Thursday, January 17, 2008

The Pressure Room

"Mr. Bond, they have a saying in Chicago: 'Once is happenstance. Twice is coincidence. The third time it's enemy action.' Miami, Sandwich and now Geneva. I propose to wring the truth out of you."

Goldfinger's eyes slid slowly past Bond's head. "Oddjob, The Pressure Room."

— Ian Fleming, Goldfinger

[WARNING: This post has been rated VILE, for Very Interesting, Lengthy, and Educational. Read at your own risk.]

Let's cut the shite, shall we?

The time has come to face some simple truths.

With the publication today on page one of The Wall Street Journal of an article entitled "Deal Fees Under Fire Amid Mortgage Crisis," I now count three major salvos in roughly the last week which have taken aim at pay practices in the financial sector, broadly defined. I have already responded to the first two, which appeared in the Financial Times, here, here, and here. I am a firm believer in the Chicago gangland maxim which Mr. Goldfinger cites, so I believe it is time to respond to the third by delivering what I hope will be a knockout blow to the mass of misperceptions, misunderstandings, and sheer obstinate stupidity which I think underly both these articles and the political movement afoot to restructure compensation practices in the financial industry.

Unlike Auric Goldfinger, however, I do not propose to wring the truth out of anyone. Rather, I intend to beat some truth into those commentators, market participants, and spectators who are busily jumping up and down in the bleachers calling for the heads of all financial intermediaries and sundry. In addition, I believe it may be salutary for many of those same intermediaries in my audience to hear and remind themselves of some of these truths as well. After all, it would be better to have our stories straight before we get hauled before a Congressional subcommittee, wouldn't it?

Consider this post a public service, from Yours Truly. I assure you it hurts me more than it hurts you.

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Before we get started, class, write down these two words: Agent and principal. There will be a quiz later.

Today's article in the Journal sets the stage for our little drama pretty well:

At every level of the financial system, key players—from deal makers on Wall Street and in the City of London to local brokers like Mr. Schmidt—often get a cut of what a transaction is supposed to be worth when first structured, not what it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a re-examination of how financiers get paid and whether the incentives the pay structure creates need to be modified. This week, Congress asked three prominent executives to testify about their pay packages.

Upfront commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar mergers are inked. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees on the front end.

Critics argue this system can give people a vested interest in closing a deal, regardless of whether it turns out to be a good idea over time.

This is all true, true, true. I don't deny it. From snooty investment bankers working on multi-billion dollar mergers to part-time real estate mortgage brokers, financial intermediaries get paid a commission for helping to originate, source, and close deals. These people are agents.

When they function purely as agents (more on that later), these intermediaries perform a function no different than that of any other agent or salesperson who gets paid a commission. This includes real estate brokers, car salesmen, telemarketers, etc. Whether they are employees or independent middlemen, all such agents are paid a fee for arranging a transaction between a willing buyer and a willing seller, or, for those cynics among you, for separating the buyer from his or her money.

Now, for those of you who have never tried selling something for someone else, or made a cold call to anyone to get them to buy something, trust me: it is hard work. It takes a lot of time and energy to find potential buyers and sellers, to persuade them to become willing parties to a transaction, and to hold their hands and make sure each party actually goes through with the deal rather than succumbing to buyer's or seller's remorse. It also takes a rather robust physical and emotional constitution, one which can sustain repeated rejection, one which can support extensive travel and work outside normal daylight hours, and one which does not implode from the daily grind of dealing with a never-ending parade of flaming assholes. I can guarantee you that you have no idea how prevalent these flaming assholes are in the general population, until you begin to try to sell something to them. (Who knows, maybe even you qualify as one in certain circumstances.)

Because it is hard work, and not for everybody, there is a scarcity of good and willing salespeople in the labor pool. Remembering your Economics 101, you will recall that scarcity of any resource factor means it can demand a higher price. We see this confirmed in practice, with sales jobs of whatever sort tending to command very good wages in relation to other jobs in any particular industry. Furthermore, unless you are a frequent and experienced buyer or seller of goods and services, with a comprehensive list of direct contacts among potential counterparties, and an extensive transaction experience encompassing many different types and circumstances of transactions, you will find real value in having an intermediary who does. When you hire such an intermediary—especially as a non-employee middleman for one particular deal—you are simply renting his or her experience, rolodex, and transaction skills. Expensive as it is, most companies and individuals tend to hire intermediaries in this way, on an ad hoc basis, because they do not need permanent sales or buyers reps on staff.

So, having clarified—I hope—the function and role of the agent or intermediary, and why they are hired, let us turn to the WSJ's poster boy for remorseful intermediaries everywhere, Shreveport, Louisiana mortgage broker Kevin Schmidt:

Mr. Schmidt arranges mortgages in Shreveport, La. [What did I tell you?] He earns his money upfront, taking a percentage of each loan once papers are signed. "We don't get paid unless we can say YES" to loans, his firm's Web site says.

The problem, which Mr. Schmidt says he sees clearly: Brokers have little incentive to say "no" to someone seeking a loan. If a borrower defaults several months later—as Americans increasingly are doing—it's someone else's problem.

Well, I must say I think Mr. Schmidt's moral scruples do him credit—assuming, of course, he is not just feeding the Journal a line to get his dot portrait on the cover of the newspaper—but I think he is a little confused. Of course he has little incentive to say "no" to potential mortgagees: it's not his bloody job.

He is hired/paid/taken golfing regularly by mortgage companies to 1) find potential borrowers and 2) persuade them to borrow money. Of course, the mortgage companies don't want Mr. Schmidt to waste his or their time, so I presume they give him guidelines to qualify potential borrowers, which I am sure he is diligent in applying. But the mortgage company decides whether or not to actually loan the borrower money, not Mr. Schmidt. The mortgage company makes an affirmative investment decision to lend out money to a homeowner every time it signs a mortgage, whether or not it actually applies any of its own judgment in lending to that particular individual or just relies on Mr. Schmidt and his colleagues to have properly screened the borrowers as good credit risks.

Now Mr. Schmidt or any other sales agent or intermediary can indeed do naughty things. He can misrepresent a transaction to the buyer and/or seller (fraud). He can pressure an unwilling buyer or seller into a transaction (high pressure sales tactics). Or he can arrange a transaction which is clearly unsuitable for one or more of the parties involved. All these misdeeds—plus countless others designed and practiced by unscrupulous salesmen ever since Satan sold Eve a bill of goods along with The Apple—are no-nos. Most in fact are already prohibited by law, and salesmen who commit them usually find themselves neck deep in hot water sooner or later. Such practices are and should be stamped out whenever they occur.

But let us not forget the material point. Mr. Schmidt brings the deal to his employer, but the mortgage company does the deal.

The mortgage company is a principal.

* * *


Figuring out what principals are is easy. You are a principal. Every time you buy or sell a stock, every time you take on or refinance a mortgage, every time you charge a purchase to your credit card, you are acting as a principal. Every time you purchase or sell an asset, and every time you assume or repay a liability, you are acting as a principal.

As a principal, because you have direct economic exposure to the potential appreciation or depreciation of the asset or liability in question, you are at economic risk for unfavorable movements in the value of that asset or liability. At the same time, you can benefit from favorable movements in the underlying item, like appreciation of an asset (think stock, or house) or depreciation of a liability (think mortgage). We undertake asset and liability exposure in our daily lives in all sorts of ways, many of which have as their principal purpose something quite different from expected appreciation, like having a place to live, or buying that new iPhone before your paycheck clears. When we choose to assume asset or liability exposure directly, for the primary reason of benefiting from favorable changes in its value, we call that investing.

Now, notwithstanding what you read in the papers and see on CNBC, being a principal is the only really effective way to get rich. "Wait a minute," you exclaim, "what about Lloyd Blankfein and Stan O'Neal and all those investment bankers making tens of millions of dollars every year?" Sure, they make a lot of money, but are they really rich, comparatively speaking?

Do a quick thought experiment: Without thinking, try to list ten of the richest people in the world. Let me guess: Warren Buffet, Bill Gates, the Sultan of Brunei, etc. I can almost guarantee you that no-one on your list is a commercial or investment banker. Even those of you who cheated and put down near- and putative billionaires like Bruce Wasserstein proved my point. For one thing, it is sad but true that several hundred million dollars, while being a whole lot of money by any normal person's calculus, is chump change in an era when you have to have multiple billions just to eke out a place on the Forbes 400. For another, guys like Bruce did not make the bulk of their net worth from salary and bonuses, they made it as substantial owners of large chunks of the investment banks they founded, ran, and sold (sometimes twice). They got rich as principals.

So, if you really want to get rich, be a principal. Realize, however, that by the same token you could lose it all. Accrued Interest puts it nicely in a recent post on Angelo Mozilo of Countrywide:

In any free market system, there will be failures. The dream of riches has to have a downside. With the potential for great success must also come the potential for great failure. Without a penalty for failure, economic agents would be incentivized to take inordinate risks. In private companies, this risk is naturally managed. Small business owners normally must put up their own capital, or borrow against existing assets, such as their homes. Obviously an entrepreneur believes in his new business idea if s/he is willing to mortgage his home and life savings to fund it. Whether the business winds up succeeding or not, the incentives are for the entrepreneur to create value.

So the divide between agent and principal is clear: the agent takes his or her cut off the top of your deal and sashays merrily away in search of the next transaction. In contrast, you are stuck with all the downside if the deal fails. On the other hand, if the deal succeeds, you get to book a tidy profit and start leafing through The Robb Report for a nifty new motor yacht. Your investment banker or real estate agent gets exactly bupkus in addition to his or her commission, unless you decide to send him or her an FTD bouquet and a nice thank you note.

* * *

"Agipals" and "Princigents"

It's the space where being an agent intersects and merges with being a principal that is the really interesting (and controversial) case to examine.

Because investment banks historically have been pure middlemen, which rarely if ever voluntarily took direct principal positions in securities or companies for love or money, many people still have that impression of their business. Indeed, certain functions in investment banking, like mergers & acquisitions advisory, securities underwriting, and trading for customer accounts, still take their traditional forms as almost pure agency businesses, where capital, if it is committed, is committed only temporarily to facilitate transactions, rather than as direct investment.

However, it has been many years now since most of Wall Street and the City have migrated to a hybrid model, where they have increasingly assumed principal risk in securities, commodities, and direct investments in companies (aka private equity) in order to boost their profitability. This principal business is where Wall Street has made most of its money until recently, and, being Wall Street, that is where the power has migrated within these banks. Just look at the CEOs of most major investment banks. They come from the Sales and Trading division, almost without exception.

After years of watching their clients at hedge funds and private equity firms get impossibly rich, investment bankers finally figured out what I shared with you above: that in order to get really rich, you have to be a principal. So, they doffed their timid, three-piece intermediary suits for polo shirts and chinos and bellied up to the table to play with the big boys. And they, and their shareholders, had quite a run, up until recently, when they (re)discovered that being a principal has its downside, as well.

But along the way, the big financial players with principal operations figured out that they had their own internal agency problem, as well. They (and their shareholders) wanted their proprietary traders to make aggressive bets, but they needed a way to discourage stupid or excessively risky behavior. So they implemented, almost without exception, the very long-term compensation plans certain market commentators have been urging from the sidelines recently. Traders at commercial and investment banks, plus anyone else who makes a lot of money (including top executives and poor little innocent M&A bankers like me, who never expose their firms to principal risk in the first place) have been getting the lion's share of their admittedly mouthwatering compensation in the form of long-vesting, restricted equity securities in their employers. They are tied to the long-term health and performance of their employers, big time. Believe me, there is no-one in the investor community or broader economy more motivated to improve the financial results at investment banks—and hence their utterly crappy stock prices—than investment bankers themselves.

So much for investment banks, investment bankers, and their shareholders. Their interests are indeed pretty well aligned. But what about other players in the investing world and the broader economy?

That is trickier, but the cleverer among you Dear Readers have already figured it out, based on the practices of investment banks. If you really want to align the interests of agents with those of principals, the principals have to give the agents some economic participation in the appreciation and depreciation of the underlying asset or liability. In other words, it's gonna cost you.

After all, all the whining and outrage I am hearing in the press has to do with why the financial intermediaries who helped investors and others get into sub-prime mortgages, CDOs, and the like aren't sharing in the downside of these transactions. What about the friggin' upside, goddammit?

If you want to keep all the upside in your vacation condo in Florida or your CMBS but have me cover your ass in the downside scenario, you, my friend, want me to sell you a put option. Okay, I'm game, but it'll cost you, and a lot more than my measly commission for putting you into the damn thing in the first place. Oh, and by the way: if you buy a put from me and I am not a complete enough idiot to sell it to you naked (i.e., unhedged), I am going to hedge that put by selling the underlying asset short. Guess what that'll do to your vaunted upside? That's right: your own little insurance policy is going to reduce your chances of striking it big. And the longer you want that downside protection, the more it's gonna cost you, as well.

Or, if you don't want to buy a put, then I'll take on some (not all) of the downside exposure alongside you, in exchange for some of the upside, too. (We'll pretend were Goldman Sachs.) That way I'll share your pain if the investment goes to hell in a handbasket. Or maybe, just maybe we'll both get rich together. You just won't be able to collect all the filthy lucre for yourself.

Bummer, ain't it? I guess there really is no way to reduce your risk as an investor without ... no, it can't be that easy ... reducing your return. Guess I should have said that at the beginning, and saved us all a great deal of time. Then again, the people among you who needed to hear this haven't been listening so far, so what the heck.

* * *

That's it, in a very lengthy nutshell. God forgive me for torturing so many innocent electrons in pursuit of your enlightenment.

I have never fully understood the following aphorism, but I will put it down nevertheless, in the hope that there may indeed be—dare I say it?—a kernel of truth in it:

The truth shall set you free.
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With this post, I think I now officially qualify as an apologist for the investment banking industry. Equity Private must be laughing her ass off.

© 2008 The Epicurean Dealmaker. All rights reserved.