Your Problem is My Problem
No, this is not an article on hippy togetherness. It’s an article on the problems generated by subcontracting.
Whether investing in high-grade tranches of subprime mortgages or contracting a job, it is important to realize that if the other party has a problem, it may become your problem. At one company, a substantial amount of product development was contracted out to another firm. The company was very careful to create a good contract in which its liability would be minimal unless the contractor delivered. Unfortunately, the contractor had subcontracted the project using a contract that was not performance-based. As a result, the contractor experienced substantial losses from its relationship with the sub-contractor. Needless to say, this affected the contractor’s ability to complete the task. Thus, the mistakes of a contractor can adversely affect the hiring firm, even if the hiring firm created a strong and properly incented contract.
This same problem occurred on a broader scale with the United States subprime mortgage crisis. Institutional investors bought various tranches of subprime mortgages, based on faith that the risk associated with them had been modeled correctly. Mistakes in modelling the risk have affected both the investors and those that sold the tranches.
How can one avoid this problem? Unfortunately, the answer is not simple. One must make the effort to analyze all of the downstream issues affecting one’s contracts. This is often hard to do, as contracts often lack the right of downstream inspection. Thus, it would be advisable for people entering into contracts to demand the right to both inspect the firm being hired, and all firms subcontracted by that firm or sub-subcontracted by the subcontractors. Thus, this clause of right to inspection would have to be included in all of the contractors contracts with its subcontractors. This way, you will be aware of the full situation, and will be able to both assess your subcontracts and be able to help your contractors before their problem becomes your problem.
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You make a good argument for really knowing who you are doing business with. However, I do foresee problems with it. For a person to look into every contractor and their subcontractors could take more time and cost more dollars than it might be worth. Consider the small business person who doesn’t have a lot of money to invest in this process. I personally would prefer to have a place to go to where I could look up those persons and see their track record. This would make it easier for someone to know who they are dealing with.
We have places like the Better Business Bureau to look up some contractors, but this really isn’t enough either. Just a thought but there might be an avenue to providing a site where one could go to look up these kinds of things that is unbiased and nonprofit.
I understand the theory behind your argument, and the theory is good. Unless the contractor can develop a binding agreement that requires the performance of all subcontractors (even the subcontractors of his subcontractors) to meet certain standards, I don’t see how your idea could work. Have you conceived of a way to make this theory work in practice?
Your post has some very interesting points to consider. But just like someone else mentioned, spending that much time on investigating every single contractor and/or subcontractor can be very time consuming. Don’t get me wrong, it’s very WISE to know who you’re dealing with, but when working on large projects, taking the time to investigate and spending the money can lead to less productivity on your project.
Even for those not involved in finance, this is a good lesson to learn. I, and no doubt many others, have experienced a similar problem in the past and found it most distasteful. I’m also curious as to whether you’ve devised a plan for putting this into practice.
The whole sub-prime isn’t quite the same as the contractor/sub-contractor problem. The sub-prime problem comes down to the inability of banks to value their investments. With a mortgage, if the buyer defaults, the house is the collateral for the bank to recover the initial loan principle. If housing prices are falling, and there is huge glut of homes not being sold, how can any bank take an estimate of the loans. Therefore they are forced to take an impairment on a accural basis. The banks haven’t really lost their money yet (unless they flipped the loans off to someone else to get them off the books). I think the risk protection is there (i.e. the banks still own the homes) so I’m not convinced that the risks were incorrectly stated.
Not previously knowing this, it does now make me aware the next time I contract with someone that one of the things to be think about and make sure that things have fully been thought of in writting contracts.
I don’t think that the solution is to micromanage the entire system. Then you have the cost and overhead of managing the system.
As a person who actually works as a contractor for a company that has subed out almost an entire project… I feel the best way to manage a subcontracted project is to have frequent progress checks. Then you don’t get blind sided when things slip.
Another thing to realize is that risk will amplify through the system… So since the risk will always increase, the responsibility lies on the initiators (big banks) to enter with less risk.
Since it is ski season… avalanche control comes to mind. Big banks should have shook off the bad snow (sub prime borrows who really were sub prime) to keep the whole mountain intact.
Yes, i have experienced the problems you mention with subcontractors. I am working in the IT-business and have learned the hard way that it is very important to be able to control your subcontractors. If possible let the customer make a standalone contract with the subcontractor although this is often difficult.