Sunday, January 16, 2011

Some People Never Learn

Beatrice: "I wonder that you will still be talking, Signior Benedick: nobody marks you."
Benedick: "What! my dear Lady Disdain, are you yet living?"
Beatrice: "Is it possible Disdain should die while she hath such meet food to feed it as Signior Benedick? Courtesy itself must convert to disdain if you come in her presence."

— William Shakespeare, Much Ado About Nothing

Honestly, Dear Readers, sometimes I just don't know why I bother.

I drone on and on in these pages about the nature, dynamics, and economics of my industry—purely out of the fulsome charity of my solid gold heart, mind you—and it doesn't seem to make one damn bit of difference. Pundits, prognosticators, and pettifoggers continue to attack investment banking with the most ludicrous assumptions, laughable claims, and lunatic suggestions I have seen in a family newspaper. It's enough to give a bloggist the vapors.

* * *

The latest doofery on offer comes from Sebastian Mallaby, whom the editors of the Financial Times describe as

the Paul A. Volcker senior fellow for international economics at the Council on Foreign Relations, and the author of More Money Than God: Hedge Funds and the Making of a New Elite.

In other words, one presumes, a reasonably smart man.

Mr. Mallaby utterly fails to cover himself in glory, however, in the jeremiad that follows. He starts off reasonably enough, excoriating both the SEC for its ill-conceived and ill-prosecuted suit against Goldman Sachs for fraud in connection with the ABACUS fiasco and Goldman itself for its mealy-mouthed efforts at self-defense and ultimate cave-in settlement to make the charges go away. He also takes well-merited pot shots at the insipid exercise in corporate pablum Goldman evacuated in the form of a report by its crisis-spawned Business Standards Committee.

But these are easy targets, products of hive-mind corporate ass-covering and the lack of courage endemic to large, bureaucratic organizations of every stripe. Goldman Sachs and big investment banks in general are no less prone to this kind of hand-waving, smoke-spewing obfuscation that any other large corporation on the planet. Beyond a certain size, a company's internal spine of principles and conviction is almost always eaten away from the inside by rapidly metastasizing cowardice, usually spreading outward from the General Counsel's office.

No, where Mr. Mallaby rapidly runs off the rails is with the following:

A bank’s first loyalty is to its profits, not those of its customers – it’s us-against-them, not zen and om. Despite claims to the contrary, banks frequently play customers for patsies, keeping the best investments for themselves while selling leftovers to clients. They exploit knowledge of their customers’ order books to make money on proprietary trading.

These sentences, and their immediate followers, are shot through with such silly assumptions, assertions, and insinuations as to make me despair Mr. Mallaby is more than recently arrived at a command of the English language, much less any concept of rational argumentation.

Mr. Mallaby correctly skewers Goldman's corporate-speak piffle by pointing out "a bank's first priority is to its own profits,"1 but he quickly loses the plot. With the phrase "us against them," he implies that banks' pursuit of profits comes exclusively at the expense of its customers. In other words, that it is a zero sum game. But this is only even potentially true of proprietary trading, where a bank's profit or loss on a trade may be a mirror image of its counterparty's loss or profit.2 All the other businesses a modern investment bank operates in—M&A, securities underwriting, private placements, derivatives structuring, and securities market making—are to a greater or lesser extent agency businesses, where the bank earns a fee or margin for executing a transaction for its client. In other words, it is the client's deal or trade to do, which the middleman investment banker is merely hired to help effect. Agency business is not "us against them," it is the bank for its client. This is pretty basic stuff.

The rest of Mr. Mallaby's indictment seems to rest on a vast overestimation of investment banks' power and position in markets and with their clients. Even in their proprietary investment operations—like proprietary trading and in-house private equity funds—investment banks almost always compete with other traders and financial sponsors for deals. Let's be clear here: almost all of these trades and private equity investment opportunities come from third parties, who naturally want the best price and terms for their business. When a bank competes as a proprietary investor, its money is no greener than anyone else's. It only wins because it offers a higher price or better terms to the seller.3 The only time a bank has an edge in a proprietary investment is the rare instance when its parent investment bank originates the trade itself and is willing to accept a lower price to keep it in house. You wanna guess how often that happens? Yeah, not much. Where does Mr. Mallaby think these "best investments" come from, the Tooth Fairy?

Hence, I find his narrative of Goldman's recent Facebook deal laughable on its face. He claims Goldman's internal private equity arm "turned down" the deal because it couldn't get the terms it liked, then after injecting $450 million of its own capital, the bank turned around and marketed participations to wealthy clients on worse terms. Where, Mr. Mallaby, is Facebook itself in your little story? Is it not more likely that Facebook laughed Goldman's PE arm out of the room because they wanted to buy too cheap, then told Goldman if they wanted to earn commissions by selling Facebook shares to its high net worth clients it would have to pay to play? Do you realize how difficult it is for investment banks to put their own capital at risk to earn an underwriting or placement mandate? We hate, hate, hate it, Mr. Mallaby. It goes contrary to everything we aspire to do. Goldman only did it because it thought it could make great fees on Facebook's eventual IPO. Facebook got a great deal to raise over $2 billion without having to go public, and Goldman's wealthy clients got a chance to buy shares in the hottest company since Google. So which client, exactly, did Goldman Sachs puts its interests before in this little drama? That's right, buster: no-one.

Next, Mr. Mallaby trots out the old canard that investment banks use insider knowledge of their trading counterparties' order books to make money, presumably by implication at their customers' expense. But if said information is gained via agency work, and is true insider stuff, there are laws against that (as well as strict confidentiality agreements), and investment banks which want to stay in business (all of them, natch) have very strict internal controls to prevent it. If, however, a client publishes a list of securities with bids and/or offers to the Street—and it is always done to more than one investment bank—how would Mr. Mallaby propose that such information is not public and fair game for anyone who discovers it? Moreover, it is far more common (and effective) for clever traders to suss out counterparties' trading books by inference: monitoring their actual trades and behavior to infer weakenesses, biases, and opportunities. But this is done by hedge funds unaffiliated with investment banks all the time; in point of fact, by every successful trader out there. More often than not, investment banks themselves are the objects and victims of such reverse engineering.

But the last accusation Mr. Mallaby levels is the purest hokum of all:

[Banks] also advise corporate clients to merge, acquire rivals, and issue copious securities – activities that generate handsome fees but don’t always benefit companies in the long run.

What utter fucking bullshit.

I have eviscerated this conceit in the past too many times to mention, but it still pops up with annoying regularity from educated people who should know better. Let me be clear: investment banks advise on mergers and acquisitions and underwrite securities for their clients because their clients hire them to do so. It is pure agency business, and we bankers take a cut off the top of each deal we conclude successfully (we do not normally get paid for failure here). But it is absolute horseshit to claim, as Mr. Mallaby seems to imply, that investment banks somehow bully or cajole corporate clients into doing deals or raising capital that they didn't otherwise want to do. Who the fuck does he think we are, Mephistopheles? Who the fuck does he think huge, sophisticated global corporations like BHP Billiton, Oracle, and Google are, willing sheep eager to be sheared? Get a grip, Mr. Mallaby. If M&A deals or corporate capital raising do not work out so well down the line, perhaps you might adopt the maturity and insight to discover that the blame for such failure—if blame indeed there be, rather than bad luck, changes in the market, or shifting economic fundamentals—lies with the CEOs and Boards of Directors charged with making such decisions who hired the goddamn bankers to do their pissant deal in the first place.


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Of course, Clever Readers will no doubt anticipate that I am not a fan of the childish proposal Mr. Mallaby advances to correct my industry's perceived failings. He suggests we split investment banks along functional lines, with M&A advisory, securities underwriting, and trading conducted by separate boutiques. But this misses the critical point I have mentioned many times in the past, that investment banks derive their value to their clients exactly from the fact that they straddle markets. Having conflicts of interest is the best evidence that investment banks can help their clients in M&A, capital raising, and trading. We derive our institutional value from the information networks, market knowledge, and corporate and financial relationships which these very conflicts of interest reflect. Investment banks trade in information. That is the value we add, and the value we bring to our various clients across all business lines and sectors. Because of that, managing conflicts of interest has been a core competency—believe it or not—of investment banks since Year One.

And the thought that hedge funds, private partnerships, and boutiques can replace large, multi-line investment banks is ludicrous, too. For one thing, independent, focused, privately held hedge funds have only grown in size, number, and market importance because there are large, integrated investment banks which can act as counterparties, intermediaries, and brokers across multiple global securities and derivatives markets and lend them the money to trade with and clear their trades in their role as prime brokers. There is an important, natural niche in the global financial ecosystem for large, multi-line, highly interconnected investment banks. If you broke us up into our functional components, some other entities would merely spring up to take our place.

* * *

In any event, it is patently obvious to this Correspondent that Mr. Mallaby has been working without tools. His analysis is wide of the mark, his proposals are deeply flawed, and his understanding of my business is less than rudimentary. If only these credentials would encourage him to keep silent on the subject.

But, like Wile E. Coyote, I suspect Mr. Mallaby will be right back at the overpass, strapping on his Acme© Rocket-Powered Roller Skates™, just as soon as he recovers from his recent plunge into the canyon. To be honest, my fellow roadrunners in the industry and I would be disappointed if he didn't. We need a good laugh nowadays.


1 It is a tautology to say that a for-profit enterprise's first loyalty is to its own profits, rather than those of its customers. Last time I checked, Coca Cola, Walmart, and Microsoft—much less your local drycleaner or delicatessen—were principally concerned with making money for themselves and their owners, not maximizing the profitability or net worth of their customers. Making money (profits) is why they are in business. Banks are no different in this regard, and certainly not unusual. Often, of course (but not always), a business will sell its products and services on the basis they will help customers save or make money, but this is marketing, not the primary corporate objective. I wish I did not feel compelled to state this obvious fact, but I fear far too many readers among Mr. Mallaby's audience may have read this statement of economic fact as an indictment of investment banks in general.
2 Of course, people say this all the time, but reflection will show that the situation is not quite so simple. At the time of the trade, the value is that at which the trade was transacted: there is no instantaneous profit or loss between the counterparties. The selling party may have made a profit or a loss, but that is only in relation to the price he or she bought the security or derivative at previously. The buyer may make a profit or a loss in the future, but that is subject to many things out of its control, and certainly out of the seller's control. So how can we say trading is a zero sum game? Based on potential forgone profits or losses? But the buyer only makes those profits or losses by assuming exposure to risk which the seller has disposed of. Perhaps we can call trading a zero sum game in total because it does not create any value in and of itself—the same old pieces are paper are just passed from hand to hand—but it is far too simplistic and almost certainly wrong to claim that each trade of necessity has a winner and a loser.
3 Now mind you, there are several investors in the marketplace—particularly private equity firms, which are large customers of the agency side of investment banks and which pay Wall Street a hell of a lot of money in the form of deal fees—who are not particularly pleased that some investment banks have proprietary investment arms which compete independently with them for deals. This is an ongoing source of tension between some banks and their customers, but it's because their competition raises prices and reduces available investments, not because banks somehow get sweetheart deals. On the prop trading side, most hedge funds don't seem to mind much: they like having big, well-connected trading counterparties. (And most hedge funds think they're better traders than investment banks' in-house traders anyway.)

© 2011 The Epicurean Dealmaker. All rights reserved.