Monday, September 28, 2009

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

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

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

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— 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.

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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.

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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.

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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.

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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.

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