Friday, September 25, 2009

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

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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.

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— 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.

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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.

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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.

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