Wednesday, January 9, 2008

Eat the Bankers

You know, Dear Readers, having been an investment banker for lo these many moons, I long ago abandoned whatever starry-eyed dreams I might have entertained in my callow youth of obtaining a measure of social respectability for the stature and gravitas of my chosen profession (accompanied, of course, by a comfortable pile of shiny simoleons). Investment bankers, in modern capitalist society, seem to fall into that social class of people which everyone else despises vociferously as greedy, money-grubbing whores, unprincipled shills and hucksters who are only marginally less despicable than personal injury lawyers or Flavor Flav. Of course, this universally fashionable scorn is never in evidence when the citizen in question is desperately trying to get into Harvard Business School so he or she can become an investment banker, wheedling them to donate to his or her favorite charity, attempting to sell them an overpriced condominium in a brand new building stuffed to the gills with other investment bankers, or persuading them to marry their comely daughter (or him- or herself).

And yet—at the risk of incurring the opprobrium of the chattering classes by tooting my own horn—I will assert that there are indeed a number of admirable traits and characteristics which can be fairly laid at the gilded doorstep of Homo investmentbankicus. While it is true that many are venal, corrupt, and/or have the interpersonal skills of Mr. Hyde on a bender, it is also true that quite a few are charming, politic, and even genuinely nice people. I am sure I will strain your credulity somewhat less by also asserting that, as a group, investment bankers tend to be better-educated, more worldly, and harder working than the average capitalist wage slave. While they are neither necessary nor sufficient for a successful career in investment banking, native intelligence, grit, and ambition are character traits which are liberally sprinkled throughout the cohorts of Wall Street. And, the last time I checked, these traits tend to be the same ones which most Americans claim to admire as valid tickets to the good life.

Certainly, there is very little about the monetary rewards accruing to the successful investment banker which is due to nepotism, cronyism, or inherited wealth or position. (The pre-1973 days when investment banking was an undemanding profession populated by the dull and unambitious sons of wealthy WASPs is long gone.) If you can't cut it on your own pluck, skills, and drive, you have no place in this industry. There are no Rigas, Murdoch, or—dare I say it?—Bush or Clinton dynasties in investment banking: it's too bloody hard. Scratch your average investment banker's Kiton suit, and you will usually find a genuinely self-made man or woman underneath.

So what's not to like? Well, the common complaint is that we make too much money, and we add little value to the economy or society.

But I'd be careful, if I were you, about adopting such an opinion without thinking it through. After all, how much "value" does your little profession add to the common weal? By whose calculation? And since when has capitalism paid laborers for the value they contribute to the general good anyway? My economics professors taught me that wage rates are set by market forces, which follow their own internal logic almost wholly divorced from such concepts as social good, intrinsic value, or even the difficulty of the work in question. If that were not true, then surely the soldiers under fire in Iraq and Afghanistan would be making a hell of a lot more money than your (or my) sorry little ass.

And like it or not, investment bankers do perform a function which is inseparable from the proper functioning of a capitalist economy. At its most basic, investment bankers are middlemen: we grease the wheels of commerce, of investment, of capital formation and allocation, and of wealth creation. Strictly speaking, investment bankers perform none of those actions themselves. When we do, our role blurs, and we become investors, capitalists, or hedge funds. Some of us eventually become Goldman Sachs. But the point is that these wheels need greasing, and "The Market"—whatever the hell that is—pays handsomely for the service. Invent a magically self-greasing economy, and you will eliminate the investment bankers. Good luck. Finish that task, and I'll give you another assignment: get rid of all the cockroaches in the world, too.
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"So," you're probably thinking to yourself about now, "what's got old TED tilting at this particular windmill?" Well, I'm glad you asked.

Current Chicago finance professor and former IMF economist1 Raghuram Rajan posted an opinion piece in the Financial Times today with the provocative title "Bankers’ pay is deeply flawed." (I dare you to disagree with that statement at your next cocktail party.) He seems to have struck a chord with the commentariat. In it, he trots out the usual objections to overpayment of investing professionals for "alpha" (manager-specific skill in capturing superior non-market-correlated returns) when in fact they are really only capturing "beta" (the returns naturally accruing to the market, like from an index fund), which they conceal or gussy up by shifting risk in time or using leverage to bolster (and mask) mediocre returns. Managers who generate high returns like this get paid whopping bonuses based on annual performance, but their investors get caught holding the bag when the strategy blows up and generates big losses, like we have seen in the CDO and subprime mortgage markets recently.

Professor Rajan wants to claw back these huge performance bonuses after the fact, when it turns out the stellar returns they were based on were just smoke and mirrors. For example, he does not seem happy that Morgan Stanley's John Mack declined a bonus for 2007, when MS's subprime chickens came home to roost, but still gets to keep all of his $40 million payout from 2006, when a lot of those chickens were being hatched.

You will not be surprised to learn, Dear Readers, that I have a few problems with the Professor's article.

First, the problem he describes is well known, and of long standing on Wall Street. Among many, it has been known as the "trader's option." This option is inextricably embedded at the core of an investment industry that employs and compensates agents to trade or invest other people's money. The concept is simple: the trader bets the ranch. If he hits a home run, he gets a huge "performance" bonus, and people who gave him the money to invest make a lot of money too. If he loses, he gets no bonus, and probably gets fired, but he can usually land on his feet at another firm without much problem. Meanwhile, the people whose money he invested are shit outta luck. The trader's asymmetric payout structurally encourages excessive risk taking. Unless the trader has a lot of his own money at risk, his incentives are misaligned with those of his backers. Expensive risk control systems, extensive monitoring, and the occasional blow up naturally follow.

But this is not twelfth level Masonic arcana. Everyone who fell off the turnip truck earlier than last week knows this. Why then, does it continue to happen? Why, to use a common metaphor making the rounds of Wall Street watering holes and mainstream media publications, do investors insist on paying traders to pick up pennies in front of steamrollers? Well, I'll tell you why: there are a hell of a lot of pennies out there for the taking. Not everyone can make money like Warren Buffett, investing in Main Street America with an investment horizon of Judgment Day. Not everyone can give a few billion Benjamins to Steve Schwarzman to buy illiquid restructuring plays of widget polishing companies. Markets get crowded, and market sectors have limits to the amount of money which can be invested in them before they become commoditized, so investors are always looking for the next pile of pennies to hoover up for their pensioners and shareholders. And, if you want to play the steamroller penny game, who else but a rabid, aggressive, fast-moving trader do you want to do the vacuuming for you?

Even if picking up pennies in front of steamrollers is no better in the long run than capturing beta, why does that make it such a bad strategy? If the returns to penny-vacuuming take so long to mean-revert—enabling, for example, traders to turn in years of double-digit returns—who is to say that an investor shouldn't pay a smart and aggressive trader a lot of money based on the premise that that trader can time the market better than someone else? After all, isn't that exactly what good trading is all about, good market timing? The only trouble is that an investor will find it difficult to identify the truly good traders (or truly lucky ones—frankly, does the investor care which?) before the blow up occurs, so he will have to pay everyone as if they were generating alpha. Perhaps this is just another tax on investing which a savvy investor takes as given.

Second, Professor Rajan makes the usual peanut gallery mistake of conflating a whole passel of different animals under the rubric "banker." The specimen he focuses his ire on—and which we discussed just above—happens to be of the species trader or hedge fund/portfolio manager, people who invest other people's money for fun and profit. The charges he outlines can be laid at the feet of SAC Capital and Citadel at least as easily as at the banks which are his target. But "banks" and "investment banks" like Citigroup and Morgan Stanley are constituted of many other types of animal which have no exposure to the types of irresponsible investing he excoriates, and whose fees face virtually none of the boomerang risks which he deplores. M&A bankers, for example. Market making traders. IPO underwriters.

Third, practicality. How the hell would the Doc propose we "claw back" compensation? Intertemporal incentives are difficult enough to structure and manage—think Corporate America and CEO pay—without creating the ex post measurement nightmares and ensuing litigation that any such plan would entail.

Fourth, while his argument is broader, Professor Rajan seems most irritated by high pay for employees at banks and investment banks, where he accuses managers and top bankers of extracting excessive annual payouts while the public shareholders are left holding the bag. Well I've got news for him. First of all, the total returns generated by most publicly held investment banks over the past several years—the Golden Age of Easy Credit—have been pretty darn good, and well in excess of total broad market returns. I do not recall many people complaining publicly while the investment bankers were making the shareholders rich. Now that the stocks have given a big chunk of those returns back, however, we're supposed to feel sorry for all the widows and orphans in MS, GS, and LEH? Sorry, my Sympathy-o-Meter is flickering at "Feeble."

Second, take a closer look at how senior investment bankers and executives actually get paid. I do not know the details, but I can guarantee you that of the "$40 million" John Mack "took home" in 2006, a distinct minority was legal tender he can actually spend at the local laundromat. Like any investment banker above the rank of First Year Analyst nowadays, Mack got the vast majority of his bonus "paid" to him in the form of funny money: options, phantom stock, stock appreciation rights, and/or plain old restricted stock in—you guessed it—Morgan Stanley. Furthermore, the restricted stock and other deferred compensation allocated to investment bankers is usually burdened by a punishing vesting schedule that can last many years. Investment bankers are "paid" the bulk of their "excessive" bonuses each year in name only. They only see the majority of the cash years later when the stock or options vest and they are able to sell the shit. (Subject, of course, to them still being at the same bank—most schemes make bankers forfeit unvested bonuses if they leave the firm voluntarily or for cause.) So in fact, for most investment bankers, a decline in their company's shares hits their net worth a lot harder than it hits that of their public shareholders. Besides, they cannot bail out of the stock at the first sign of trouble, like Fidelity, CalPERS, or Professor Rajan.

So have a little sympathy when you write about John Mack, Professor Rajan. I very much doubt that your personal net worth has plunged over 35% from May of last year.

1 Now, if that isn't a background which lends itself neatly to sniping at highly compensated finance professionals, I don't know what is.

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