Felix Hernandez, Superstars, and Frictional Costs

I was going to do my list of the 10 worst off-season transactions today, but I’m going to push it back to next week, since I have some things to say about yesterday’s news.

The Mariners are apparently set to sign Felix Hernandez to the largest contract ever given to a Major League pitcher. The total commitment is $175 million over seven years. It’s a staggering amount for a guy who wasn’t eligible for free agency until after the 2014 season, and in many ways, this contract is the continuation of the trend that we saw begin last year with Joey Votto’s deal with the Reds. Here’s what I wrote a year ago when that deal was announced:

So, at this point, we have a couple of options – we can continue to be shocked and amazed at the growing rate of contracts that guarantee big money to players from 2018 and beyond, or we can adjust our expectations for what premium players are going to be able to command going forward. With the promise of new money flowing into many organizations over the next three to five years, I’d imagine we’ll see more and more teams being aggressive in trying to lock up their young stars before they get to free agency and have to bid against whichever franchise just happened to renegotiate their television contract a few months prior.

For the Reds, the equation was pretty simple – keep Votto and contend during the run-up to the expiration of their television deal, or trade him away, rebuild, and come to the table asking for more money after a couple of years of going young and probably taking their lumps. Given those options, giving Votto a couple of extra years at the back end to increase their bargaining position doesn’t look quite so crazy.

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This deal is going to have lasting repercussions on the sport. Not only does it suggest that the Reds are going to remain competitive in the NL Central going forward, but it also resets the price expectations for every pre-free agent player in the sport. Congratulations, players, all of your expected prices just went up. Way up.

Felix’s deal with the Mariners is the pitcher’s version of Votto’s deal with the Reds. It’s a free agent price for a pitcher who wasn’t a free agent, and in that sense, there’s a pretty good argument to be made that it’s too much money. The Mariners are taking on significant additional risk by guaranteeing him his 2015-2019 salaries now, and like with Votto, that risk wasn’t offset by getting a below market price on the deal. Given the history of pitcher attrition, there’s a significant chance that this deal will go south for the Mariners, and they’ll end up with an expensive and overpaid former ace. Most good young pitchers don’t turn into good old pitchers, and the Mariners have just made a huge bet on Felix being the exception rather than the rule.

So, there’s reasons to believe that this contract might end up looking like a mistake. For instance, Ken Rosenthal used the news of the extension to once again dust off his “the Mariners should have traded Felix” argument:

The commitment by both the player and team is admirable, as is the passion of the fans. But get back to me in a few years, and tell me if everyone still holds the same romantic view.

I’m sorry, the risk of trading Felix — even when factoring in the possibility that the return might have been disappointing — was less than the risk of signing him for $175 million.

Rosenthal has been beating this drum for a few years now, repeatedly arguing that the Mariners should trade Felix for a haul of young prospects, since they didn’t have the supporting cast around him to put a contender on the field. And, models that we use, measuring a player’s total surplus value — the difference between his actual performance and what you’d expect to get by spending that money on other players – support the notion that the team could have done better by trading Felix than by signing him to a market-value extension. After all, if the Mariners had $175 million to spend, couldn’t they have turned Felix into an amazing group of young talent and then simply reallocated that $175 million to other Major League free agents in order to replace his lost value?

On some level, yes, they could have. But, when looking at what their $175 million might have bought them and when it might have brought real returns, we need to account for the frictional costs of making that kind of series of moves, and recognize that those costs can be so high that a team ends up worse off than they’d have been otherwise.

A frictional cost is the extra price that has to be made to complete a series of transactions. Sales tax is the easiest example of a frictional cost, as the government takes between 7-10% of the total sales price of an item whenever you go to the store to buy something. We generally just factor sales tax into the price of an item, and go about our days, since that tax can’t easily be avoided. But, there are other times where frictional costs play a large role in the decision to buy or sell; the housing market is actually a great example.

If you’ve ever sold bought or sold a house, you know that there are substantial costs associated with the transaction. Real estate agents generally earn 6% of the sale price in commission, so on a $500,000 home, the seller would lose $30,000 simply by hiring a realtor to help them list the property. Meanwhile, the buyer is responsible for closing costs, as fees associated with securing a mortgage — appraisal, title insurance, loan origination, etc… — average around $4,000 per transaction. Add in the costs of repairs to the home you’re selling before you close along with moving expenses, and even if you’re making a lateral move between one $500,000 house and another $500,000 house, the external costs will likely be over $40,000 by the time you’ve relocated.

Frictional costs might not be quite so obvious in Major League Baseball, since no one is applying a set tax on each transaction. However, I do think we can look through history and see that there is evidence of additional costs associated with constant roster turnover, especially the kind of turnover that involves continually shipping out your best players for low cost minor leaguers.

Dan Farnsworth did a great piece in the Community Blog a month ago about the revenue ramifications of entering into a long term rebuilding project. You should read the whole thing, but pay specific attention to the table that lists the total change in revenues for losing teams that either cut payroll or increased payroll at that point. His calculations returned a $15 million revenue loss for a .500ish team that cut payroll, versus a $20 million revenue gain for a .500ish team that increased payroll. It’s just one study, and I wouldn’t quote those numbers as gospel, but there is evidence that teams that regularly cut payroll by trading away their best players when they get expensive can enter into a never-ending cycle of payroll slashing and revenue degradation.

For instance, let’s take the Cleveland Indians as an example. From 1995-2001, they made the playoffs in six of seven seasons, ranking 1st or 2nd in the AL in attendance every season except 2001, when they ranked 3rd. Their payroll was consistently in the top five in Major League Baseball, topping out at $92 million in 2001. However, as their winning core got older and had to be broken up, the Indians decided to go into a full-scale rebuild, shipping out most of their recognizable stars and starting from scratch with new young talent.

After spending $92 million in 2001, they spent $78 million on a losing team in 2002, then really went with a house cleaning in 2003, spending just $48 million on their Major League team. Within two years, they went from having the fifth highest payroll to having the fifth lowest payroll in baseball.

Here’s where the Indians have rated among the 14 AL teams in attendance since that 2003 season: 12th, 12th, 12th, 11th, 9th (team wins 96 games and makes ALCS), 9th, 13th, 14th, 9th, 13th. Not coincidentally, the Indians have had some of the lowest payrolls in baseball ever since, never getting higher again than 16th in total team salary (following their 2007 division title), and more regularly sitting in the bottom 5-10 teams in overall spending. Even when the Indians won, they topped out at 2.3 million fans, a 25% decrease over their total attendance in 2001. There’s no question that the new park bonus related to Jacobs Field’s opening in 1994 — combined with the team’s run of success immediately afterwards — pushed attendance and revenues to their maximum potential, and some regression was inevitable simply based on the market size and any franchise’s inability to contend every single season.

But, the Indians have essentially lost half of the fan base that they had at their peak, and even developing new stars like CC Sabathia, Grady Sizemore, Victor Martinez, Travis Hafner, and Cliff Lee didn’t bring those fans back. From 2005 to 2007, the Indians averaged 89 wins per season, using their restocked farm system to build another good young core. Attendance barely moved at all. Revenues didn’t grow fast enough, and so the team traded away the new stars they’d developed, beginning the cycle all over again. Last year, the Indians drew 1.6 million fans.

We simply can’t ignore the costs of rebuilding, and assume that constantly shipping out franchise players has no impact on an organization’s ability to generate revenue. We probably can’t determine the exact revenue implications of retaining Felix Hernandez — after all, the Mariners have had him since 2006, and their attendance has been in a downward spiral the entire time — but we can say with some certainty that perpetual rebuilding cycles have a significant negative impact on a franchise. It doesn’t take too much digging to see the handful of teams that have been rebuilding for the past couple of decades, and have essentially turned themselves into feeder systems for higher revenue franchises in the process.

Major League Baseball’s overall profitability and the sport’s investment in revenue sharing have given teams a way out of this cycle. The lowest overall team payroll in 2012 belonged to the Padres, checking in at $55 million, a 52% increase over the lowest payroll of 2011. While there will always be a separation between franchises in their ability to spend, baseball has done a pretty terrific job of funneling money to lower revenue clubs, and those clubs are taking that money and giving it to their best players. Troy Tulowitzki in Colorado. Ryan Braun in Milwaukee. Joey Votto in Cincinnati. And now Felix Hernandez in Seattle.

I don’t think it’s a coincidence that these teams are now more willing to make large, long term commitments to keep their superstars around. The costs of these contracts are extremely high, but the actual outcomes for teams that have perpetually traded away their best players shows that the frictional costs of such a transaction are higher than has been recognized. It is not as simple as taking the $175 million that the Mariners gave to Felix and giving it to someone else in free agency. Players of this caliber rarely make it to free agency anymore, and when they do, they’re not signing with mid-market clubs that have spent years rebuilding their rosters from the ground up.

Over the last decade, we’ve gotten pretty good at counting the costs of bad contracts. There’s no getting around the fact that Felix’s extension may very well turn into a bad contract. In fact, the history of pitchers breaking down suggests it may even be the most likely outcome. But, if we want to evaluate the sign-or-trade decision, we have to evaluate the costs of both options, and for too long, we’ve overlooked the costs associated with perpetual rebuilding. Those costs exist, and they have to be factored into the discussion.

If a fair extension for Felix this far out from free agency was something closer to 7/150 as I guessed a few weeks ago, then the extension he’s getting might be termed a $25 million overpay. But, if the frictional costs of shipping Felix out are as high as Farnsworth’s estimates suggest that they are, then it may very well be in the Mariners best interests to overpay Felix in salary rather than try to make due with depressed revenues in the future. Paying a pitcher this much money is risky, but so is perpetually rebuilding. We can’t focus solely on the costs of one without recognizing the costs of the other.