Nature Red in Tooth and Claw: Part IV

Westley: "Who are you? Are we enemies? Why am I on this wall? Where is Buttercup?"
Inigo Montoya: "Let me 'splain. ... [pause] ... No, there is too much. Let me sum up."

— The Princess Bride

* *

EDITOR'S NOTE: This is the fourth and final installment of a multi-post treatise on investment banking compensation. Previous entries include:

• Part I: Investment Banking, A Love Story, about the evolution of the industry;
• Part II: The Right Hand of Doom, about the drivers and structure of banker pay; and
• Part III: Seed of Destruction, about risk factors and risk management in the industry

This post attempts to tie together the preceding entries and come to some sort of reasoned conclusions. Fasten your seatbelts.

* *
— Part IV: Darkness Calls —

We have covered a lot of territory already. Let me sum up.

Traditionally, investment banks acted as intermediaries or agents for wholesale capital markets transactions, not principals. As such, while they did perform services that exposed capital to risk, traditionally these risks were of short duration, relatively small, and very well contained. Risky activities such as these are concentrated on the capital markets (or sales and trading) side of the business, and consist of using the bank's capital on a temporary basis to facilitate securities issuance or securities trading by their institutional customers. Due to investment banks' privileged position at the nexus of market flows and information and their ability and inclination to trade rapidly in and out of positions, banks have historically been able to conduct such business pretty successfully using relatively small amounts of equity capital.

Because their business is designed to make money off the flow and volume of transactions in the marketplace, rather than off sustained price appreciation or direct investment, investment banks have a business model and a culture which focuses almost exclusively on chasing transaction fees, or revenues. Since markets are often volatile, and revenue opportunities are fleeting, there is an institutional bias within investment banks to chase and book revenue first and worry about consequences later. With its low fixed salary component and theoretically unlimited upside incentive bonus, compensation for revenue-producing investment bankers is explicitly designed to encourage this pursuit.

On the other hand, investment bankers historically were very good at managing their business risks. Capital markets risk used to be managed by senior partners who had been traders themselves, and who had complete visibility and understanding of the risks in the bank's trading book.¹ Encouraging and supporting this hands-on supervision was the fact that senior trading partners typically had a major portion of their own personal wealth tied up in the equity capital of the firm, along with that of senior management and other partners. Accordingly, risk management was a very high priority for all of the firm's key decision makers, and it acted as a powerful and effective brake on the countervailing tendency for bankers to pursue revenues at all costs.

Using this time-tested model, traditional investment banks used to do pretty well for themselves. They ate what they killed, feasting in times of plenty and tightening their belts in times of famine. Because the bankers were the owners of the firm, they kept a pretty tight balance between revenue generation and capital preservation. Accordingly, firm-threatening or -ending mistakes were rare.

But this was not a model suited to rapid growth or global scale. And as the capital markets continued to grow, and the global economy became more connected, the old partnership model of investment banking began to disappear.

* * *

In its place arose large, publicly-owned global investment banks and—with the gradual erosion of Glass-Steagall barriers between commercial and investment banking—large, integrated "universal" banks. Banks funded their expansion with increasing doses of outside capital—other people's money—and merged and acquired their way to greatness with their peers. Unfortunately, with increased scale many of the built-in checks and balances of the partnership model began to break down.

Large public banks did retain much of the partnership compensation model, which deferred ever more of a banker's pay the higher up he got and the more he made. But keeping risk management a central concern for every banker was never a principal reason for this. Instead, banks were much more concerned with preserving cash and attempting to lock up bankers with deferred equity so they could not leave for a competitor. More importantly, deferred pay lost its effectiveness as a distributed risk management tool. As investment banks grew ever larger and more complex, each banker had less and less impact on the overall results and health of his bank, almost no matter how much he made. A banker's deferred equity nut began to look more and more like a ball and chain, rather than a direct link and meaningful incentive to control the overall risk of his employer.

Exacerbating this was the professionalization of risk management at large investment banks. As banks got bigger, and their trading books swelled with ever more complex securities, grizzled old traders with big equity stakes in the firm no longer had the experience or the bandwidth to monitor their underlings' trading positions. Instead, professional, dedicated risk managers—who often came from a structuring or academic background, not sales and trading—took over the role of trying to say "enough" or "no" to the hotshot revenue producers. Given the revenue-worshipping culture embedded at the core of every investment bank, such a system was bound to fail, as the big swinging dicks with real skin in the game ignored, bullied, or coopted the sniveling little (equity-less) PhDs sent to rein them in.²

Adding to the problem, the only people with enough skin in the game and the power to do something about firm risk—senior executives—became increasingly beholden to outside public shareholders. Because most of these outsiders were big, diversified institutional investors, they had an even more aggressive risk posture than the investment bankers themselves.³ They pushed the bank CEOs and Boards for ever more growth and return on equity, and the senior executives, being investment bankers who worship at the altar of revenue anyway, complied.

Finally, the growth in investment bank balance sheets and the increasingly complex securities either demanded by customers or manufactured "on spec" by revenue hungry bankers led to increasing concentrations of opaque and badly understood risk in many banks' trading books. Market making shaded into speculative trading, which morphed into full-blown proprietary trading (and even internal hedge funds at some banks). Investment banks began to accumulate—apparently without their full knowledge—poorly understood contingent obligations that hinged upon their traditional market-making role as buyer of last resort for securities they underwrote. Risk seems to have been misunderstood and significantly underestimated by almost everybody in the financial markets, but when the shit hit the fan, investment banks were uniquely positioned to have most of it blow right back onto them.

Of course, increasing leverage and lax regulatory oversight played a role, too. But leverage acted as an accelerant and a conduit for contagion across market sectors, and sloppy supervision added to the general haze of ignorance and the thicket of unintended consequences. Neither was the ultimate source of the breakdown in the financial markets. Had they not been present, the fire might not have spread so quickly or so broadly. But make no mistake: the fire would have started anyway, and it still would have burned down a pretty big swath of the financial forest.

* * *

So, what can we conclude from all this?

Well, for one thing, the need for traditional investment banking services—intermediating capital flows and financial transactions for all comers—is not going to go away any time soon. It is simply impractical to imagine a world without investment bankers, no matter how eagerly the torch and pitchfork crowd would love to do so. But it seems to be a somewhat paradoxical business, one best suited to entities which combine extremely aggressive pursuit of revenues with a highly developed aversion to risk. The old partnership system, where the revenue producing bankers were also the owners and providers of equity capital, seemed to work pretty well. The currently much-maligned system of investment banking compensation is a relic of that earlier time, but it does not seem to balance these tensions well in today's huge, publicly-owned global investment banks.

Instead of the old integrated risk model, we now seem to have one where outside investors have high risk tolerance, revenue producing employees have low risk tolerance but cannot effectively influence it, and professional risk managers tasked with controlling it are politically and economically disenfranchised. This is not an unavoidable outcome of the current model, but it certainly makes the whole system far more difficult to manage. Unfortunately, there is absolutely no way to recreate entities the size of Goldman Sachs or Citigroup with purely private partnership capital. Even if you could, I am not sure you could avoid the span of control, scale, and complexity issues bedeviling these enterprises.

One solution, of course, is to shrink investment banks down to a more "manageable" size, whatever that means. The immediate question this raises, however, is whether such smaller banks could perform their systemic function in today's highly integrated global financial system adequately. The next question, if we determine they cannot, is whether we would miss them. My crystal ball is too cloudy to offer an opinion on that one, although I can guess what Matt Taibbi would say.

* * *

In any event, I hope I have convinced those hardy souls who have soldiered along with me this far that investment banking compensation was not the sole source of our current troubles. It is part of the puzzle, make no mistake, but it is not the only piece. Therefore, fixing it and nothing else will not right the ship.

Notwithstanding what legions of indignant and self-righteous commentators contend, the incentive system currently in place operates exactly as most of them propose: a large portion of banker pay is deferred for years and is tightly tied to the overall health and success of the firm. Bankers are not incentivized to print huge risky trades and run away as soon as they collect their bonus at the end of the year. In fact, they are more closely tied to the long-term health of the firm and its stock price than any other stakeholder. They just can't do anything about it. Unfortunately for them and for us, such a system does not seem to have prevented anything.

Perhaps a solution could be structured which balances all of the competing pressures and strains that the modern investment bank encounters. It would be complicated, involve multiple variables, and require constant monitoring, adjustment, and correction to adapt to ever changing market conditions. It sounds like a fun project for Larry Summers and crew.

Sadly, they never taught multivariate optimization techniques on the savannah when I was coming up in the business. I guess I'll just sit here, gnawing a wildebeest bone, until somebody tells me what to do.

— THE END —

¹ Capital markets activities are the only significant source of firm-wide risk for the traditional pure investment bank.
² This was made worse by the fact that the huge expansion in most banks' capital markets operations during the Great Moderation meant that Capital Markets grabbed the political reins of power from their partners in M&A and Corporate Finance. (Investment banks allocate power based on the Golden Rule: He who brings in the gold gets to make the rules.) Since M&A and Corp Fin bankers enjoy little direct upside from increasing sales and trading revenues but face a lot of downside if sales and trading blows up, they tend to be strong advocates for clear risk limits and controls in the trading book. But the traders were the ones bringing home most of the bacon, so M&A and Corp Fin bankers had no choice but to shut up and view the ballooning risk with increasing disquiet.
³ If Fidelity or another outside investor got worried about Lehman Brothers, they could (at least theoretically) sell all their shares. Dick Fuld and most of the other bankers at Lehman had to watch helplessly as a lifetime's worth of deferred compensation evaporated into thin air when the firm collapsed.

Photo credit for the series: Nathan Myhrvold's 2007 photo essay on lions in Botswana, Africa. Warning: blood, gore, and sex galore. Now do you see the connection?

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part III

I've been to Paris
And it ain't that pretty at all
I've been to Ro-ome ...
Guess what?

I'd like to go back to Paris someday
And visit the Louvre Museum
Get a good running start and hurl myself at the wall

Going to hurl myself against the wall
'Cause I'd rather feel bad than feel nothing at all
And it ain't that pretty at all
Ain't that pretty at all

— Warren Zevon, Ain't That Pretty at All

* *

EDITOR'S NOTE: This is the third installment of a multi-post treatise on investment banking compensation currently in progress. Previous entries include:

• Part I: Investment Banking, A Love Story, about the evolution of the industry; and
• Part II: The Right Hand of Doom, about the drivers and structure of banker pay

This post focuses on risk factors and risk management in the industry.

* *
— Part III: Seed of Destruction —

We have discussed in general terms both the history and evolution of the investment banking industry over the last few decades and the sources and nature of investment banker compensation. Before we can draw some conclusions about how they interacted in the recent financial crisis, however, we must first take a little detour to understand where an investment bank's risk comes from and how investment bankers typically manage that risk.

Historically, pure investment banks were always relatively thinly capitalized entities. This made sense, considering the nature of their business and the risks they undertook. Remember: of the three basic business lines pure investment banks pursue—M&A advisory, securities underwriting, and sales and trading¹—only underwriting and sales and trading carry any material risk to capital. M&A advisory is pure agency business, where the only risk you run is that you put a lot of time and effort into a transaction which does not lead to a fee. The bank puts no capital at risk whatsoever.

In traditional underwriting, on the other hand, there are risks, but they are largely short-term market and liquidity risks. The bank spends a lot of time and energy pre-selling (and usually over-selling) a securities offering to potential investors, so when they buy the securities from the issuer and immediately turn around and sell them to the public, they are assured of a smooth offering. The risk is lowest for what are known as "best efforts" offerings, wherein the bank tells the issuer they will do the best they can to sell the paper, but no promises. The bank does not commit to a particular size or price for the offering, but simply offers to drum up investor demand for a slice off the top. Investment banks love to do these deals; clients not so much.

The alternative is a "bought deal," where the investment bank essentially promises to purchase an entire offering from the issuer at an agreed size and price. In such a deal, it is up to the investment bank to cut a check to the issuer (minus its fee, of course) and then turn around and offload the paper to third party investors. Clients love these deals because they transfer virtually all of the market and execution risk onto the shoulders of the underwriter. Of course, in such circumstances the bank will do as much pre-marketing and pre-selling as it can, and the morning of the sale to investors is usually a frenzied, all-hands-on-deck sort of fire sale. Since it really is putting a substantial chunk of capital at risk, an investment bank tries to price its purchase from the issuer at a level that will comfortably clear the market afterwards. Sadly, bought deals are often found in highly competitive situations, where more than one investment bank is competing for the business, so the winning bank is usually the one which has the most aggressive posture toward market risk (or is the most foolhardy).

Consider as well the fact that it does not take much of an adverse price move to wipe out the investment bank's economics on the deal. If you offer a typical high yield bond at par, and the market moves against you or you have misjudged demand, it only takes a clearing price 2% or 3% below par to wipe out your entire underwriting spread. Given that investment banks normally don't want to end up owning a lot of their client's paper, you can see how nerve wracking it can be to put a couple hundred million of capital at risk to collect a $6 million fee. Talk about picking up pennies in front of a steamroller.

Bought deals were relatively rare a couple decades ago, but they have become increasingly more common over the course of my career. Being able to offer bought deals to large, lucrative, demanding clients like private equity firms funding LBOs has become a competitive requirement for the larger investment and universal banks. Other things being equal, the more bought deals a bank does, the more capital it needs and the more sales and trading capacity it has to have to shovel them out the door, fast. Bought deals are expensive, in terms of capital, people, and risk. They may not be happy about it, but banks painted themselves into this corner. Bought deals increased as a percentage of all underwriting because banks acquired enough capital to do them, weaker banks literally "bought" their way into deals with the practice, and clients flocked to the new product in droves. On Wall Street, the competitive arms race never ends.

* * *

There is also a relatively small risk that an underwriting—either best efforts or bought deal—can go so wrong it needs to be rescinded. Normally this happens because the issuer blows up, fraud is discovered, or the like. In such instances, the bank typically makes the purchasers of the issue whole by buying the securities back from them at the offer price and then tries to collect the money from the issuer. This does happens on occasion, but investment banks try to minimize this risk by performing good due diligence on the issuer before the fact.

More interestingly, there is a longstanding tradition on Wall Street that a bank which underwrites a securities offering has an ongoing obligation to make a market in (i.e., buy and sell) those securities. Usually this is a good thing, as the bank can continue to make money crossing trades in the securities after they have been sold the first time. Unfortunately, it also means the underwriter is the de facto buyer of last resort for such paper. You can see how this can become a nontrivial source of pain for an investment bank when the market is in free fall and Fidelity or Putnam phones you for a bid on $100 million of toxic CDOs you sold them three months ago. It's even worse when everybody calls you up at once, because then you become the market.

Generally, bankers think long and hard before they try to welsh on this obligation. Traders and investors on Wall Street pride themselves on very long memories, and more than one investment bank has lost millions of dollars of repeat business from a buy-side account because they flouted this rule. Unlike M&A and other corporate finance activities—where you have to sign a 30-page contract, confidentiality agreement, and indemnification provision just to go to the bathroom—much of the sales and trading activity that takes place around the world continues to do so on the moral and virtual equivalent of a handshake. Even if most of the CDOs and other toxic securities Wall Street underwrote during the boom did not have explicit investor put options embedded in them—as those sold by Citigroup were reported to have—the implicit put was always there. It was no surprise that most of this shit ended right back on the balance sheets of the banks which underwrote it in the first place.

* * *

Market making—also known as nonproprietary or "customer" trading, in distinction to proprietary trading for the bank's own account—also carries material risk. The real purpose of market making is to provide liquidity for an investment bank's customers: be a buyer when they want to sell and a seller when they want to buy. In exchange for this service, the bank collects a fee which consists of the spread between price paid and price received on the securities it crosses. Unless the security in question trades very frequently in high volumes (i.e., is highly liquid), the bank will likely need to hold a material amount of it in inventory, in its trading book. This inventory must be supported by capital, and it poses nontrivial market and liquidity risk to the bank.

The more a bank treats a particular trading book like a pure market making facility, the fewer securities it will typically hold in inventory. That way, if the market price plunges, its mark-to-market loss will be smaller and more manageable, and it will be easier to sell the (small) losing position to another buyer. The real risk in this situation is a market stoppage, or complete evaporation of liquidity. If trading in a security completely stops, not only is the bank stuck with any securities it has in inventory, but the true market price either becomes unknown or severely discounted from the last trade. Big mark-to-market losses result, and capital takes a nasty hit. Fewer pennies, bigger steamroller.

Finally, as I mentioned previously, market making can shade almost imperceptibly into proprietary trading and speculation. The more it does so, of course, the more an investment bank's risk profile increases in relation to both market (or price) risk and liquidity risk. While investment banks have always prided themselves on their market sense, derived from their privileged position astride the global financial markets, it is a different kettle of fish entirely to surf the ebb and flow of the market to capture nickels and dimes than to build and hold concentrated investment positions over extended periods of time. The sorry history of most of the internal hedge funds set up within investment banks over the past few years is proof of this.

* * *

Now, what does this tell us about how investment banks have typically gone about managing risk?

Well, for one thing, you need to understand that investment bankers have traditionally viewed their business as a flow business. That is, for most of its history, investment banking has focused on facilitating the investment and capital allocation transactions of others. They are not in the business of accumulating assets, inventing products, building businesses, or indeed building anything. They are pure agents, and their objective is to get paid to help other people do things with capital and markets.

Also, as capital markets intermediaries par excellence, investment bankers believe in their very bones that every market they participate in—M&A, equities, bonds, commodities, derivatives, etc.—is deeply and irrevocably cyclical. Each of these markets goes through repeated cycles of boom, bust, and inactivity.² Hopefully, an investment bank has adequate capabilities and market position in a selection of markets, so it can enjoy the boom in one or more sectors while it struggles through a bust in others. But for individual investment bankers, who nowadays tend to be highly specialized and therefore difficult to reassign to other duties, that means you have to be ready to rumble when the time is ripe. Most investment bankers can expect only so many boom cycles in their chosen specialty during their career, so they tend to go whole hog when they happen.

Not for nothing is the informal motto of my industry "Make hay while the sun shines."

The entire industry compensation system is designed to manage this cyclicality, too. Bankers are paid fixed salaries which are a small fraction of their expected average pay, with the balance made up of variable incentive compensation, otherwise known as the "bonus." This does several things. For one, it reduces fixed labor cost to a bare minimum, in case results for the year—measured firmwide, by division, by group, or by banker—don't pan out. For another, it encourages bankers to work as hard as possible to make lots of revenues, since there is no theoretical upper limit to a senior investment banker's compensation. Given that healthcare banking may only boom once every five years, for example, the firm wants to make sure the banker who has already booked $75 million in revenues keeps trying to get another $25 or $50 million more. Finally, the fact that a huge portion of a banker's wealth is tied up in stock of his employer gives him an important incentive to keep trying for revenues even in a down year.

Having a seat at the table the next time a boom comes around gives a banker a very valuable option. Bankers work hard to hold onto a position at their firm in bad times, and they work like the Devil to harvest revenues when the sun is shining. Given the intensity of competition and the stakes at hand, investment bankers rarely tend to think in terms of a "career." Instead, they focus deal to deal, and on booking the next trade. This is true in every division of the modern investment bank. When the revenue salmon are running, you don't stop to count how many you have caught, worry whether you will get ill from eating too many, or wonder when they will stop. You just keep fishing.

Investment bankers don't do the future well.

* * *

For some businesses, like M&A and best efforts underwriting, this is where the story ends. Bring in a good deal, and you get paid. Lose it, or mess it up, and you may get dinged, or even fired, but it will not seriously threaten the firm.

It's different in sales and trading, where bankers commit real firm capital. Mistakes can have huge effects, and a single trader's mistake can wipe out half the bonus pool for his division or cause a net loss for the firm. There, traditionally, traders managed themselves. That is, a grizzled old veteran who cut his teeth trading XYZ bonds was the guy who monitored the trading book and risk positions of the junior trader tasked with that job today. In the old days, when most investment banks were partnerships owned by their employees, this made for very effective risk control. No crusty old bastard who has given 30 years and three marriages to his employer is going to let some wet-behind-the-ears tyro blow his retirement account. Even now, with atomized public ownership diluting investment bankers' stakes in their own firm, you can make an argument this is a decent system. Who better to understand the risks than a guy who sits on top of the market and has the best view of short-term opportunities and threats?

But monitoring markets in real time this way has serious limitations as a form of risk management. It was sufficient for traditional market making and early proprietary trading, when positions held were small, turnover was fast, and trading books were relatively uncomplicated. You didn't put on or maintain a position you couldn't close out in a couple hours or days, and the head trader personally understood all the securities in his underlings' books backwards and forwards. Nowadays, that is not the case, so risk management has become professionalized and separated from the sales and trading function. This helps preserve objectivity, but at the price of introducing a more serious problem.

For it should be clear to you by now that the most important people in an investment bank are the people making the money. The revenue producers have always held the power and authority; staff are an afterthought. Due to the cyclical nature of their markets, their incentive compensation structure, and the aggressiveness and drive of the people they attract, investment banks have always worried about revenues first, second, and third. Efficiency, resource management, and risk control were always far down the list.

And while this may have worked when span of control was short and revenue producing bankers' incentives were completely aligned with active risk control (because it was their capital they were risking), it clearly has not worked in today's environment. Forget about whether risk managers even understood the risks their firms were taking over the last several years. For all I know, they may well have.

What I do know is that when investment banks got big enough and bureaucratic enough that risk management and revenue generation could be separated, the wheels began to come off the bus. When senior executives—almost all of whom, by the way, came from revenue producing backgrounds, not risk management—no longer had direct responsibility for risk control, the importance of risk control diminished at their firms. Sure, lip service continued to be paid, but that's all it was for most of them. Risk managers were co-opted, captured, or ignored by the very revenue producing divisions they were supposed to monitor and control. As a capper, the nature of risk assumed by many investment banks changed too, to long-tailed, multi-period risk from structurally illiquid securities—exactly the opposite of the type of securities investment banks had a long history of understanding and managing well.

It all had to end in tears, and it did.


Next and last: Part IV: Darkness Calls ...


¹ A clarifying word about terminology. As a rule, investment bankers are promiscuous, sloppy, and lazy in the terms they use to describe their own business. Sadly, I am no exception. In part, there is a good reason for this, since our business is defined by how it straddles different customer universes and different market-related activities. "M&A Advisory" and "Corporate Finance" typically describe the divisions that work with corporate clients to do deals and issue securities. Sometimes this division is called "Investment Banking" by (self-described) purists, but many people also use that term to describe everything an investment bank does. "Capital Markets" is the formal term of art for the division which services the needs of institutional investors, but it is often called "sales and trading," too. Sales and trading is where you find institutional salesmen, market makers, proprietary traders, securities structurers, and the like. Complicating the picture, Corporate Finance and Capital Markets cooperate to underwrite new securities for issuers, with Corporate Finance usually sourcing the deal and Capital Markets executing it. I could go on, but I notice your eyes are beginning to droop. Alles klar?
² By which I mean cycles of activity, not price level. Investment bankers don't make money when markets go up, at least not directly. We make money when people do deals, issue paper, and trade securities. While there is some correlation between these activities and upward market moves, they are not tightly linked. In fact, on the trading side of the business, investment banks tend to make the most money when markets are flopping around like a dead fish; that is, when volatility is high.

Photo credit for the series: Nathan Myhrvold's fascinating 2007 photo essay on lions in Botswana, Africa. Warning: as Nathan says, "some of the photos are a bit gory, and one shows explicit lion sex." Yawn. If that's explicit, I Dream of Jeannie should be rated R.

© 2009 The Epicurean Dealmaker. All rights reserved.

And Now for Something Completely Different

One of the great errors in modern policy is to confuse disclosure with information.

— Steve Randy Waldman

After an extended and much-regretted absence, a voice of reason has returned to the econoblogosphere. Steve Randy Waldman has put up a post about the Administration's recent decision to drop the requirement that financial institutions provide "plain vanilla" (i.e., standardized, simple, understandable) financial services to consumers from its proposal for the creation of a Consumer Financial Protection Agency. This reversal is a serious mistake, and Steve explains why. While his post is lengthy (sound familiar?), it is a model of clear exposition and sound argument. Go read it, and learn something. I did.

Dedicated Readers of this blog already know that I do not write about consumer finance. It is not my area of expertise. I work in the wholesale financial markets. But I am a consumer of retail financial products and services, like everybody else. And I can say, in all moderation and fairness, that the state of consumer finance—revolving credit, mortgages, retail brokerage, etc.—in this country is appalling. The kind of crap, bullshit, obfuscation, misdirection, misinformation, and just plain awful customer service you have to put up with to transact personal financial business nowadays is a national disgrace.

And, as Mike Konczal points out elsewhere, financial sophistication is no defense. Hell, I write, read, and negotiate extremely complex, lengthy financial contracts between highly sophisticated institutional counterparties for a living, and even I can't understand half the shit in a typical credit card application or "account terms update" mailer. Plus, even if I could, why the hell would I want to spend the time to do so? Consumer financial products are supposed to be about convenience, right? Too bad they're all about information asymmetry and rent extraction instead. I shudder to think what a normal person—who (correctly) believes the use of the phrase ;provided, however, as a transitional modifier in a 300 word sentence in the middle of a 20-page contract is a Sign of the Devil—does in such circumstances. I imagine they just close their eyes, sign on the dotted line, and hope for the best. That is no way to run an economy.

* * *

Anyway, read Mr. Waldman and come to your own conclusions. I wish there was a way to convene a panel of intelligent economics bloggers like Mr. Waldman, Felix Salmon, and others before a joint session of the US Congress and have them debate such policy issues in front of them. Attendance for legislators would be mandatory, and there would be a quiz afterwards to check their absorption and comprehension of the issues discussed. I would be happy to attend as well, but I think the purpose of the gathering would be better served if I eschewed direct participation in the policy discussion. Instead, I propose to roam the aisles of Congress carrying a large, metal-edged yardstick, muttering curses to myself, and glaring menacingly at the Congressional numbskulls in attendance. I might need a substantial supply of yardsticks—to replace those I would break over the heads of idiotic or recalcitrant legislators—but I would be happy to absorb all other expenses.

Hell, investment bankers like to work pro bono on occasion, too.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part II

You know, I just had a short vacation, Roy
Spent it getting a root canal
"Oh? How'd you like it?"

Well, it ain't that pretty at all
So I'm going to hurl myself against the wall
'Cause I'd rather feel bad than not feel anything at all

— Warren Zevon, Ain't That Pretty at All

* *

EDITOR'S NOTE: When last we left our Intrepid Reporter, he was explaining how he lusts after Milla Jovovich investment and commercial banks evolved into their current hybrid principal/agent form and what they actually do for a living. You are joining his massive, multi-post treatise on investment banking compensation currently in progress.

* *
— Part II: The Right Hand of Doom —

Second, let me explain how investment bankers get paid.

Compensation is actually one of the simpler elements to understand in the entire discussion of the origins of the recent financial dust-up.¹ However, the details matter, and moreover they have some interesting implications for investment bankers' motivations and behavior, so try to keep up. For my part, I will continue to try to restrain myself to words of three syllables or less. (You know, like a real investment banker.)

There are two important elements to investment banking compensation: how much bankers get paid, and what they get paid with. The first is pretty easy: they get paid a lot. Now, I could caveat this statement up the wazoo: not everyone gets paid a lot, not everyone gets paid the same, and not everyone gets paid (i.e., some get fired). But the simple fact is that, on average, on the whole, and by comparison to almost everyone outside the charmed circles of elite professional athletes, world famous movie stars, and certain Russian oligarchs, we get paid a fucking shitload of money. I mean, let's not beat around the bush: we're loaded.

There, I said it. There's no reason not to, really. It's not like its a secret anymore, if it ever was. But I have too much respect for both myself and the benighted Everyman to even try to pretend that an industry in which all 30,000 employees of über-investment bank Goldman Sachs are "on track to earn an average of $700,000 this year" does not qualify as an industry whose employees are extremely well paid. I mean, seven hundred grand is 14 times the real median family income in the United States for 2007. I think that safely counts as a lot.

By the same token, I will make no effort to defend the huge pay investment bankers bring home, either on the basis of the complexity of the work we do, its real and imagined hardships, or the investment most of us make in an expensive graduate education in order to break into the inner circle.² By virtually no measure are any of these criteria exceptional, or even especially rare. Nor will I attempt to rationalize stratospheric pay in the industry on the basis of some sort of self-aggrandizing claim to the particular socioeconomic utility or virtue of what I and my peers do (and, if you are honest, neither will you).³

No, I acknowledge unreservedly that the level of my pay is set according to one thing and one thing only: the demand in the marketplace for my services. Most of my (more honest) peers would admit the same thing. Investment bankers get paid a lot of money because that's what the market will bear. That's where the labor demand curve intersects the labor supply curve.

It's all Adam Smith's fault.

* * *

Drilling a little deeper, I can say that investment bankers make a lot of money because investment banks make a lot of money. For historical reasons shrouded in the mists of time, i-banks tend to pay out around 50% of their revenues as compensation and benefits to their employees. Therefore, when my bank makes a boatload of simoleons, I and my partners make half a boatload, which adds up fast.

Why do investment banks pay half their revenues to their workforce? I don't know. It probably has to do with similar, time-tested compensation arrangements prevalent in any sales-intensive industry, going all the way back to Mastodon rib vendors. Virtually all investment banking services consist of extremely expensive, variably episodic, and highly customized intangible services, which in my limited experience of other industries tend to require highly motivated, extremely well-paid salesmen to flog. Notwithstanding what a casual reader of The Wall Street Journal might conclude, $10 billion mergers and billion dollar IPOs are as rare as hens' teeth. Bankers spend years cultivating relationships with companies and other potential clients for a chance at such fee jackpots. When they eventually arrive, they have to feed a lot of people for a lot of work over many years, so it is no surprise banks have to pay a lot to the hunters who brought down the beast.

Adding to the pressure to divert revenues to employees is the fact that—notwithstanding the complex, time-consuming nature of investment banking transactions—the various investment banks competing for a piece of the pie are almost indistinguishable. Investment banks compete desperately to differentiate themselves in their clients' eyes, including such patently ridiculous efforts as squabbling over league table rankings. Because their capabilities are essentially identical, banks spend a great deal of time and energy burnishing and competing on the basis of their reputations.

The truth is that scrappy little Jefferies is probably just as capable of underwriting your IPO or advising on your acquisition as gold-plated Goldman Sachs. Investment banks are a dime a dozen. Companies that sell commodities tend to pay their salespeople a lot of money, for the simple reason they must rely on the sale for their business, not on the unique advantages of their product or service (unlike, for example, Microsoft). Not for nothing are successful repeat sellers in my trade called "rainmakers." Without them, otherwise lookalike investment banks would never harvest anything.^{4, 5}

Okay, you say, bankers get paid a lot because banks get paid a lot. Why do banks get paid a lot for admittedly complex but essentially commodified services? That's a good question. I have tried to answer this question a couple of times before, explaining why customers continue to pay what they complain are ridiculously high fees for cookie-cutter services provided by one or more investment banks in an industry which most investment bankers—Your Dedicated Correspondent included—claim has had too much competition forever. You can offer a lot of ideas, but at base they all boil down to supply and demand.

Demand is strong and inelastic, supply is plentiful and elastic, but price competition remains low. Go figure. (Gee, maybe we bankers really do earn our money.)

Damn that Adam Smith.

* * *

The second important characteristic of investment banker compensation—what we get paid with—is more critical to our goal of understanding the sources of the recent crisis in the financial system.

First, let me advise you that I will speak in generalities, and mostly about big publicly owned firms.⁶ Junior bankers, newbies, and other worker bees on the professional side of the firm tend to make a lot for their age and level of responsibility, but it is rare to see total compensation for an investment banker breach the $1 million barrier before they reach the level of Managing Director. This is the fancy title for senior bankers with revenue responsibility, translated by management to mean "Now that You've Arrived, You Damn Well Better Produce or We're Gonna Can Your Sorry Ass." That being said, there are a lot of people in the industry who make this amount of money and much, much more.⁷

Once a banker's pay reaches some level, which has typically gotten lower every year I have been in the business, he starts getting substantial portions of his pay in the form of deferred compensation. Usually this is restricted stock, which vests over some multi-year schedule (sometimes all at once, in a "cliff" vesting) and which the banker forfeits if he leaves his employer for a competitor. Sometimes, and the higher up you get, you get stuffed with restricted stock options, "stock appreciation rights," "phantom stock units," and all other kinds of dubious shit designed to both i) prevent you from jumping ship easily and ii) provide your employer with cost-free short-term financing.

Due to this, the typical Managing Director who has been with his firm for a number of years has an ever-increasing proportion of his net worth tied up out of reach in his employer's stock. Given that, and given SEC- and firm-mandated policies and biases against active securities trading for your own account (not to mention the complete lack of time to do so), most investment bankers' financial position looks horrifically undiversified. (A friend of mine used to joke that his personal beta—sensitivity to price changes in the overall equity market—was somewhere between 6.0–9.0: 2.0–3.0 for his employer's unvested stock, 2.0–3.0 to reflect his job and income's dependence on this same employer, and 2.0–3.0 for his exposure to Manhattan real estate, which lives and dies by Wall Street. This same friend now raises chickens in New Hampshire.) It was not uncommon for a mid-level MD at a big bank—no superstar—to have $10 to $20 million or more tied up in unvested stock before the crash.

Senior executives and senior producing investment bankers, of course, have more. Given that these are the same people who make the decisions, run the firm, and make the trades and transactions that generate revenue for the firm, it is ludicrous to suggest that they are insensitive to their employer's health and stock price. Sure, they do get paid some amount in cash every year, and they are usually able to convert some restricted stock into cash when it vests, but most of them spend most of that money on living expenses. The big nut of deferred compensation they have tied up in their firm becomes their retirement account, and believe you me they watch it like a hawk.

More to the point, it is extremely rare that an investment banker is faced with an opportunity to print a ticket huge enough to render inconsequential the future health of his firm and unvested compensation. Even if it does happen, you can bet that senior management will do all in their power to prevent the banker from collecting a gigantic windfall, arguing, among other things, that the rarity of the event is proof enough that the banker wasn't solely responsible for it. And if a banker does collect outsized compensation one year on the basis of huge revenue production, you can also bet the firm will stuff him with so much illiquid paper he could open his own recycling plant.

There are a lot of knocks you can legitimately put on Wall Street, but claiming investment bankers take crazy risks just so they can walk out the door December 31st with pockets full of cash, free and clear of future effects on their employer, is not one of them. Unlike the public shareholders in their firms, who are mostly highly diversified and therefore have far lower relative exposure to the health and survival of any one bank, investment bank employees can't yank their accumulated years of compensation out of their employer when the shit hits the fan. They are stuck, and they have a hell of a lot bigger personal stake in the future health and survival of their firm than any public shareholder.


Next: Part III: Seed of Destruction ...


¹ Perhaps that, plus the fact that everyone on the planet cares about money—whether they admit it or not—is the reason commentators who wouldn't recognize an investment banker wearing a neon placard reading "Hello, I'm an Investment Banker" if they tripped over him at the corner of Wall Street and Broad tend to focus on money to the exclusion of all else.
² For the purposes of my discussion, I will focus mostly on what are known in the trade as "professionals," i.e., those individuals armed mostly with college and/or MBA degrees who do the line work of an investment bank, like M&A, underwriting, and sales and trading. I will not discuss the huge numbers of highly effective and highly paid support staff without whom no investment bank could even open its doors. Suffice it to say that while few of these latter ever become millionaires, they do tend to earn extremely attractive wages in relation to people doing similar or identical work in other industries. You need shed no tear for Goldman Sachs' receptionists.
³ You mean to tell me your work as a [fill in the blank here] is "worth" more to society than that of a firefighter? An elementary school teacher? A combat infantryman in Afghanistan? A priest? Good luck with that.
⁴ I do not want to oversell this important concept. There is a constant tension within investment banks as to whether a banker's success is due primarily to his own skills and efforts or to the cachet and capabilities of the platform he works for. This argument reliably rears its head near the end of every fiscal year, when bankers and top management go to war to carve up the bonus pool. I do not need to tell you which side argues which position.
⁵ This analysis also helps explain why some investment banks are willing to pay a lot of money—offering multi-year guarantees, buying out a banker's unvested stock in his prior employer—to poach big producers from other banks. Note as well that big, successful banks which pride themselves on the strength of their platform and reputation, and which spend a lot of time and energy promoting the firm and not their bankers, tend to find poaching and multi-year pay guarantees annoying. Gee, I wonder why.
⁶ Small, privately held investment banks and boutiques often pay higher percentages in cash, or substitute partnership units or stakes for public stock. None of these firms caused the systemic breakdown, however, so we need not pay attention to them.
⁷ See my pal Andrew Cuomo's exposé on the number of people earning over a million bucks at TARP banks, for example. In fact, you might argue this has been one of the perennial attractions of investment banking. Unlike most industries, where the graph of pay against responsibility looks relatively flat and low until it goes asymptotic at the executive suite, the belly is much shallower and pay is much higher in the middle of the curve for investment banking. In most industries, only the CEO or the owner can get rich. In investment banking, lots of people can get rich. (Or used to be able to.)

Photo credit for the series: Nathan Myhrvold's fascinating 2007 photo essay on lions in Botswana, Africa. Warning: as Nathan says, "some of the photos are a bit gory, and one shows explicit lion sex." Yawn. If that's explicit, I Dream of Jeannie should be rated R.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part I

Well, I've seen all there is to see
And I've heard all they have to say
I've done everything I wanted to do
... I've done that too

And it ain't that pretty at all
Ain't that pretty at all
So I'm going to hurl myself against the wall
'Cause I'd rather feel bad than not feel anything at all

— Warren Zevon, Ain't That Pretty at All

Heaven forfend.

You must forgive me, Dear Readers, but I'm beginning to feel a little like Milla Jovovich in the Resident Evil movies. I have been trapped for what seems like years in a war to preserve myself and my fellow travelers from hordes of ravening killers lusting for blood. Yet no matter how many of these I dispose of, more just keep coming.

The difference, of course, is that the zombies hunting me and my kind have been infected with the anti-bonus virus, and they are hell bent on sucking every last drop of excess compensation and ill-gotten gain from my and my fellow investment bankers' bank accounts. Like normal zombies, however, I am sure some of them would be happy to drain us completely of real blood, as well.

Sadly, my analogy is not overwrought.

Like Ms Jovovich's cinematic antagonists, anti-bonus zombies come from all walks of life: taxpayer, union member, regulator, Congressman, economist. They are generally dim-witted, slow-moving, and awkward, and they are relentless in their pursuit of redistributive justice. Having no subtlety, strategy, or basic understanding of their prey, they prefer massed frontal assaults, and they cannot be dispatched without inflicting massive head trauma of some sort. What is more disturbing, the anti-bonus virus appears to turn whatever poor soul infected with it—no matter how intelligent, perceptive, or reasonable he or she might otherwise have been—into a raving, spittle-flecked lunatic who seems completely disinterested in the facts of the matter and who has no tolerance for any dissent. This virus has attacked and consumed persons great and small, from lofty public personages like the Financial Times' Martin Wolf all the way down to the twitching, ignorant pond scum infesting the comment boards of finance sites too cowardly or meretricious to ban them.

Most of these are lost to reason forever. But in the interest of perhaps slowing the tide of anti-bonus hysteria—stemming it would be too much to hope for—I would like to offer some balanced, fact-based commentary which might help those retaining their faculties come to a more reasoned conclusion on the subject. Since my extensive previous efforts have not done the trick, I will try to make my remarks as straightforward and simple as possible. We will see whether this has the intended effect.

— Part I: Investment Banking, A Love Story —

First, let us understand what investment bankers do.

Historically, investment banks have facilitated transactions of all types in the wholesale financial markets,¹ including mergers and acquisitions (the purchase and sale of businesses and their assets), capital raising or "underwriting" (of equity, debt, etc.) on behalf of corporations or their shareholders, and trading of securities, derivatives, and all other sorts of financial instruments. In this role, they act as agents. In other words, they take no material, non-temporary investment or ownership position in the entity or securities being transacted, but rather help match buyers and sellers who do. In return for this service—acting as a pure middleman—they take what they consider to be a relatively modest fee.

Investment banking fees depend on three things: the type of transaction, the size of the transaction, and the relative negotiating power of the client to bargain the fee downward. Barring securities trading fees, which are for all intents and purposes immaterial for institutional clients nowadays, typical fees range from a fraction of a percent for very large M&A deals and investment grade debt underwriting all the way up to 7%, which has been the standard rack rate for initial public offerings (for small companies, natch) from time immemorial.

A slight wrinkle to this description has to do with underwriting and trading securities. When an investment bank underwrites a security on behalf of an issuer, like an IPO, often the bank does take temporary ownership of the securities. In fact, the bank purchases the securities from the issuer directly, and then—if all goes according to plan—turns around and immediately sells them to investors it has lined up to buy. There is ownership, but it is temporary, and there is risk, but it is (usually) limited and well-controlled.

By the same token, when a sales and trading client (like a hedge fund or pension fund) wishes to sell an existing security or other financial instrument from its portfolio, the investment bank often buys it and takes it into "inventory" on its own balance sheet. There it stays, in the "trading book," until the bank finds another client who wishes to purchase those same securities. The bank makes its money by collecting the difference, which is hopefully positive, between what it paid to buy and what it collected upon sale of those securities. Traditionally, and still commonly today, the time securities spent on an investment bank's balance sheet was very short—sometimes milliseconds, if a buyer was found quickly—and rarely more than a few days. You see, holding securities on one's balance sheet exposes one to the potential risks and rewards of price changes typically borne by an investor, and historically investment banks did not aspire to be investors.

Now, the line between market maker—which is the term of art for what I have just described to you—and speculator—or investor who typically makes short-term, speculative bets on price movements—is a very blurry one.² In fact, the one line of business where investment banks historically did act as true principals—people who invest their own money, rather than just collect fees on others' activity like an agent—was in sales and trading. Enjoying a privileged position in the midst of constant buying and selling by hundreds of clients, and having the best information available on prices, market trends, and the like, encouraged investment banks to let their hair down a little and take advantage of their market edge. Banks began to hold positions in inventory longer than pure market-making would require, with the intent to profit from short-term price trends and information about potential buyers and sellers' appetites. Of course, information can be wrong, and trends can change—often with lightning speed—so this form of proprietary trading carried higher risks than simple market making and underwriting. That being said, investment banks were very cognizant of and sensitive to these risks, and they rode very careful herd on their traders' positions and risk taking. Notwithstanding the occasional blow up, this strategy worked, and generated very attractive, relatively low risk profits for its practitioners.

* * *

Of course, nothing lasts forever. Investment banks got bigger, their business lines and the securities and financial instruments in which they made markets became ever more diverse, and banks used their privileged understanding of markets and securities to create ever more complex instruments to trade. They did this for a combination of reasons. For one, they were following their customers, whose needs grew and became more complex. For another, they expanded globally alongside increasing globalization of the world economy. Third, they grew because they wanted to: more products and more scale meant more revenues, and investment bankers get paid on the basis of revenues, as described in our next installment. And finally they grew because they were the market participants best positioned to extend their reach: middlemen already in place and relatively well trusted by most market participants (or, what is the same thing, distrusted equally by everybody).³

Naturally, investment bank balance sheets grew as their business grew, which offered even more opportunities to profit from proprietary trading. Most big investment banks followed the path of least resistance and drifted further away from pure market making into trading for their own account. Envy and greed played its part, too, as some explicitly got into the principal business by building internal hedge funds and private equity arms in order to soak up some of the juice flowing to real hedge funds and PE firms during the Great Moderation. As they did so, they began to look more and more like a hybrid of agent and principal, with hybrid risk characteristics.

At the same time, the relaxation and eventual repeal of the old Glass-Steagall separation of commercial banking from investment banking saw the transformation of old line commercial banks into what are known today as universal banks, hybrids of commercial and retail lending and depositary businesses with traditional investment banking businesses. This turned a class of principals—for what is making loans to corporations and individuals but another form of investing?—into a very similar type of hybrid. Commercial banks began to admire and copy the "originate to distribute" form of lending (underwriting, as above) in preference to their historical practice of originate to hold. (Given that corporate lending is typically a low margin, capital intensive business, you can see why they might be attracted to fee-oriented businesses that utilized their capital more efficiently. Their shareholders didn't disagree at the time.) The biggest of these—Citigroup, JPMorgan, and several European banks which came from a long tradition of universal banking—crowded into the new market for investment/commercial bank hybrids.

And our pre-Crash financial ecosystem was formed.


Next: Part II: The Right Hand of Doom ...


¹ By which I mean transactions conducted by corporations, businesses, and institutional investors. This excludes, for my purposes, retail brokerage, retail lending, or any other practice which centers on what are euphemistically known as "unaccredited investors"; that is, the hoi polloi. Never mind that some traditional investment banks were also retail brokers: it affects my analysis not at all.
² Many principal investors like hedge funds have gone into market making from the opposite direction for the very same reason.
³ As opposed to another set of candidates with arguably comparable capabilities, the rapidly growing global hedge funds, for example. In their case, however, nobody would even consider entering the locker room, much less bend over to pick up the soap.

Photo credit for the series: Nathan Myhrvold's fascinating 2007 photo essay on lions in Botswana, Africa. Warning: as Nathan says, "some of the photos are a bit gory, and one shows explicit lion sex." Yawn. If that's explicit, I Dream of Jeannie should be rated R.

© 2009 The Epicurean Dealmaker. All rights reserved.

Supermassive Black Hole

A reader writes in response to my most recent jeremiad on the proper size of investment banks in our Brave New World:

I couldn’t agree more with the notion that what the world needs is more, smaller financial firms that have less ability to dominate the capital markets with their large balance sheets. But I must take issue with the following:

If I had to pick one decision which played the pivotal role in the financial crisis, it would have to be the SEC's agreement to waive leverage limits at the biggest investment banks in 2004. From traditional levels in the low teens, leverage ratios at banks like Lehman Brothers and Bear Stearns skyrocketed to the mid thirties and higher.

This statement is repeated over and over and couldn’t be farther from the truth. Look at the Bear Stearns financial statements for the 20 years they were publicly held and you’ll see that the firm was leveraged between 25 and 35 times for over a decade prior to 2004. Lehman was the same, made worse by the fact that their leverage came despite the fact that they did massive quarter-end window dressing to reduce their reported leverage; intra-quarter they were close to 50 times leveraged. And neither of these numbers nor the leverage numbers of their competitors even included off-balance sheet leverage on derivative transactions, foreign exchange and the like.

So please: the SEC has more than enough responsibility for our current crisis without dumping on them something that wasn’t of their making. Moreover, when we simplify the notion of leverage as being simply total assets divided by total equity without looking at the character and risk of the assets we ignore the real failure of the banks and investment banks to manage their risk.

Now, notwithstanding my employment in an industry which is not known for strict adherence to the facts—especially when those facts might interfere with the collection of a nice, juicy fee—I do somewhat idiosyncratically aspire to membership in the reality based community. Therefore, faced with cogent and forceful criticism such as this, I do what any self-respecting investment banker does: I force some pathetic sleep-deprived analyst to do some quick and dirty research.¹

This is what he found.

* * *

The balance sheets of the five largest "pure" investment banks² did indeed swell over the last decade. From fiscal year end 1999, total assets controlled by these banks grew at a compound rate of 16.3% per year, from $1.27 trillion in 1999 to $4.27 trillion in 2007. Given that the general economy was enjoying no such heated expansion, I find it rather remarkable that my elephantine peers almost quadrupled their asset bases over a period of eight years. This can be read as pretty clear and damning evidence that these investment banks, at least, strayed pretty far from their traditional mission as the handmaidens of capitalism and began to act like they owned the place.

And, pace my interlocutor's reasoned remarks, I find it telling that the balance sheets of the big five began to swell at an accelerated pace after the April 2004 SEC ruling I alluded to in my previous piece. The line graphs for total assets at each of the investment banks in the following chart mark a noticeable inflection point after fiscal year end 2003:



I am not dim enough to claim that correlation equals causation, but this data is intriguing, no?

As far as leverage ratios, however, my correspondent scores some valid points. First of all, my prior claim that investment banks toodled along modestly with leverage ratios "in the low teens" before the shift in SEC policy is clearly false. I apologize for my error, which I blame on a particularly fine Amontillado which unaccountably became corked during the composition of my earlier piece. (You didn't think I would accept full blame, did you?) Put it down to wishful thinking, if you choose.

Mr. X is also correct that the leverage ratios I bandied about in my post, and which are commonly used in the mainstream press, are incomplete and misleading. They do not include off balance sheet liabilities, most derivatives, and many other obligations which investment banks (and others) thought they had cleverly divested themselves of in their asset-gathering frenzy. (Thought incorrectly, it turns out.) However, full data on these non-disclosed items is not forthcoming from any source I know about. Therefore, even though I concede that the ratio of total assets to shareholders' equity is incomplete and simplistic, I would rather use it and its limitations to at least dimension the situation, rather than not speak at all.

Doing this, we discover some interesting results:



In fact, it does seem there was a noticeable pickup in leverage across all the major investment banks around the time of the SEC ruling. The five major investment banks seemed to maintain pretty consistent ratios of total assets to shareholder equity prior to 2004, ranging on average from the high teens to the high twenties, according to their different business models and appetite for disaster risk. (Note particularly that the two earliest victims of the crisis, Bear and Lehman, were also the two banks which maintained the highest leverage ratios historically.)

But note the material pickup in year-end leverage from pre-2004 averages at each of the five banks by year-end 2007:

	Average		Percent
	leverage	Leverage	change
	1999–2003	at FYE 2007	in ratio
Bear Stearns (BSC)	27.6	33.5	21.5%
Goldman Sachs (GS)	19.2	22.4	16.6
Lehman Brothers (LEH)	25.8	30.7	19.2
Merrill Lynch (MER)	18.5	32.0	73.2
Morgan Stanley (MS)	21.7	33.4	53.8

Based on this, the Vampire Squid everyone loves to hate looks almost diffident, but the rest of its peers look downright suicidal. Forget the hidden IEDs and unexploded ordnance squirreled out of sight by investment bank executives in off balance sheet waste dumps, these guys were on a tear. Strangely, I do not remember legions of diligent public shareholders banging on the podia at these banks' annual meetings demanding execs dial back their firms' risk profile. (Perhaps they were too fat and happy counting the excess equity returns these leveraged time bombs were generating to bother.)

The picture painted above does not even approach the full extent of operational leverage employed by some (all?) of the banks above in between audited reporting periods. My new best friend and pen pal writes in a follow-on note that:

The really fascinating story—and one with almost no discernable evidence—is what the balance sheets looked like intra-quarter. I once met someone from Lehman whose business card showed her to be part of the Office of Balance Sheet Management and whose role was to cleanse the balance sheet for the 4 quarter-end public financial statements so that they’d look less leveraged.

Fun!

* * *

So, based on this back-of-the-envelope historical analysis, I am disinclined to let the SEC off the hook for the relaxation of leverage limits as my correspondent urges me to do. Even if the SEC's action was not the primary reason that investment banks levered themselves up to ultimately ruinous levels, it certainly added fuel to the fire or, at the very least, did nothing to dampen it. Furthermore, a re-reading of the excellent piece in The New York Times about the fateful SEC hearing on leverage limits—complete with full audio recording, for the obsessive-compulsive among us—clearly indicates the Commissioners approved leverage relief on the understanding that the SEC was going to actively monitor and manage the situation. For various reasons, it did not.

Whether relaxing leverage limits for already highly-levered large investment banks and essentially allowing them to regulate themselves under their own recognizance was wise or not—and you might suspect how I feel about that, Dear Readers—it was clearly a massive dereliction of duty by Christopher Cox, the SEC Commissioners, and the SEC staff to undertake such a material change of the regulatory system without following through. Had they done so, and had the SEC Commissioners paid attention to the information generated by such close supervision, we might very well have slowed the speed at which the financial industry plunged over the cliff, if not stopped it entirely. The fact that they did not is borderline criminal.

The more I read about the SEC, the more I agree with those who would scrap it altogether and start over. Failing that, I think I will take my copy of the Times article on the 2004 decision with me the next time I visit Washington, D.C. and staple it to Mary Schapiro's forehead when I see her.

Maybe that will get her attention.

Ooh baby don't you know I suffer?
Ooh baby can't you hear me moan?
You caught me under false pretenses
How long before you let me go?
...
I thought I was a fool for no-one
Ooh baby I'm a fool for you
You're the queen of the superficial
But how long before you tell the truth?

— Muse, Supermassive Black Hole

¹ It's good to be the king, no?
² These are the five firms which petitioned the SEC for relief from previous leverage limits. I do not speak of universal banks like Citigroup, BofA, and JPMorgan, which also play a major role in the investment banking industry. We will save their sorry asses for another day.

© 2009 The Epicurean Dealmaker. All rights reserved.

Let a Hundred Investment Banks Bloom

Clive Crook nails it this morning in the FT:

At the recent G20 finance ministers’ meeting in London, Tim Geithner, the US Treasury secretary, won tentative, sometimes grudging agreement to his main ideas for stronger regulation. The single most important change, he believes, is requiring banks and shadow banks to hold more capital. He proposed higher capital ratios—higher still for systemically important firms, with new counter-cyclical components—and a cap on total leverage. To supplement these more demanding capital requirements, he also called for minimum levels of liquidity, and for “living wills” to allow the orderly winding up of failing financial firms.

All this makes excellent sense. If Mr Geithner’s proposals are acted on, the global financial system will be far better protected in future. ...

The global finance industry is in no position, yet, to mount a vigorous campaign against changes which, if they are adequate, will implicitly tax its growth. That is what higher capital requirements would do, and is precisely why they are needed. Checking the industry’s expansion must be seen as an aim of policy, not an unintended consequence.

The financial sector is, by wide agreement, too large in relation to the general economy. It must shrink in relative terms—not grow—as the economy recovers from recession.

More to the point, our biggest financial institutions are far too big. Of course, it will do us no good simply to force existing too-big-to-fail banks to shrink, since that will mean even less lending and credit provision on their part. Given ongoing asset bubble deflation and the fragility of the economic recovery, the last thing we need is for credit intermediaries to tighten the lending spigot further.

Instead, what we need is a period of deconsolidation in the financial industry to mirror what now appears to have been a risky and eventually ruinous period of consolidation and aggregation over the past three decades. I have pointed out before in these pages that financial intermediaries at every scale—individual banker, individual bank, and industry as a whole—comprise a dense and dynamic network for the connection of sources of capital to the users of capital. It just makes sense that this network would be more robust and less prone to catastrophic failure the more independent nodes there are in the system and the less network "traffic" (i.e., capital) flows through any one node or pathway. Such a network should be less costly to monitor and regulate than a more concentrated one, as well, since we would care less about the fate of any one bank within it.

Redistributing and rebalancing the nodes of distribution in the global financial system is job number one. Designing, imposing, and carefully monitoring relatively simple, risk-adjusted leverage limits based on the type of activity a financial intermediary conducts¹ is the best way to do it. While financial innovation seems to have played a significant role in the recent bustup, I am less worried than some about its inherent riskiness to the stability of the financial system. It was contagion across market sectors, accelerated by huge leverage at critical investment and commercial bank nodes of the system, which helped the looming collapse in real estate securities spill over into the broader economy, not the particular intricacies or flaws of CDOs, credit default swaps, or mortgage-backed securities.

If I had to pick one decision which played the pivotal role in the financial crisis, it would have to be the SEC's agreement to waive leverage limits at the biggest investment banks in 2004. From traditional levels in the low teens the high teens to high twenties, leverage ratios at banks like Lehman Brothers and Bear Stearns skyrocketed to the mid thirties and higher. I don't care how good a risk manager you are, if you only have three dollars in equity supporting $100 in assets, the merest market move or collapse in trading liquidity can kill you. If you fail with a balance sheet of $10 or $20 billion, a bunch of shareholders, employees, and counterparties will wipe away a tear and mourn your passing. If you're holding half a trillion to a trillion dollars, however, the collateral damage from your ruin will have everybody licking their wounds—and writing outraged letters to the Times—for years, if not decades.

* * *

The global banking industry is huge, and quite diverse. It will take time to bleed the air out of that bubble and reallocate people and capital to more productive pursuits. In the meantime, however, perhaps all the populist demagoguery and officious government interference is providing an important and unrecognized service in the industry's long-term transformation. After all, the more bankers and traders leave floundering giants like Citigroup and Bank of America for regional investment banks and independent advisory boutiques, and the more they divest high-risk proprietary trading operations like Phibro, the closer we will be to a system where the failure of either or both of those firms won't merit more than a shrug of the shoulders on Wall Street or Main.

Based on recent developments, many commentators contend we have become proto-socialists in this country (or worse). Given that, we could do worse than follow the sage advice on social transformation offered by one of last century's most successful proto-capitalists:

Letting a hundred flowers blossom and a hundred schools of thought contend is the policy for promoting progress in the arts and the sciences and a flourishing socialist culture in our land.

— Mao Zedong

Forward, Comrades! Let a hundred small- to mid-sized investment banks bloom!

UPDATE: A correspondent gently reminds me that I was a complete knucklehead when I asserted that historical leverage ratios in the industry were in "the low teens." I have done the research, corrected the error above, and managed to generate another War and Peace-sized chunk of prose in the process. Sigh. The gods of brevity are not pleased with me.

¹ Naturally, a firm which originates consumer loans and mortgages with the intention to hold them and funds its business with a large dollop of low interest-bearing consumer deposits should merit a higher leverage limit than a firm which conducts riskier activities funded solely by volatile wholesale funding markets. With leverage ratios, there is no reason to default to "one size fits all."

© 2009 The Epicurean Dealmaker. All rights reserved.

The Burning Ones

In memoriam, September 11, 2001:

Er ruft spielt süßer den Tod der Tod ist ein Meister aus Deutschland
er ruft streicht dunkler die Geigen dann steigt ihr als Rauch in die Luft
dann habt ihr ein Grab in den Wolken da liegt man nicht eng

He calls play death more sweetly Death is a master from Germany
he calls stroke the violins darker then you'll rise as smoke to the sky
then you'll have a grave in the clouds there one doesn't lie closely

— Paul Celan, Todesfuge

May all the innocent victims of unreasoning hatred and man's inhumanity to man rest in comfort and peace. Heaven knows there are far too many of them.

© 2009 The Epicurean Dealmaker. All rights reserved.

Never Say Never

I might like you better if we slept together
I might like you better if we slept together
I might like you better if we slept together
But there's something in your eyes
That says "maybe."
That's never.
Never say never.

— Romeo Void, Never Say Never

Goldman Sachs CEO Lloyd Blankfein gave a speech earlier today in Frankfurt, Germany at the Handelsblatt Banking Conference. As befitting an address delivered by an anointed power broker and Führer of vampire squiditude, it was an anodyne and uncontroversial exercise designed to smooth the brow of regulators, populist demagogues, and Rolling Stone correspondents alike. Even so obstinate a heretic in the despite of investment banking as Felix Salmon seemed to approve, or at least did not find it too objectionable.

While I personally did not object to the bulk of Mr. Blankfein's peroration, I would be less than candid were I to confess I had no reservations with his remarks. Of course, being Dedicated and Discerning Readers of mine, you already suspected that.

* * *

Amidst the other chestnuts which Lloyd chose to strew before the upturned gaze of his rapturous audience was this summation of Goldman's "detailed principles of compensation":

• The percentage of compensation awarded in equity should increase significantly as an employee’s total compensation increases.
• For senior people, most of the compensation should be in deferred equity. Only the firm’s junior people should receive the majority of their compensation in cash.
• An individual’s performance should be evaluated over time so as to avoid excessive risk taking and allow for a “clawback” effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.
• No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer term interests of the firm and its shareholders.
• To avoid misaligning compensation and performance, multi-year guaranteed employment contracts should be banned entirely. The use of these contracts, unfortunately, is a common practice in our industry. We should all recognize that they are bad for the long-term interests of our industry and the financial system.
• And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.

The first two points say the same thing: the more money you make, the more funny paper you get crammed down your gullet instead of cash. This makes complete sense, and amounts to a restatement of standard industry practice.

It's true that senior management expects its junior bankers to work so hard and so long they will not have any time to spend their disposable income or even rest their weary heads on a surface more closely resembling a pillow than the stained carpet under their desks. Nevertheless, common sense and common decency dictate that one should endow one's foot soldiers with enough legal tender to pay their rent and buy an occasional meal on their own dime. Paying 22-year olds pulling down $85 to $100 grand more than token amounts of unvested stock is guaranteed to be counterproductive, if only because they will be forced to commute to work from New Hampshire. (You try finding a halfway decent apartment in Manhattan for less than two grand a month.)

As a corollary, beyond a certain level, cash compensation—while nice for the recipient and his hangers-on—can only encourage a distorted worldview, negative social externalities like inflated real estate and luxury goods prices, and disturbingly louche behavior. Far better to align an investment banker's incentives with those of his firm and external shareholders by stuffing him to the gills with long-dated unvested stock and options and forcing him to hold onto them for years. Heck, this also has the neat side benefit of boosting the investment bank's equity capital base with the hard-earned sweat equity of its indentured servants most productive employees. (Too bad ol' Lloyd didn't follow his own advice back in 2007, when he took 40%, or $27.4 million, of his record $68.5 million total compensation in cash.)

Lloyd's third point is all very well and good, too, albeit a little vague. He does not really explain what this "clawback" mechanism looks like, or when it would apply. It could be explicit, and actively applied—for example, in the case of fraud or a profitable trade blowing up two or three years after it was booked—or implicit, and tied to the overall results and share price of the firm.¹ I think Goldman's senior executives are clever enough to leave it vague. It gives them more power over any employees who decide to get uppity or fractious.

Point number four is a fine, well-intentioned principle more honored in the breach than in the observance across Wall Street. Interestingly, Goldman Sachs is one of the few firms which pays more than lip service to this ideal. Compensation is one of the most powerful tools in the investment banking manager's arsenal, outside of firing someone and frog-marching their ass out the front door. If senior management uses it to explicitly reward teamwork—by, say, paying a good bonus to a banker who had a crappy year personally but helped out unselfishly elsewhere—and punish its opposite—by docking the pay of a productive banker who steals credit, backstabs, and generally acts like a complete asshole—then you will see marvelous improvements in the level of teamwork across the organization. You might even become Goldman Sachs in time.

Finally, Lloyd's last point strikes me as a little draconian. In my view, it's a little unreasonable to expect a 30-year veteran of the firm to live in relative penury because he can't withdraw any portion of the $250 million he's got socked away in Goldman stock until he retires in five years. If anything, such restrictions might encourage just such a seasoned, experienced banker to retire early in order to enjoy a little of his ill-gotten gains for a change (or at least get his wife and mistress off his back). This happened more often than not during Goldman's pre-IPO partnership days, by the way, when the compensation system followed just such a principle. You got fabulously rich as a Goldman partner, but you couldn't enjoy it until you were too old and tired to do so. We no longer live in such self-denying times, so it is silly to think such a plan would fly. Just make sure the locked up portion of the senior exec's stock is big enough relative to his total wealth, and you will definitely keep his eye on the ball. More than that will encourage cheating, borrowing against unvested stock, and other potentially risky and counterproductive behaviors.

* * *

Where Lloyd and I truly part ways is at his fifth, or penultimate point, about guaranteed employment contracts. He is not shy about declaring his dislike of them, and wants them banned. I disagree with him in principle (more later), but I also think it incumbent upon me to inform my Loyal Audience that the Grand Poobah of Broad Street is talking his book.

Goldman is well known across the Street for not offering multi-year guarantees to senior recruits (presumably single year guarantees are okay). There are sensible business reasons for resisting them: they increase fixed costs in a highly volatile business, they diminish short-term pressure to perform for their beneficiaries, and they increase resentment among the rest of the bankers who do not have guarantees. They also prevent managers from using compensation as a tool to enforce teamwork, at least while the guarantee is in place. I know for a fact, however, that Goldman has given very lucrative guarantees to senior recruits in the past, so it is not completely unheard of there. But mainly Goldman dislikes guarantees because they are more likely to have their producers poached by the competition than to be poachers themselves.

As befits a shop that focuses intently on building and preserving a strong and unique culture, Goldman prefers to grow its bankers internally. They are big enough, and successful enough, that they rarely need to search for senior bankers from outside the firm. The rest of Wall Street, on the other hand, views Goldman as its farm team: an outstanding source of well-trained, hard working bankers who make up for any personal shortcomings with an impressive carapace of mystique. Hence, when competitors come knocking on Goldman bankers' doors, they bring big, fat, multi-year guarantees to shake them free from the mother ship. If the banker is amenable, then Goldman must decide whether to counter the poacher's offer with a guarantee of its own or suffer a potentially painful defection. Neither is a pleasant alternative.

You can see why Blankfein hates them, but that is no general argument against multi-year guarantees.

* * *

Most investment banks use multi-year guarantees to recruit senior producers: Big Swinging Dicks, in the parlance of our time. They hire guys and gals with big clients and big Rolodexes to build new businesses or to ramp up penetration and market share in existing lines. They pay guarantees, and suffer the associated disadvantages and risks attendant upon them, because they have to.

I know it sounds hard to believe nowadays, but investment bankers are a surprisingly risk-averse bunch of people, at least when it comes to their own personal financial situation.² Getting one to jump ship from the sweatshop hellhole he knows—where he has history, understands the labyrinthine internal politics, and pretty much knows who is out to get him and who has his back—to another sweatshop hellhole he doesn't is no easy matter. The average banker would be a fool not to push for a guarantee, and, if he has been recruited to build a new business which will take several years to get off the ground profitably, he would be a fool not to press for a multi-year guarantee.

Recruiting banks pay it because it is an investment. By "buying" a revenue-generating banker, they are buying a producing asset, just like an offshore drilling platform or a new assembly line. Who wouldn't expect to pay a lump sum to get control of such an asset? Last time I heard, it was common practice to pay signing bonuses to new recruits across a wide range of industries, and senior executives have enjoyed multi-year guarantees for years as a perk of their job hopping. Proven assets of production are valuable, no matter the industry, and they cost money to acquire and maintain.

* * *

More to the point, one of the most prevalent knocks against guaranteed compensation is that it supposedly increases investment bankers' risk appetite. This is just nonsense. If the bank has hired well, a guaranteed bonus allows the recruited banker to focus on all the things he was hired to do, like building a business, establishing and developing internal and external networks at his new employer, and contributing to a long-term sustainable franchise. By definition, he does not have to worry about short-term results, so he has no incentive to chase ambulances or pursue high-risk, high-reward opportunities. One of the tricks about guarantees you eventually learn as a banker is while the contract states they are guaranteed minimums, the reality is that they are guaranteed maximums, as well. There is absolutely no incentive whatsoever to hit the cover off the ball, or to chase bad business for short-term gain.

Of course, this caveat does not apply if the multi-year guarantee is not fixed, but rather takes the form of a percentage of revenue or operating profit.³ There, you can plainly see there is every incentive to pursue revenue at the expense of risk. Such arrangements could indeed worsen a bank's risk position if they are not monitored carefully. Nevertheless, as Lloyd himself states,

it is important to recognize that while incentive structures should be improved across our industry, that is no panacea for poor risk management.

Compensation is a necessary method of managerial control, but it is not a sufficient one. I continue to maintain that it was not even the determining one during the recent financial crisis.

I am not insensitive to the fact that the compensation figures we investment bankers bandy about as a matter of course seem outrageous, if not obscene, to the vast majority of citizens outside our incestuous little bubble. This has always been the case. What makes it different now is that everyone is paying attention, due to the not inconsiderable fact they have pulled my industry's collective chestnuts out of the fire at great and painful collective expense. Joe Sixpack now has a vested interest in how we do things, and he is not pleased by what he sees.

Nevertheless, far too much of the heat generated in the mainstream media and blogosphere about compensation is, for all intents and purposes, beside the point. Guaranteed compensation is just one more red herring in the net.


¹ If you doubt the efficacy of such a mechanism to claw back years of potentially inflated results and unwarranted stock price appreciation, I suggest you have a chat with your local Bear Stearns or Lehman Brothers employee over a few beers one evening. Just remember to bring lots of Kleenex, and expect to pay the bar bill yourself.
² It's not that hard to believe, if you think it through. If you had set up a lifestyle which cost north of half a million to a million dollars per year—not so outrageous for a family of four in New York City, by the way—and all you had to support it was a "guaranteed" salary of $400,000 plus whatever cash savings you could liquidate until your next bonus—which could be anything from $0 on up—you would be pretty damn conservative, too. It takes a lot of money in the bank—liquid money; cash money—to get your average investment banker to relax about money. Then again, given how much stock most big banks stuff their senior bankers with, why should any of them ever relax? Just ask former centimillionaires Dick Fuld or Jimmy Cayne to answer that one.
³ During the portion of my career when I worried about such things, these were relatively rare situations. Perhaps they have become the dominant form of multi-year guarantee out there, but I doubt it.

© 2009 The Epicurean Dealmaker. All rights reserved.