Consumers vs. Payors: Misaligned Incentives

All of the great American industries seem to be in states of crisis today, don’t they?

Banks. Automobile manufacturers. Newspapers. Health care institutions. Apparently, all types of industries — from the producers of massive machines to the deliverers of personal services — are teetering on the precipices of catastrophic collapse.

Experts within each of these industries have identified any number of unique reasons that explain their onslaughts of challenges. But there is one factor, a single unusual condition, that is common to all of these sectors and that might explain many of their problems.

Can you identify this factor? As Robert Redford explained to Dustin Hoffman in All the President’s Men, if you want to identify it, you’ll need to follow the money.

Who is the Customer?

So let’s do that; let’s follow the money. From whom do companies in these industries receive money?

From their customers, of course! They collect cash from sales; then they reinvest their proceeds in their own firms.

But who are their customers? And how do they pay for their transactions?

Well, in most industries, the customer is both the consumer and the payor. In other words, the person or organization that pays for the product or service is the one that actually uses it. But in the case of these four industries, the consumers and the payors are very different entities.

Consumers, Payors, and Wholesaler “Middlemen”

For instance, let’s consider the mortgage banking industry. A person buying a new home may be the consumer of a mortgage, but he isn’t the payor at the time of closing. Instead the payor is usually an anonymous investor who purchases the mortgage security for his portfolio. The bank itself is simply a wholesaler “middleman” or intermediary who temporarily advances money to the consumer and then “flips” the mortgage asset to another party.

But don’t automobile manufacturers sell cars directly to consumers? Well, no, not at all. Dealership wholesalers actually acquire the vehicles and then “flip” them to the consumers. And whenever consumers borrow money to purchase or lease these products, loan brokers advance them the necessary funds and then “flip” the securities to anonymous investors.

Newspaper publishers, likewise, define their payors as their advertisers and their consumers as their readers. And health care institutions routinely treat their patients and then receive money from health insurers, who in turn charge employers and government programs for their intermediary services.

Misaligned Incentives

But why is it a problem when consumers are not payors, i.e. when producers must manage two different sets of customers? Well, when this occurs, consumers and payors may each receive a different array of incentives. And when different parties are offered different incentives, they will likely respond with different behaviors.

Once again, let’s consider the mortgage industry. Why should any bank that originates loans maintain debt collection and mortgage service functions when it flips all of its debt securities to anonymous investors? Clearly, under such circumstances, no party is obligated or incentivized to continue serving consumers after their mortgage transactions are finalized.

Automobile dealers face the same situation. After they sell each new automobile to a consumer, they can make far more money by servicing each vehicle than by collecting monthly debt or lease payments. Because these securities are purchased by anonymous investors, no party is obligated or incentivized to maintain effective collection functions, leading to situations where defaults and foreclosures become commonplace.

Newspapers and healthcare institutions face similar problems. If a large buyer of advertisements in a local community newspaper threatens to terminate its purchases unless an editor cancels a series of critical articles about the buyer’s business practices, how can the publisher remain in business while protecting his editor’s right to free speech? Likewise, if a health insurer refuses to pay for an expensive clinical procedure that a covered member wants but cannot afford to finance out-of-pocket, what is a surgeon or hospital administrator to do?

When the payor and the consumer are the same party, at least the producer can try to bargain with a single individual. But when they are different parties, any misalignment of incentives can make bargaining impossible.

The Solution: Make ‘Em Pay!

So what’s the solution to the problem of incentive misalignment when consumers and their wholesalers are relieved from the responsibility of payment? Increasingly, producers and their regulators are making ’em pay – in whole or at least in part – for the transactions in which they are engaging.

For instance, in the near future, look for regulators to require that banks be prohibited from flipping 100% of their mortgage portfolio to anonymous investors, and to meet minimum consumer debt service requirements as well. Also, look for regulators to set similar standards for automobile loan and lease transactions.

Likewise, don’t be surprised if you begin to be billed for accessing your favorite newspaper’s web site, or if your physician co-pay requirements continue to increase. You may not enjoy these new costs, but at least you will understand why producers are attempting to shift the burdens and incentives of payors away from third parties and back towards their consumers.