a variable payment where the effects of incentives are large and mostly controlled by the employee (such as attendance at practice or weight gain).

The central lesson of this theory is that incentives are costly.  Because employees dislike risk, a contract involving more incentives has to pay more on average to the employee to compensate for bearing the additional risks.

Now suppose that an optimal contract is agreed to by both parties.  But now a new securitization market opens, and the employee takes the incentives part of the contract, for which they are on average being paid more, and securitizes it so as to insure the risk away (at least partly).  The employee has just re-written the contract in a way that is disadvantageous to the employer who now no longer has an employee with (as strong) incentives to perform well.  Anticipating this possibility undermines the writing of the original contract.

An analogy might help.  Imagine a CEO who was highly incentivized by company stock and as a result highly paid securitizing his human capital.  Securitization the CEO’s human capital would look like the CEO shorting the company stock – turning the expected high income into a sure thing, unaffected by company performance.  Thus CEO contracts and US regulations prohibit this.  And this is socially optimal (at least the bit about prohibiting shorting own-company stock).

So, while, the general idea of securitizing human capital seems great, it can undermine incentives.  For contractual relationships (rather than spot labor markets), it opens the possibility for employees to change incentives after contracts have been written.  In the case of Arian Foster, we are only talking about 5 percent of earnings.   But if I were the NFL, I would be quite concerned about my employees using financial instruments to weaken the strength of incentives.

Jonathan A. Parker is the International Programs Professor in Management and a Professor of Finance at the MIT Sloan School of Management.