Thursday, September 24, 2009

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.