Holiday Tonic II

December 19, 2008:

As I came over Windy Gap
They threw a halfpenny into my cap,
For I am running to Paradise;
And all that I need do is to wish
And somebody puts his hand in the dish
To throw me a bit of salted fish:
And there the king is but as the beggar.

My brother Mourteen is worn out
With skelping his big brawling lout,
And I am running to Paradise;
A poor life do what he can,
And though he keep a dog and a gun,
A serving maid and a serving man:
And there the king is but as the beggar.

Poor men have grown to be rich men,
And rich men grown to be poor again,
And I am running to Paradise;
And many a darling wit’s grown dull
That tossed a bare heel when at school,
Now it has filled an old sock full:
And there the king is but as the beggar.

The wind is old and still at play
While I must hurry upon my way,
For I am running to Paradise;
Yet never have I lit on a friend
To take my fancy like the wind
That nobody can buy or bind:
And there the king is but as the beggar.

— William Butler Yeats, Running to Paradise

Things may go quiet here at the Volcano Lair for a bit. I am sure you will all get along just fine without me.

Happy holidays. Be good.

© 2008 The Epicurean Dealmaker. All rights reserved.

The Three Faces of Bernie

Will the real Bernie Madoff please step forward?

Stories, news articles, and rank speculation continue to rocket around the mainstream media and the blogosphere concerning everyone's favorite bubeleh, Bernie Madoff. As of this writing, real information about the nature, extent, and Bernie's motivations for what appears to be the investment shitstorm of the century¹ remains in short supply, so it is difficult to get a good handle on the former knacker's character. (I do not know the man personally, but he always seemed balbatish to me.)

Since nature—and human perversity—abhors a vacuum, commentators, kibbitzers, and assorted know-it-alls have jumped in to offer their opinions on the great man. Currently, there seem to be three leading theories in circulation:

1) Bernie as goniff

Goniff: Crook, thief, burglar, swindler, racketeer²

As in Snidely Whiplash, dastardly ur-villain of stage and (small) screen, who preferred to act out his antisocial tendencies by tying Little Nell to railroad tracks and rubbing his hands in gleeful anticipation of her impending dismemberment. While perhaps most satisfying to the enraged victims of his shenanigans, this image seems most at odds with the known facts about the life and public personality of Mr. Madoff, who previously resembled one on whose tongue butter would not melt.

So, barring further disclosures—such as the discovery of paste-on handlebar mustaches next to falsified trading records in a locked safe in Madoff's 17th floor volcano lair—I suggest we put this characterization aside.

2) Bernie as Destroyer of the Jews

As in Pharaoh, one distinctly unpleasant Austrian housepainter, or the Senator who voted last month against sending TARP money to Israel. We can probably put this characterization down to understandable hyperbole, brought about by some big shot's momentary rage triggered by an unsettling phone call from his accountant. Otherwise, it does seem a bit much. While fifty billion clams is a lot of shellfish to have lost in your sock drawer, at last report Bernie's victims still seem to have their freedom and their health, which is far more than one can say for millions of their less fortunate ancestors.

That being said, the Madoff Scheme does seem to have been one of the largest affinity frauds ever perpetrated. While Bernie did not limit his predations to Jews, he does seem to have delivered several Members of the Tribe a rather heavy blow, at least in the pocketbook. Representatives of certain Palm Beach country clubs, New York synagogues, and Jewish charities might be forgiven if they view old Bernie as the Jewish Neutron Bomb: a device which vaporizes its victims' liquid wealth while leaving them, their creditors, and their rapidly depreciating real estate intact.

Given that some contend that investors who withdrew funds or collected dividends from Madoff's firm before the scandal broke might be required by a court receiver to repay those monies so investors who lost it all can be compensated, he certainly has set the stage for some long drawn-out, vicious infighting. It could turn out to be the most titanic struggle of Jew against Jew since Bialystock v. Bloom.

3) Bernie as shlemiel

Shlemiel: Clumsy bungler, an inept person, butter-fingered; dopey person

As in Alfred E. Neuman and pathetic shmendriks everywhere. This theory, for which I am developing a growing fondness, contends that Bernie did not start out to swindle his clients, but rather got caught up in spiraling losses and/or overwhelmed by shoddy record keeping. Once he found himself in the soup, he figured it would just be easier to make things up, rather than trying to make things right.³ There is some preliminary evidence for this, but the size and extended timeframe of the fraud does seem to indicate Bernie got pretty comfortable camping out on the dark side.

In any event, given the pathetic behavior of Madoff's investors and other enablers, I am sure we will have plenty of other candidates to choose from as the biggest shlemiel of the bunch. Leading candidates include the SEC, hedge fund-of-funds Fairfield and Tremont, Bramdean Asset Management's "Superwoman" Nicola Horlick, and any individual, charity, or institution foolish or greedy enough to place all or most of their money under Bernie's control. The only question will be whether these players should be considered shlemiels or shlimazels.

Shlimazel: Luckless person. Unlucky person; one with perpetual bad luck (it is said that the shlemiel spills the soup on the shlimazel!)

I know Bernie is waiting for all this to be resolved, too. In the meantime, I imagine

Er drayt sich arum vie a fortz in russell⁴

Stay tuned, campers. It's going to be a busy Chanukah.


¹ Don't relax yet: the century is young.
² Today's Yiddish definitions and usage brought to you courtesy of Thomer M. Gil. Any errors of emphasis or usage are completely his fault, as my own native knowledge of Yiddish is strictly limited to reruns of Mike Meyers skits.
³ Thereby ignoring the Law of Holes, which states that if you find yourself in a hole with a shovel in your hand, stop digging.
⁴ He wanders around like a fart in a barrel (aimless).

© 2008 The Epicurean Dealmaker. All rights reserved.

Plus ça Change ...

But the most absurd and preposterous of all, and which shewed, more completely than any other, the utter madness of the people, was one started by an unknown adventurer, entitled "A company for carrying on an undertaking of great advantage, but nobody to know what it is." Were not the fact stated by scores of credible witnesses, it would be impossible to believe that any person could have been duped by such a project. The man of genius who essayed this bold and successful inroad upon public credulity, merely stated in his prospectus that the required capital was half a million, in five thousand shares of 100£ each, deposit 2£ per share. Each subscriber, paying his deposit, would be entitled to 100£ per annum per share. How this immense profit was to be obtained, he did not condescend to inform them at that time, but promised that in a month full particulars should be duly announced, and a call made for the remaining 98£ of the subscription. Next morning, at nine o'clock, this great man opened an office in Cornhill. Crowds of people beset his door, and when he shut up at three o'clock, he found that no less than one thousand shares had been subscribed for, and the deposits paid. He was thus, in five hours, the winner of 2,000£. He was philosopher enough to be contented with his venture, and set off the same evening for the Continent. He was never heard of again.

— Charles MacKay, "The South Sea Bubble," Memoirs of Extraordinary Popular Delusions and the Madness of Crowds

Bernie Madoff was a piker. A piker on a grand scale, I grant you, but a piker nonetheless.

Cold comfort, I know. But look on the bright side: it's a banner day for misanthropes.

© 2008 The Epicurean Dealmaker. All rights reserved.

Mission Statement

In an era of faceless organizations owned by other equally faceless organizations, Bernard L. Madoff Investment Securities LLC harks back to an earlier era in the financial world: The owner's name is on the door. Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair-dealing, and high ethical standards that has always been the firm's hallmark.

— Bernard L. Madoff Investment Securities LLC website

* * *
Only two things are infinite, the universe and human stupidity, and I'm not sure about the former.

— Albert Einstein

Well, the dog has caught the car. Now what?

© 2008 The Epicurean Dealmaker. All rights reserved.

Why So Serious?

"Do I really look like a guy with a plan? You know what I am? I'm a dog chasing cars. I wouldn't know what to do with one if I caught it. You know, I just ... do things. The mob has plans, the cops have plans, Gordon's got plans. You know, they're schemers. Schemers trying to control their little worlds. I'm not a schemer. I try to show the schemers how, pathetic, their attempts to control things really are."

— The Joker, The Dark Knight

Felix Salmon is getting "bailout fatigue." I am sure he is not alone.

He is tired and frustrated with the Fed's and the Treasury's ad hoc approach to the financial crisis, and the appearance that they are pissing away the $350 billion Congress advanced to them with no rhyme, reason, or accountability. He wants a plan, and he wants one now. Give us a strategic plan for the next installment of the TARP, he urges: give us a roadmap.

But we already have a map, Felix. Unfortunately, we sailed right off the edge of it some time ago, into uncharted waters.

Here be monsters.

* * *

Many commentators, myself included, have pontificated ad nauseam on the social, political, economic, and institutional sources of our present travails. I will not punish you further in that regard. However, I think it worth exploring, briefly, one or two deeper facets of the pickle we find ourselves in today.

One of the most remarkable intellectual breakthroughs, or paradigm shifts, in the markets over the past quarter century has been the widespread mathematization of finance. Due to the pioneering work of thought leaders like Fama and French, Miller and Modigliani, Black, Scholes, and Merton, traditional practices like security valuation and portfolio selection have been completely transformed, and huge new markets have been constructed out of whole cloth. Underlying many of these developments has been the sophisticated adoption of the concepts of probability and the tools of statistics to define and describe the behavior of securities, derivatives, and markets.

The mathematization of chance, in this context, has been an extremely powerful and useful tool. Vast swathes of our intellectual landscape have been colonized by statistical methods and concepts, and finance has proved pleasingly susceptible to such treatment. So susceptible, in fact, that trillions of dollars of new financial instruments and markets have sprung into existence on the back of it. Without the tools and techniques of statistical finance, many securities and markets would simply not be possible. Without the ability to model and manipulate the workings of chance through mathematics, we simply could not be where we are today.

However, these powerful new tools came prepackaged with a potentially dangerous cognitive trap. Probability is a notoriously slippery concept to get a handle on. Few people understand it well.

It is my belief that many quants, hedge fund managers, and investment bankers came to believe—consciously or not—that, by explicitly embracing and accounting for chance, they had tamed it. They spent countless millions of man hours designing and implementing elaborate mathematical models and risk control systems based on aleatory principles that could predict, with remarkable accuracy, the variation in return and behavior of securities and derivatives under normal circumstances. They spoke confidently about "value at risk" and "maximum expected daily trading loss" as if they knew what they were talking about. As if those terms actually meant anything. And then they trotted off to their bank, or their prime broker, or the Discount Window to borrow a couple more turns of leverage against their proprietary positions.

But you cannot tame chance. That is what makes it chance. At base, implicitly attributing the kind of predictability these individuals seemed to ascribe to chance was a fundamental error, a category-mistake.

To use an example from the not-so-distant past, could the principals at now-defunct hedge fund Long Term Capital not see that pegging the odds of losing all their capital in one year at 10²⁴-to-1 against was ludicrous on its face? (And I am not arguing that Myron Scholes and the other LTCM propeller heads picked the wrong distribution for their probability estimates, as if settling on a Levy skew alpha-stable distribution with α = 1.8 and β = 0.93¹ would have been more accurate than a lognormal one.) In all intellectual honesty, how could they possibly know? Hubris, yes, but more importantly epistemic blindness was at play here.

For even if you have guessed (or calculated) the probabilities correctly, giving one-in-ten-million odds that a life-destroying asteroid will hit Earth in the next ten years does you no good when a Manhattan-sized meteorite is discovered hurtling toward Rio de Janeiro the following day. In retrospect, it seems pretty clear that it is far more important to plan how you intend to deal with an unlikely event when and if it does happen than to shrug and say it will probably never happen. Disaster planning and scenario testing are far more valuable risk management practices than fine-tuning the estimated volatility inputs to your CDO trading model.

Perhaps some of the lapsed mathematicians and physicists on Wall Street who designed these complicated securities and derivatives and created the programs to model their behavior understood this. Perhaps not all of them were blinded by the power of statistical methods or the efficacy and accuracy of probability-based theories of physical behavior like quantum mechanics into believing their elegant formulations were complete and accurate descriptions of securities and markets dependent on human beings. But somewhere between the PhDs programming Ito's lemma in C++ in the basements of investment banks and hedge funds and the Executive and Investment Committees approving proprietary trades, this understanding got lost.

And the shit, as they say, eventually hit the fan.

* * *

So does that mean we should throw away 25 years of finance theory, and scrap billions of dollars of software and systems designed around its principles? Should we go back to throwing sheep knuckles in a dirt circle to make decisions under uncertainty? Of course not.

But we need to rediscover a little more respect (and fear) for the ineluctable and irreducible operations of chance in our lives, including in the markets. We need to keep reminding ourselves that having a 95% confidence level that our hedge fund will not lose more than 100 million dollars in a day does not mean it won't lose $500 million tomorrow, or $75 million a day for ten days in a row. We need to rediscover that well-understood probabilities are usually more stable in the long run, so the whipsaw of short term events doesn't blow us up before we can profit on our longer-term investments.

And it's a good idea to have a plan, a direction in which you'd like to go. But its always a better idea to have back-up plans as well, alternate routes you have mapped out in case your main chance doesn't work out as expected. Keep those in your back pocket, so you don't frighten the Congressmen or limited partners you rely on into paralyzed immobility. But keep them nevertheless.

And hope—pray—that some whackadoodle with the means and the understanding to do it doesn't decide to show everyone just how tentative our hold is on reason and predictability in the financial markets.

That way madness lies.

* * *

Watch out, you might get what you're after
Cool baby, strange but not a stranger
I'm an ordinary guy
Burning down the house

Hold tight, wait 'til the party's over
Hold tight, we're in for nasty weather
There has got to be a way
Burning down the house

Here's your ticket pack your bag; time for jumpin' overboard
Transportation is here
Close enough but not too far, maybe you know where you are
Fightin' fire with fire

All wet, yeah you might need a raincoat
Shakedown, thieves walking in broad daylight
Three hundred sixty five degrees
Burning down the house

It was once upon a place sometimes I listen to myself
Gonna come in first place
People on their way to work say baby what did you expect
Gonna burst into flame

My house, S'out of the ordinary
That's right, Don't want to hurt nobody
Some things sure can sweep me off my feet
Burning down the house

No visible means of support and you have not seen nothing yet
Everything's stuck together
I don't know what you expect staring into the TV set
Fighting fire with fire

Burning down the house

— Talking Heads, Burning Down the House

¹ Don't worry, kiddies, that's just a for instance. There won't be a quiz or anything.

© 2008 The Epicurean Dealmaker. All rights reserved.

The Source of De Nile

[Scene: A therapist's office. A cellphone rings.]
Mrs. Ari: "Ari? I told you to turn that off."
Ari Gold: "I did turn it off, but this is the emergency line. This is the Bat Line, baby."
Therapist: "Do you need to get that?"
Ari: "I do need to take this, yeah."
Mrs. Ari: "No he doesn't. I ask for one hour out of the day. For his undivided attention. And I can't even have that."
Ari: "You can have it if you wanna live in Agora fucking Hills, and go to group therapy. But if you want a Beverly Hills mansion, and you want a country club membership, and you want nine weeks a year at a Tuscan villa, then I'm gonna need to take a call when it comes in at noon on a motherfucking Wednesday!

— Entourage

In case you hadn't noticed, the gravy train is over.

This is bad news for investment bankers, private equity moguls, and hedge fund professionals, of course. It is also bad news for the lawyers, accountants, consultants, and commercial and residential real estate brokers who depend upon them for their livelihood.

But it is even worse news for their wives and mistresses, and the largely parasitic community of wealth suckers who feed upon the steady flood of ill-gotten gains which these women¹ have been siphoning out of their husbands' bank accounts and pumping into the community for years. Luxury goods retailers, twee French bistros, personal drivers, personal trainers, personal shoppers, and the women manning the cosmetics counter at Henri Bendel should all begin to worry that theirs will be a much bleaker and more impecunious future.

I don't think the strappy Manolo sandal has dropped for everyone yet, though.

With few exceptions, Girlfriend and her "retail therapy" enablers seem to be in a state of denial similar to the one their Sugar Daddies passed through over a year ago. I don't care how many €150,000 crocodile Birkin bags Russian oligarch wives buy, Bernard Arnault didn't build LVMH into a €16 billion retail juggernaut by selling one-of-a-kind baubles to the ultra-rich. The €175 billion luxury goods industry depends on armies of women from the middle class on up not only to lust after its wares, but also to buy them.

You can understand why Mrs. Big Swinging Dick might be having a little trouble coming to terms with today's realities, though. The poor thing has been far too busy spending BSD's money for the last several years to worry about where it was coming from or whether it would continue indefinitely. Given that it now seems that hubby didn't have the answers to those questions either, it is a little much to expect her to have worried her immaculately groomed little head about it herself.

Besides, after years of telling her maid to wash the blood off the soles of her man's wingtips every night, I think she knew better than to ask.

* * *

It's not just the Ladies Who Lunch and their hangers-on who are going to have to bite the bullet.

In the same way, nightspots in Manhattan have become dependent on horny young investment bankers, dangling scantily clad Ukranian and Czech hotties as bait to draw in undersexed youngsters able to spend $300 on a bottle of Ketel One on the off chance they might get lucky before some Managing Director calls them back into the office to spread the S&P 500. A recent unscientific survey in the trendy Meatpacking District by Yours Truly revealed that the only things inhabiting the tables and banquettes reserved for bottle service were dust bunnies and a couple of Somali pirates. Likewise, art dealers and auction houses have gotten hooked on the crack cocaine of laundered hedge fund profits, and real estate developers seem to have built enough inventory in downtown Manhattan to house five times the total number of future employed junior investment bankers for the next twenty years.

It's not all grim, however. Felix Salmon thinks there will be a bull market in escapism. Journalists and bloggers alike—your Dedicated Bloggist included—are certainly long schadenfreude, but I feel compelled to remind everyone that this is a very rapidly depreciating asset. I think the average Joe and Josephine are getting close to their fill of industry exposés and critical profiles of the former Titans of Finance. There is only so much you can read (or write) about Dick Fuld or Ken Griffin before you collapse from sheer boredom.

I have high hopes for Hollywood, though. There's always the sequel to Wall Street to look forward to, although I imagine it could use a serious trip to the Rewrite Department about now. I don't know: perhaps we will even get our own big budget musicals, with Fred Astaire and Ginger Rogers dancing blissfully on the rooftop of 15 Central Park West while unemployed i-bankers and hedge fund traders down on the street burn CDO and SIV documentation in oil drums to keep warm.

In the meantime, though, retailers of aspirational goods and services are going to take it in the shorts.

Silk lamé or not.

¹ I make no apologies for the apparent sexism of my remarks. Notwithstanding my best efforts, the proportion of the fairer sex who actually hold professional positions in the finance industry (outside the Human Resources Department, natch) remains vanishingly small. Until and unless I see substantially more evidence that women are manning up and bringing home the big bucks themselves, rather than relying on their or someone else's hubby to do so, I will continue to assume that bankers, PE guys, and hedgies should be referred to with male pronouns. Go ahead, ladies, prove me wrong. As I have warned the missus from the beginning, I am more than willing to chuck her, the i-banking grindstone, and everything else to become some Amazon's boy toy if one ever shows up. To date, Mrs. Dealmaker has remained disappointingly unworried by my threats. (Memo to self: Next time, marry a dumb blonde.)

© 2008 The Epicurean Dealmaker. All rights reserved.

Holiday Tonic

November 27, 2008:

A truth that's told with bad intent
Beats all the lies you can invent.
It is right it should be so:
Man was made for joy and woe;
And when this we rightly know
Through the world we safely go.
Joy and woe are woven fine,
A clothing for the soul divine.
Under every grief and pine
Runs a joy with silken twine.

— William Blake, Auguries of Innocence

Happy Thanksgiving.

© 2008 The Epicurean Dealmaker. All rights reserved.

Graveyard Spiral

While descending turns are commonly performed by pilots as a standard flight manoeuvre, the spiral dive is differentiated from a descending turn owing to its feature of accelerating speed. It is therefore an unstable flight condition and pilots are trained to recognise its onset, and to implement recovery procedures safely and immediately. Without intervention by the pilot, acceleration of the aircraft will lead to structural failure of the airframe, either as a result of excess aerodynamic loading or flight into terrain. Spiral dive training therefore revolves around pilot recognition and recovery.

— "Aircraft Dynamic Modes," Wikipedia

I do not know whether you already know this, O Dearly Beloved, but apparently human beings are not well designed for powered flight. No, no, I am not pointing to the incontrovertible fact that few humans outside of the occasional Managing Director at Goldman Sachs possess either wings or the chest and back muscles to power them. Rather, I refer to the rather more subtle limitation that our internal mechanism for determining motion and orientation is not well suited to many of the maneuvers one can and does perform in three dimensional space at the controls of an airplane.

Especially when one does not have an external visual reference point to fix on, executing a gradual, sustained, or slow turn in flight can trick the inertial orientation system in your inner ear (and hence you) into believing that you are not turning, but are rather holding to a straight course. This can be disorienting when you attempt to change direction, since your body has no kinesthetic clues as to your current course. All sorts of spatially disoriented behavior can result, including my favorite, the "leans."

[While I have never piloted an aircraft myself, I have experienced a rather similar disorientation now and again when I have unexpectedly discovered myself listing to port or starboard on the perch of a barstool somewhere in the Midwest while plying clients with booze and other controlled substances. The bartender moves away, and suddenly you notice a thoroughly disreputable character, tilted thirteen degrees from vertical, leering at you from the mirror, with the tip of his Hermes tie swimming in his neighbor's Budweiser. It's not a pretty sight, and it's even less pretty when you realize that's your tie which now needs to be drycleaned. But I digress.]

Among the most dangerous maneuvers resulting from this disorientation, the cheerfully named "graveyard spiral" usually happens when a pilot loses sight of the visual horizon and enters a gradual turn. After 20 seconds or so, the pilot loses all sense that he is turning, but rather feels that the plane is descending in a gradual straight line. If the pilot does not consult his instruments to check whether he is indeed level or in a turn, he will likely try to pull out of the dive by pulling back on the stick and applying power. Unfortunately, if you are already in a turn, aeronautics dictates that doing this will only tighten and accelerate the turn, locking the plane even tighter into its downward spiral. Eventually, if the pilot does not correct, he gets trapped in a high speed spiraling dive that is almost impossible to pull out of.

The right thing to do instead, apparently, is cut the throttle to reduce acceleration, check your instruments, and gently turn out of the spiral. This will feel weird, but the point is that you have to trust your instruments, not your gut, the seat of your pants, or your inner ear.

* * *

As we witness the increasingly fast, increasingly narrow turns that Citigroup is making this week on its continuing spiral toward a sticky end, I wonder whether it is too late to give CEO Vikram Pandit a little in-flight training. Clearly he thinks the appropriate response to Citi's sinking stock price is to pull back on the stick and goose the throttle, proclaiming ever more strenuously that all is well and that he intends to stay the course. But Citigroup is not in a straight line level dive.

What Pandit does not seem to realize—and what Bear Stearns' Alan Schwartz and Lehman's Dick Fuld failed to realize before him—is that his company is experiencing a potentially deadly spiral of evaporating confidence. The more loudly he proclaims his own confidence in Citigroup's solvency and bright prospects—which may, for all I know, be objectively true—the more investors take a look at Citi's swooning stock price and rocketing default insurance premia and conclude he doesn't realize how desperate his situation is. They think management is in denial, or uninformed, or lying. This, in turn, destroys even more confidence, and the downward spiral speeds up. Trying to halt a slide in confidence by boosting confidence alone is not only futile: it is counterproductive.

No, what he obviously needs to do is slow things down, and begin acknowledging to his stakeholders that Citigroup needs to change course. (How he should do this, and what changes he should propose, are above my pay grade, although I might be persuaded to take the job for $25 million a year plus options.) Only these actions have a chance of persuading investors that Citigroup can last the weekend. Once they believe Pandit and the board acknowledge the seriousness of the situation, and are examining every alternative to correct it, they will stop running for the exits in panic. Confidence will stop evaporating, at least temporarily, and the company will have a few more days or weeks to pull some rabbits out of its hat.

(Of course, you still have to land the plane after you pull it out of a graveyard spiral, but at least you have more time, and a chance to do it without executing that charming maneuver, "flight into terrain.")

* * *

The real question of interest for me, Dear Readers, is what this promising but perhaps painfully extended metaphor means for the future management of highly leveraged, public financial institutions like commercial and investment banks. It is clear from the spectacle of Bear Stearns, Lehman Brothers, and other victims of the current panic that many if not most top managers of these firms were the rankest amateurs, in terms of management or piloting skills. Give them a clear, cloudless day, gentle supporting thermals, and no other traffic in the sky, and these panjandrums were more than capable of piloting their tricked-out Cessnas the five hours from Reno to Orange County. They got paid ridiculous amounts of money for flying under perfect conditions, too, almost as if they were personably responsible for the favorable weather.

But put them over unknown terrain, in fog, cloud cover, or at night, and let them drift into a gentle turn, and they fell apart. They had neither the sensitivity to tell when they were drifting into trouble nor the training and skill to recover from it. Their insensitivity to changing conditions, exacerbated by arrogance, swollen heads, and the echo chamber of handpicked loyalists in the executive suite put them all on the path to doom and destruction. They just kept listening to their inner ears and staying the course, never realizing they were steering directly into the ground until it was too late. Even now, most of these guys have absolutely no idea what they did wrong or how they should have acted differently to avoid cratering their once-proud institutions. Just ask Dick Fuld.

Fortunately, however, now that the United States government owns every financial institution larger than a piggy bank, we can make sure that this type of disaster never happens again. I recommend we institute a federally mandated Financial Institutions Piloting course for every executive with management responsibility over more than 10 people. Perhaps there could be a tiered license system, with candidate CEOs for large financial institutions only eligible to take the job after they have proved their skill by not cratering a regional bank and putting in 1,000 hours of Executive Committee flight time.

Either that, or we can conduct regular ear exams.

© 2008 The Epicurean Dealmaker. All rights reserved.

This Can't Be Good

Randolph Duke: "Exactly why do you think the price of pork bellies is going to keep going down, William?"
Billy Ray Valentine: "Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low. Which means that the people who own the pork belly contracts are saying, 'Hey, we're losing all our damn money, and Christmas is around the corner, and I ain't gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain't gonna fu ... my wife ain't gonna make love to me if I got no money!' So they're panicking right now, they're screaming 'SELL! SELL!' to get out before the price keeps dropping. They're panicking out there right now, I can feel it."
Randolph Duke: "He's right, Mortimer! My God, look at it!"

— Trading Places

Citigroup below $7. Goldman below $56. Morgan Stanley below $11. Blackstone below $6. Fortress below $2.50.

I'm beginning to smell a black, black Christmas on Wall Street. Furthermore, I don't think we're going to see any babies born on the Upper East Side, in Greenwich, Connecticut, or in Mayfair next August, September, or October, either.

Get your G.I. Joes with the kung-fu grip while they're hot.

© 2008 The Epicurean Dealmaker. All rights reserved.

Confirmation Hearings

Congressional Committee hearings, like the one Rep. Henry Waxman held yesterday to survey five hedge fund managers on the current and future state of the financial industry, can be fascinating theater. With few exceptions, however, yesterday's proceedings turned out to be a disappointingly anodyne love fest, with grizzled populists and battle-scarred demagogues alike practically jumping over the dais to flatter and genuflect before the most concentrated source of potential campaign contributions ever assembled on Capitol Hill.¹

Such hearings can also offer interesting insights into the character and capabilities of those under the klieg lights. Not only do we get to see how the persons in question react under pressure, but we also get to read how they would like to present themselves, in the form of their prepared testimony. As is common with all such exercises in autoeroticism, one can often learn far more about a person from these voluntary revelations than that person ever expected or intended to reveal.

Among the advance remarks presented to the Waxman Committee, your Dedicated Correspondent was particularly struck by those submitted by Mr. John Paulson, renowned far and wide as a modern-day St. George, slayer of the fearsome Dragon of Subprime Mortgage Securities. Since I am sensitive to criticism that I am often unkind to persons whose pecuniary plenitude varies in inverse relation to their physical stature or the intrinsic interest of their personality, I thought it might be a useful exercise to share with you, my Faithful Readers, some of Mr. Paulson's own words (and, I must admit, a few more of my own).

* * *

With that in mind, let us see what kind of insights about Mr. Paulson can we glean from his prepared testimony.

First, we discover that he is not merely an obscenely rich financier in a tasteful suit. He is also a gentleman and a scholar:

Prior to founding the firm, I was a Managing Director in Mergers & Acquisitions at Bear Stearns. I am a summa cum laude graduate from New York University and graduated with high distinction, as a Baker Scholar, from Harvard Business School in 1980.

Modest, too.

Notwithstanding his documented brilliance, however, I get the sense he's a bit muddled as to the true reasons for his success:

We believe that our ability to protect our investors’ capital and generate positive absolute returns with low volatility over the long term is the reason we have grown to be one of the largest hedge funds in the world.

Actually, Paulson & Co. started in 1994 as an event-driven investment fund betting on M&A transactions and other corporate "events." This is a reasonably uncomplicated, well-understood strategy with a long pedigree and relatively low volatility, assuming you can handicap merger deals with any degree of success. Mr. Paulson enjoyed consistent but distinctly modest returns with this strategy for most of the early life of his fund. As late as July 2003, for example, his fund employed only nine people and controlled assets under management totaling a mere $700 million.

This is nothing to sniff at, mind you, but long-term, low volatility returns is not the primary reason current investors have entrusted 37 bajillion smackeroos to his care. No, I tend to think it has much more to do with the fact that Paulson made approximately 32% more money than God last year by betting on the complete collapse of the securitized subprime housing market.

Perhaps all those fresh billions bulging out of his safe deposit box have addled Mr. Paulson's memory. Or perhaps he thinks, secretly, that the Congressmen and women in the room—and the millions reading and watching at home—wouldn't respect him if they discovered he was just some washed-up, ex-Bear Stearns ambulance chaser who had a brain wave one morning in 2006 and won the investment lottery. They wouldn't respect his impressive college and business school degrees, or defer to his authoritative proposals on how to fix the current financial crisis, if they thought he was just some lucky schmuck from Queens.

Don't sell yourself short, John: You were right, and your timing was almost spot-on (if a little early). Rejoice in it, man! America loves a plucky, lucky bastard, and you were about the luckiest bastard in that committee room yesterday. Just ask Ken Griffin.

* * *

Most importantly, I think, we learn that Mr. Paulson is clever enough to wrap himself in the American flag when he is testifying before a Congressional Committee that is looking for someone to blame for the ongoing clusterfuck that is our economy and financial system. This shows some nicety of judgment, given that he and co-grillee Philip Falcone are two of the most prominent members of that tiny fraternity of investors who have profited personally and directly from the nuclear meltdown of the American Dream.

Either that, or he is a true patriot:

As Americans, we are proud of the leadership position the United States occupies in this industry, the jobs our industry has created, the export earnings we have produced for our country and the taxes we generate for the Treasury. For example, over the last five years, our firm has increased our employee count by 10x, creating numerous high-paying jobs for Americans.

Wow, John. You're a fuckin' force of nature, you are. That would be increasing your employee count to what, approximately 70 warriors for truth, justice, and the American Way? I guess we can all stop worrying about General Motors going bankrupt with that kind of job creation going on.

(As an aside, I always find it amusing to hear poobahs from hedge funds or private equity nattering on about their oh-so important "industries." They always seem to omit the critical modifier "cottage" in front of the word "industry." Christ, Citigroup fires more people in a week than work in hedge funds and private equity combined.)

* * *

But patriot or not, dissembling scoundrel or not, I think we can all agree that Mr. Paulson does not have a promising career awaiting him in international economics should he ever decide to hang up his investing spurs:

In addition, eighty percent of our assets under management come from foreign investors. The revenues we receive from foreign investors allow us to contribute to the U.S. economy like an exporter of goods, bringing in money from abroad.

What, exactly, does Mr. Paulson think his firm "exports" to all these eager foreign consumers in exchange for their foreign "revenues?" Why, last time I checked, that would be money. Hmm.

And where does this money come from? Why, from all those investors and institutions who were on the opposite, losing sides of Mr. Paulson's short trades in mortgage securities.² Of which, I presume, the vast majority were American investors and institutions.

So, let's say for each dollar of investment Mr. Paulson took in, he earned around ten dollars in trading profit last year. After taking his cut of $2, he shipped $8 back to his limited partners, $6.40 of which went to foreign investors. Eighty cents of cash into the US; $6.40 out. That doesn't sound like a very favorable input to the current account deficit to me. In fact, it sounds much more like a massive offshore wealth transfer from American investors, institutions, and pension funds into the pockets of foreign investors. It's a good thing for Mr. Paulson that the Congressmen and women he testified before yesterday didn't have a fucking clue the sense to press him on this issue.

Of course, looking at the situation more broadly, re-exporting American wealth may be the fair thing to do anyway, considering how many of those toxic subprime securities we sold to German banks, Norwegian municipalities, and other furriners in the first place. In fact, it may be a small price to pay to maintain international peace and cooperation in today's uncertain, multipolar world. Americans and foreigners alike should be grateful for Mr. Paulson's strenuous efforts on behalf of the United States in this regard.

Some people have gone so far as to propose John Paulson for Treasury Secretary.

I recommend him for Secretary of State instead.

¹ It always amazes me how the mere sight of a billionaire can turn Americans from practically every walk of life into cringing, tail-wagging puppies. Warren Buffett is Exhibit A in this respect. Rugged American individualism, my ass.
² Given that such trading is a zero sum game, naturally.

© 2008 The Epicurean Dealmaker. All rights reserved.

Et in Arcadia Ego

The Dude: "Look, nothing is fucked, here, man."
The Big Lebowski: "Nothing is fucked?! The goddamn plane has crashed into the mountain!!"

— The Big Lebowski

Dealbreaker.com did a nice job yesterday quoting the I-Ching of all earthly wisdom, The Big Lebowski, in its blog post title referring to Drew Faust's November 10th letter to faculty, students, and staff of Harvard University.

In a remarkable and surprisingly realistic appraisal of the Stanford of the East's financial prospects now that the cream of Western Civilization is migrating from Park Avenue and Nob Hill into dingy caves in the West Texas Hill Country lighted only by Sterno, President Faust¹ has warned her various constituencies that All Is Not Well:

... we must recognize that Harvard is not invulnerable to the seismic financial shocks in the larger world. Our own economic landscape has been significantly altered. We will need to plan and act in ways that reflect that reality, to assure that we continue to advance our priorities for teaching, research, and service.

Our principal sources of revenue are all likely to be affected by these new economic forces. Consider, first, the endowment. As a result of strong returns and the generosity of our alumni and friends, endowment income has come to fund more than a third of the University’s annual operating budget. Our investments have often outperformed familiar market indexes, thanks to skillful management and broad diversification across asset classes. But given the breadth and the depth of the present downturn, even well-diversified portfolios are experiencing major losses. Moody’s, a leading financial research and ratings service, recently projected a 30 percent decline in the value of college and university endowments in the current fiscal year. While we can hope that markets will improve, we need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint.

Okay, so Ms Faust obviously didn't receive the memo that Moody's reputation for trustworthiness and probity currently ranks somewhere below that of Adolf Hitler or Caligula, but the rest of her remarks are sound. Losing 30% of an endowment the size of Harvard's—37 billion clams, or bones, or whatever you call them—is going to leave a nasty mark whatever the lighting. If Harvard chooses to maintain the absolute amount of operating support from the endowment at current levels, that will mean cutting into principal even more, and if it maintains the current percentage support, absolute dollars flowing into the university's operating fund will plummet.

Plus, leaving aside how much money Harvard chooses to bleed out of its investment kitty, the tyranny of compound returns—so charming, pleasant, and satisfying on the way up—means that it will take quite some time for the Crimson's rainy day fund to recover its current losses. Should Moody's estimate be correct, Harvard's investment managers will need to book more that 19.5% compound annual returns for the next two years running just to return to the high water mark of 2007. (Forget about growing bigger.) While this is certainly possible, those strike me as rather heroic return assumptions in today's post-bubble market environment, especially for an ocean liner like the Harvard Endowment fund.

President Faust then notes that Harvard's other sugar daddies are unlikely to remain as generous as they have been in the past, either, much less chip in enough to cover the expected shortfall from the endowment:

The economic downturn also puts pressure on other revenues that fuel our annual budgets. Donors and foundations will be harder pressed to support our activities. Federal grants and contracts for sponsored research will be subject to the intensified stress on the federal budget.

Right and right. It can be awkward and uncomfortable to rely on the kindness of strangers, especially when most of those strangers are either tapped out, over-leveraged and desperate themselves, or more focused on paying the mortgage and the grocery bills than buying another Rembrandt etching for the university art museum. Harvard will be lucky indeed if charitable donations do not drop by 50% or more this year, and government grants become a relic of the past. You can bet that Ms Faust and her minions are spinning rapidly into action to forestall the evaporation of millions of dollars in pledges made in happier times and to beat the bushes for those increasingly rare individuals who still have the wherewithal to underwrite the third biochemistry lab on campus. The John Paulson Real Estate Sciences Building, anyone?

But then, predictably, Ms Faust flies off the rails:

Tuition remains an important source of revenue, but in times like these we want to keep increases moderate, mindful that many students and families are facing economic strain.

Keep tuition increases moderate? Oh, President Faust, you were doing so well up until then. Since when have hallucinogenic mushrooms been on the menu at the Faculty Club?

* * *

To be fair to Ms Faust, I suspect that she is not alone among university heads in believing that raising prices in the face of a looming multi-year recession and the ongoing destruction of billions of dollars of net worth among the families which comprise her target consumers is even possible. When viewed in historic context, such apparent mass psychosis might even seem reasonable. After all, the price of a college education in this country has been rising at a compound annual rate over the past quarter of a century that is approximately double that of inflation. Given that this period has encompassed a couple of ruinous wars, the odd stock market boom and bust, general ups and downs in the economy, and several political administrations of varying fiscal rectitude, why shouldn't college administrators believe their target market is as hopelessly price insensitive as your average crack whore?

Sad to say, they have been right so far.

* * *

It is important to note that the very nature of education is such that it is afflicted with Baumol's cost disease. Education is one of those socioeconomic activities which is subject to very little improvement in labor productivity over time: it takes the same number of professor and grad student man-hours to educate little Billy or Sally today that it took to educate Adolphus and Hortense in 1842. Perhaps the content or comprehensiveness of the education delivered today is superior (perhaps), but the core delivery of service is subject to virtually the same constraints in effect when students wore caps and gowns to class.

Because education is so labor intensive, and because its laborers are still delivering the productivity of medieval scholars, the relative cost of education has grown at a pace well in excess of other activities subject to traditional labor productivity growth. This is exactly the case for other activities subject to the same dynamics, such as classical orchestras, for which Professor Baumol and his collaborator William Bowen famously noted "that the same number of musicians are needed to play a Beethoven string quartet today as were needed in the 1800s." As a result, it would cost a lot more Model Ts today to buy a season ticket to the Metropolitan Opera or four years of Ivy League education than it did in 1909.

You can see, then, that educational institutions are faced with constantly escalating labor costs which are effectively out of their control. Harvard does not set the wage for an Assistant Professor of Physics nowadays, Wall Street does (or did until recently). You price the services of a run of the mill Professor of Comparative Literature based on what he or she could earn as an auto assembly worker (okay, perhaps that is another bad example), not on the actual units of education he or she delivers. Harvard and its peers in the private education industry are price takers when it comes to labor inputs, not price setters. That is done elsewhere in our economy.

Unfortunately, a cursory examination of the physical plant or operating budget of a typical private college or preparatory school will quickly disabuse the curious enquirer of the quaint notion that its administrators are otherwise modest, frugal creatures who are only compelled to raise prices against their will by the tyrannical labor markets. In my admittedly limited and anecdotal experience, I have yet to encounter a Manhattan school Headmaster or an Ivy League Dean who would hesitate even one minute before sending the entire English Department on a ten-day "fact-finding" jaunt to China or who would equip the new Freshman Chemistry Lab with standard-issue microscopes when electron microscopes are available at ten times the price.

Last year, on the occasion of a reunion visit to the leafy groves of my own alma mater, I was dismayed to discover that practically all of the verdant green expanses of my salad days (perfect for snoozing over a physics textbook on a sunny day) were no more. There was almost no plot of grassy space left on campus that had not been filled with the hulking form of yet another architectural monument to the pride and vanity of some self-fellating panjandrum. On a previously nondescript and inoffensive corner, some brand-name architect had erected at undoubtedly outrageous expense a swooping steel and glass science library not ten minutes walk from a central library big enough to house in triplicate every book, magazine, and pornographic pamphlet published since 1362 plus have room left over for a small suburban mall. I did not see it then, but I fully expect to encounter gilded toilet paper in the Faculty Club mens room on my next visit.

In short, private education in America spends money like a drunken sailor with Warren Buffett's credit card.

* * *

Why they should want to do so is completely clear. How they have been able to get away with it for so long is more opaque.

My view, which you are welcome to classify under Education, Gratuitous Unverified Crackpot Theories Of, is that private educational institutions have been able to charge whatever the hell they want to for so long because Education has become the new Religion of the socially ambitious. There is almost no other way to classify the fervor, zealotry, and passion with which the parents and children of upwardly mobile classes pursue, discuss, and glorify the imprimatur of an Ivy League or equivalent degree, and the supposedly necessary interim steps thereto. Ask the typical upper middle class parents on the East or West Side of Manhattan whether they would prefer Junior to save his immortal soul or graduate from Princeton or Yale with a 4.0 grade point average, and they will look at you as if you had three heads. There simply is no question in their minds that eternal salvation takes a back seat to the right sheepskin on the wall.

This belief also explains why some New York parents are willing to pay so much money—the equivalent of $30,000 or more per year—to send their little darlings to the "right" private preparatory schools plus donate generously to the school's headmaster slush fund annual giving campaign to boot. They are convinced that a degree from Dalton, or Chapin, or Collegiate is a one-way ticket to the promised land on the banks of the Charles River. Once there, of course, there is no question that Mom and Pop will pay whatever Harvard asks to keep their offspring in crimson clover. After all, the Catholic Church got rich in the Middle Ages in part by selling indulgences. Why should Harvard, Princeton, or the University of Chicago be any different?

The skeptics among you will no doubt remain unconvinced, but I find it somehow revealing (and disturbing) that President Faust makes a point in her letter of mentioning that families with incomes between $60,000 and $180,000 per year "and typical assets" can expect to pay around 10 percent of their income as tuition to the Great Red Mother. Tithing to Harvard: some cultural forms never change, do they?

* * *

Whether this new Religion of Education will become an ossified, out-of-touch edifice ripe for challenge and Reformation by the iconoclasts of Google, Wikipedia, and Web 2.0, or whether it will pass unreformed straight through to the increasingly marginalized, irrelevant, and underfunded status of actual religions in the leading centers of Western Civilization is unclear to me. As federal grant-grubbing denizens of academe are wont to say: further research is required.

What is clear to me is that while the spirit may still be willing, the flesh (or the wallet) is beginning to get weak. Spending over half a million after-tax dollars per kid just to say that Little Bobby lost his virginity at one of the best universities in the nation is becoming harder and harder to justify for more and more parents. (Especially since one of the major reasons to send him there in the first place was to guarantee him a position in the immensely lucrative and prestigious fields of investment banking, securities law, or private equity. Oops.)

There is even shocking anecdotal evidence leaking out that formerly flush lawyers, investment bankers, and luxury goods retailers are beginning to pull their progeny out of the hallowed "feeder" schools of Upper Manhattan because they cannot afford the freight. Laugh if you will, but this is the upwardly mobile's equivalent of "jingle mail." Having written more than my fair share of eye-watering checks to such schools, I can only hope that the formerly arrogant, self-satisfied Headmasters and Headmistresses of New York are beginning to wet their beds on a regular basis.

This problem is not limited to the Ivy League, or Manhattan private schools, either. The entire over-leveraged, over-invested edifice of higher education in America is beginning to teeter and sway, and cracks are spreading across the foundation. Gone are the days, in my opinion, when university and preparatory school administrators could add sums collected from private and public donors to income harvested from the endowment, subtract that total from the amount of money they would like to spend in a perfect world, and divide the difference by the incoming student body to set the tuition.

No, it appears that the iron laws of economics have finally arrived on the peaceful doorstep of the Academy.

It's about time, too.

¹ Forget Pascal's Wager. If anyone needs definitive proof that there is a Supreme Being, that It has a wicked sense of humor, and that It is currently laughing Its Divine Ass off, one need look no further that the name of the current President of Harvard University. Irony much?

© 2008 The Epicurean Dealmaker. All rights reserved.

Ring, Ring! It's the Cluephone, for You

[Fred] Joseph, the former Drexel CEO, said companies that don't pay bonuses risk losing employees who are unwilling to settle for salaries. Salaries in the industry range from about $80,000 to $600,000 a year.

"A lot of guys wouldn't want to work this hard just for salaries,'' he said. "You'd have a serious exodus from the business by a lot of really talented people—they'd become CFOs of companies, go to firms that didn't participate in the TARP program, go to hedge funds, or start hedge funds.''

God, Fred, I love ya dearly, but you've gotta stop granting interviews.

Fred Joseph, dusty old fart and erstwhile Pillager in Chief from the Dark Ages when Drexel Burnham Lambert stalked the earth, has simply been out of the game so long he doesn't realize we have traded in leather skullcaps for more modern headgear. To be fair, he is not alone among investment bankers in this regard, and the venerable old i-banking industry has been whipsawed through so many violent changes recently that it's leaving even us whippersnappers dazed and confused.

But times, as they say, are a-changin', and it's (past) time to wake up and smell the coffee.

In the Bloomberg article for which Mr. Joseph provided his pearls of wisdom, we do get some nicely understated insight from another Ancient Mariner:

Wall Street's chief executives will hunker down and pay bonuses this year in the face of the worst financial crisis since the Great Depression, a taxpayer bailout and mounting political outcry, industry veterans say.

Odds that Wall Street will forgo the payouts are "slim to none,'' said John Gutfreund, 79, president of New York-based Gutfreund & Co. and the former chief executive officer of Salomon Brothers Inc. "They're going to have to be a little bit sensitive because politicians, whether they like it or not, are part of their lives now.''

No shit, Sherlock.

With both Congress and the New York Attorney General's office crawling up the asses of major Wall Street firms with flashlights, Roto-rooters, and cattle prods looking for juicy little sound bites on excessive compensation for the Senate floor and the nightly news, it will be a long time indeed before investment bankers regain control of their compensation processes. If ever.

But listening to these two, a naïve observer might believe that massive year-end bonuses are a sacrosanct and ineluctable feature of employment within the industry. Henry Waxman, Andrew Cuomo, and the rest can just go pound sand, because nothing is going to change. Unfortunately—or fortunately, depending on how you view the subject—however, history, economics, and policy are arrayed against them.

* * *

First, we have history. It seems that recent research cited by Zubin Jelveh at Odd Numbers gives evidence suggesting that financial sector employees have been substantially overpaid in recent years, coinciding with the credit bubble. A nifty chart tells the tale:


As Zubin remarks, "It implies that workers in finance are overpaid by 40 percent."

Another nifty chart, this time from a paper by Thomas Philippon (hat tip Zubin, again) demonstrates that aggregate compensation and share of total GDP has been climbing steadily in finance for years, and is now at levels substantially above long-run averages reaching back to 1927.


Phillipon's data also show that finance carries no God-given right to its current share of the national pie, since it averaged much closer to a 3 to 4 percent share of GDP during the Great Depression and post-war period, versus its current level of approximately double that.

The implications of this research are crystal clear, as Professor Philippon himself notes:

In April 2008, in an interview with Justin Lahart of the WSJ, my idea was translated in the following way: "Mr. Philippon argues that the surge of financial activity that began in 2002 created an employment bubble that is now bursting. His model suggests total employment in finance and insurance has to fall to 6.3 million to get back to historical norms, and that means losing an additional 700,000 jobs in the sector." In truth, my model is not about the number of jobs but about the GDP share, so it would be more accurate to say that the annual wage bill of the financial sector needs to shrink by approximately $100 billion.

Take your pick: 700,000 jobs lost in finance, or $100 billion less in aggregate compensation. Either way, that's a helluva lot of blood on the streets. And that conclusion, by the way, is based on the assumption that finance should account for approximately 7% of US GDP under normal circumstances. Does anyone out there believe we are passing through normal circumstances?

Given that this shrinkage is happening across the entire industry, show me an investment banker who is clueless enough to believe there is a better bid away if his or her own employer doesn't match his or her expectations. I will show you someone destined for the unemployment line.

* * *

Second, we have economics.

In his quote at the top of this post, Mr. Joseph trots out one of the hallowed shibboleths of i-bankers everywhere: "If banking doesn't work out, I've got options!" As a rule, investment bankers are unshakable in their conviction that no other class of human is quite so intelligent, attractive, or capable as they are. You cannot persuade them that there is any job in society or the economy they cannot undertake and master. (Perhaps this might explain why we have so many Goldman Sachs alumni stumbling around the corridors of 1500 Pennsylvania Avenue.)

Unfortunately, it does not appear that Ol' Fred has been reading a lot of newspapers recently. He mentions ex-bankers becoming CFOs of companies in the real economy, joining a bank not subject to the TARP restrictions and scrutiny, or sashaying off to hedge fund land. These ideas, to be blunt, are irredeemably stupid.

The last time I checked, a robust consensus had developed among virtually all conscious participants in our economy that we are headed into a long, deep, and nasty recession. Given that such travails tend to have a rather depressing effect on the financial performance of existing companies, and put a rather serious damper on the ability of new companies to find start-up financing and commence operations, where the hell does Mr. Joseph think all these CFO jobs are going to miraculously appear from? All the CFOs I know are desperately trying to hold onto their own crappy, high-pressure, thankless jobs, given that the current financial crisis has obliterated both their retirement accounts and any fond hopes they might have held about retiring early (or even on time). Furthermore, I know plenty of CFOs and CEOs in the real economy who would be absolutely delighted to suffer under the privations of a $600,000 annual salary sans bonus. Most of them work at least as hard and as long hours as any pissant thirty-something investment banker.

The CFOs and CEOs who historically have been compensated at levels the typical investment banker would consider barely adequate all tend to reside within the walls of the Fortune 1000 and their ilk. Even if all 2,000 of them get killed in a freak electrical storm at Davos next year, where are the other 698,000 of you going to find jobs?

Joining a bank not participating in the Bend Over and Take It Financial Stabilization Program directed through TARP is a joke, too. By the time this is all over, any bank which has not received an equity injection from the Treasury will be pushing up corporate daisies, since Henry Paulson will only decline to invest if he thinks a bank is going bust, and so far no bank has been given the option to decline Mr. Paulson's largess.

I can also tell you for a fact that independent i-bank boutiques, which have been advertised as the Great White Hope for unemployed dealmakers and rainmakers, are far too small to absorb more than a few hundred senior professionals worldwide. Furthermore, once most of these Big Swinging Dicks leave their huge, resource-rich bureacratic environments for the cold tundra of independent advisory work and have to start feeding their families with only what they kill themselves, you will begin to see a remarkable realization among most of them that they do not have an entrepreneurial bone in their bodies. All of a sudden, those grinding, low-paying, low-prestige CFO jobs they cannot get will begin to look pretty good to them.

And hedge funds. Hah! Given the little information we can glean from the media about conditions in that industry, the Darwinian bloodbath caused by the Great Unwind there is going to make Pol Pot's killing fields look like a friendly stickball game in a leafy suburb. The only reason hedge funds will be hiring new people in the next few years is to dig graves for the friends and colleagues they have shot, stabbed, and hacked to death in a desperate struggle to survive themselves. Most investment bankers would not recognize a shovel if their frustrated wife wrapped it around their head after having her credit cards declined.

* * *

Third, we have policy.

Forget politics. Put out of your mind the torch-bearing, pitchfork-waving mobs beating on the glass doors of every investment bank in New York. Ignore the ignorant, meretricious, pandering politicians who are gleefully piling on the battered corpse of the finance industry in order to win plaudits, votes, and campaign funds from their current and future constituents. (Although make sure you answer their subpoenas swiftly, with grace and humility.) Both groups will tire of their sport after a while and move on to the next hapless victim of mob vengeance.

No, just realize that eventually, after the usual witch hunts and occasional miscarriages of justice, this society will come around to a consensus that the investment banking and finance industries cannot continue in their current size and form. Parts of this transformation are already underway. When the last great survivors of three decades of consolidation, Goldman Sachs and Morgan Stanley, throw in the towel, convert to bank holding companies, and start offering free toasters to clients with every M&A deal and IPO closed, you know that a line has been crossed, once and for all.

Part of that line involves compensation. Structurally lower profitability, a multi-year exodus of surplus personnel, and direct and indirect regulation will take a serious toll on pay earned by the erstwhile Masters of the Universe. This is probably as it should be. While I do not agree with the common prejudice that investment bankers add absolutely nothing of value to the economy, I do believe that too large a portion of investment banks' role (and wage bill) over the past several years has been devoted to maintaining and speeding up the increasingly frenetic velocity of money circulating around the global financial system. Now that that velocity is slowing down, and excess leverage is bleeding out of the balloon, there is obviously less need for professionals whose jobs consisted primarily of inflating the bubble.

Regulation, too, will take its toll. I am not a big fan of regulation—not because I do not think well-designed, carefully implemented regulation can add value to an industry: I do—because I have little faith that real-world politicians and regulators won't botch things up and make conditions worse with silly rules, badly enforced. But there are no odds right now in opposing regulation: it is coming, whether we like it or not.

And history tells us that regulation of the financial services sector is not kind to its participants' pocketbooks. Citing yet another Philippon paper, Zubin Jelveh notes the following:

From 1900 to the mid-1930s, the financial sector was a high-education, high-wage industry. Its workforce was 17% more educated and paid at least 50% more than that of the rest of the private sector. A dramatic shift occurred during the 1930s. The financial sector started losing its high human capital status and it wage premium relative to the rest of the private sector. This trend continued after World War II until the late 1970s. By that time, wages in the financial sector were similar to wages in the rest of the economy. From 1980 onward, another shift occurred. The financial sector became a high-skill high-wage industry again. Even more strikingly, relative wages and relative education relative to the private sector went back almost exactly to their levels of the 1930s.

...

We find a very tight link between deregulation and human capital in the financial sector. Highly skilled labor left the financial industry in the wake of the depression era regulations, and started flowing back precisely when these regulations were removed.

This is not good news for the Ferrari dealerships in New York, Greenwich, or Mayfair.

* * *

So what can we conclude?

Pace the structural changes in the industry, which all point toward a long-term decline in both the absolute and relative levels of investment banking compensation, the CEOs and Boards of Directors of major commercial and investment banks are under severe short-term political pressure to reduce pay. Because this is true for the entire industry, senior management at the leading banks may take this opportunity to cut their wage bill in tandem from, say, the traditional 50% of net revenues to 40%, or lower.

I can think of many senior executives who would love to stick it to their restive, pain-in-the-ass bankers and traders who are never happy with their pay, no matter how high it is. This crisis could provide the industry great air cover for a structural change in the level of pay to employees. "It's not us," they will cry, "Congress made us do it!"

Nevertheless, even at reduced payouts the absolute level of pay for the typical bog-standard Managing Director will still be plenty large enough for Henry Waxman to string him up with piano wire on the steps of Capitol Hill and be applauded for doing so. Panicky, resentful voters who can only dream of making enough money to break into Obama's higher tax bracket and who are worried about keeping their homes, their jobs, and their three large-screen plasma TVs will not look kindly on anyone making over $1,000,000 this year. Even in a shitty year like this one, there will be plenty of those to go around.

So i-bank management better start getting pretty clever about justifying, explaining, and structuring its compensation practices and payouts in the glare of public scrutiny. For what it is worth, I think most people could accept even high pay packages if it were shown that bankers were not walking away with the family silver after the public has saved their house from burning down. Limit maximum cash compensation for everyone to less than $1 million, and make up any excess in the form of long-dated options and long-vesting restricted stock. I imagine even Joe the Plumber could accept an MD earning $10 million this year if he knew that $9 million of it was in the form of company stock he cannot touch for five to 10 years. That way, the banker will thrive or suffer in tandem with his firm's other shareholders and the US taxpayers who have rescued his cookies, and Messrs. Waxman and Cuomo will take comfort in knowing that TARP's billions have not flown straight out the door to fund cocaine and hooker binges on St. Barts this Christmas.

As every investment banker knows, money is what matters. But "optics," or how deals appear to the person on the outside, matters at least as much. Especially in these troubled times.

You have heard of windfall profits tax, no? Let's try to prevent the imposition of a "windfall bonus tax" this year, shall we?

© 2008 The Epicurean Dealmaker. All rights reserved.

We're in Ur Boardroom, Smokin' Ur Sigarz

"A riot is an ugly thing ... undt, I sink zat it is chust about time zat ve had vun!"

— Inspector Kemp, Young Frankenstein

First, we had Rep. Henry Waxman subpoenaing compensation information from the nine commercial and investment banks which have received equity injections from the Treasury's TARP program, in an annoying but understandable effort to find out whether these banks were simply turning around and paying out taxpayer monies to fat cat investment bankers.

Earlier today we had Mario Cuomo's idiot son getting in on the act as well:

We believe that the Board of Directors is most appropriately positioned to respond to our requests as the firm's top management likely has a significant interest in the size of the bonus pools. In this new era of corporate responsibility we are entering, boards of directors must step up to the plate and prevent wasteful expenditures of corporate funds on outsized executive bonuses and other unjustified compensation.

As my Office has told AIG, now that the American taxpayer has provided substantial funds to your firm, the preservation of those funds is a vital obligation of your company. Taxpayers are, in many ways, now like shareholders of your company, and your firm has a responsibility to them.

Accordingly, we also ask that the Board inform us of the policies, procedures, and protections the Board has instituted that will ensure Board review of all such company expenditures going forward. Please provide this Office with an accounting of the actions the Board plans to take that will protect taxpayer funds.

Now, I am no lawyer, nor have I ever pretended to be one. (Except that one time in Panama, but that doesn't really count.) Perhaps Mr. Cuomo is within his rights to warn his targets in advance against actions which could be construed by an aggressive, politically ambitious attorney general as fraudulent conveyance under Section 274 of the NYD&C Law. (From the information he is requesting, it sure looks like he is on a fishing expedition for intent to violate the law, since no bonuses have actually been awarded yet.)

Perhaps he also has the authority to demand a detailed accounting of how the boards of these companies plan to protect federal taxpayer funds going forward. But I must say, as a simple layperson, that both these actions reek of a level of governmental interference and oversight which strikes me as both egregious and premature.

What does Mr. Cuomo intend by intervening at this point in time? Does he propose to "help" these institutions develop their corporate and board level policies on governance and compensation? Does he expect to wield real-time oversight over the actions of these private corporations because they have received public funding? Does he want a leather-covered seat in the oak-paneled boardroom?

And let us not forget, Dear Readers, that Mr. Cuomo wields the baton of the top law enforcement official in New York State. The last time I checked, the TARP investments in the balance sheets of these nine banks were being funded out of federal taxpayer monies. Putting two and two together, I am led to one niggling little question: Who the fuck does this clown think he is?

Sadly, the answer is depressingly simple and banal: He is a politician.

And, apparently, he is an effective one who knows his audience. All you have to do is read the reactions of the mouth-breathers, wing-nuts, and whack jobs in the comments section of the DealBook post cited above to see that opinion is running approximately 52,000-to-1 in approval of his actions and 25,000-to-1 in support of extrajudicial torture and killing for anyone who even knows how to type "Wall Street" without using ALL CAPS.

The paragraphs I have cited above from his letter demonstrate that he is highly skilled in the demagogic arts of grandstanding, gratuitous flag-waving, presumptive credit-taking, and delivering stern lectures to those he presumes guilty. Most of those remarks are certainly extraneous to the straightforward requests for information he makes elsewhere in the letter, but it is clear that he has included them for purely public consumption.

In this regard, Mr. Cuomo is no original. He is simply following the well-trodden path of previous law enforcement officials from this fair city and state, who have used the smoking wreckage and twisted bodies from previous financial panics both as a bully pulpit from which to harass and harangue the real and imagined evildoers of Wall Street and as a launch pad to higher political office. Whether and to what extent the parties they have pursued were actually guilty of wrongdoing never figured prominently in the political calculus of Eliot Spitzer or Rudy Giuliani, as long as they could get good (nationwide) press for cleaning up Tombstone. I have little expectation that Mr. Cuomo will behave any differently.

Of course, one must not feel too surprised or dismayed at this turn of events. Even on the savannahs of Africa, the King of the Beasts may be harried from his kill by a determined pack of hyenas, and the hyenas in turn must yield to jackals and vultures. The hyena is—evolutionarily speaking—a magnificent beast, purpose-built for its ecological niche in the grassland food chain. Too bad it is such an ugly, fear-inspiring, despicable beast. At least in Africa the other animals do not allow hyenas to kiss their babies.

As for my part, all I can say is I am relieved I do not hold an executive position at one of these banks.

You literally could not pay me enough to deal with a bunch of self-righteous, self-aggrandizing, self-pleasuring dipshits like Andrew Cuomo and his band of merry men at the NY OAG. I positively look forward to their eventual self-immolation on the Eliot Spitzer Memorial Pyre of Hubris and Hypocrisy.

Who's going to buy the marshmallows? Can I nominate Kenny Langone?

© 2008 The Epicurean Dealmaker. All rights reserved.