Saturday, September 24, 2011

A Victim of Soycumstance

[The Stooges are about to attend a fancy ball]
Moe: “Now then, gentlemen, remember your etiquette.” [Gives both Larry and Curly a slap.]
Larry: “What’s that for?”
Curly: “We didn’t do nothin’!”
Moe: “That’s in case you do when I’m not around!”

— The Three Stooges

Bloomberg published a nice piece earlier this week which supports my long-held belief that the term “investment banking management”—like “military intelligence” or “legal ethics”—is, in the trenchant phrase of Raymond Chandler,1 “an expression which contains an interior fallacy.” In other words, an oxymoron.

Authors Michael Moore and Max Abelson do a creditable job illustrating how the toxic relationship between Colm Kelleher and Paul Taubman, co-heads of Morgan Stanley’s Institutional Securities Group (corporate finance and M&A, plus capital markets)2 is creating all sorts of fallout for that division. Kelleher is the hail-fellow-well-met Irish Oxford graduate who runs Morgan’s sales and trading operations, and Taubman is the weedy, quiet loner who leads the investment bankers. I have seen working relationships between similarly mismatched personalities work out very well over the course of my career, with complementary skill sets and different management styles combining synergistically to produce results beyond the capacity of either party alone. Of course, such success stories depend at their root upon the parties in question respecting each other’s different styles and abilities and working together explicitly for the greater good. This does not appear to be the case in this instance.

Interestingly enough, Morgan Stanley’s ISG seems to be turning out near-record results and taking market share, so a naive outsider might question whether its co-heads’ feud matters, or, what is more, might even be good for the division. Certainly this is what the Aspergers-addled technocrats who populate the executive ranks of most investment banks measure and value to the exclusion of all else, so I can understand how CEO James Gorman might consider his lieutenants’ squabbling an unimportant sideshow.

If so, he is dead wrong.

* * *

Put aside, for a moment, the not inconsiderable problem that the tension and infighting between Kelleher and Taubman is, sadly, the norm rather than the exception when it comes to interactions among senior executives at investment banks. This is much more than an issue of incompatible personalities. For one thing, investment bankers and traders who are hard-charging, capable, and, dare we say it, psychopathic enough to climb the slippery pole and get within reach of the top tend to have sharp elbows, short tempers, and little patience for those who oppose their wishes. Given furthermore that Taubman and Kelleher seem to have been put in implicit if not explicit competition for the top job, and the Bloomberg article indicates they both want it, such a set up would make it hard for Mother Teresa and her twin sister to get along.

Whatever its sources, the competition and bad blood at the top of their respective organizations cannot help but trickle down to Kelleher’s and Taubman’s subordinates. These will line up sensibly behind their leaders and take their tone of interaction with colleagues across the functional divide from the top, if only in the interest of self-preservation. This is Organizational Dynamics 101. The result will be inadequate communication, counterproductive political maneuvering, and willful lack of cooperation between investment banking and sales and trading at all levels. Traders will fall back into the venerable habit of regarding investment bankers as foppish, ineffectual parasites in suits, and investment bankers will resuscitate their ancient scorn for capital markets folk as barely literate, knuckle-dragging troglodytes. In addition to being unhelpful and untrue, such behavior never ends well.

For investment banks in general derive the greatest source of their power, value, and privileged position in the economy from the fact that they straddle the markets for capital, operating on both the supply and demand side. Investment banks serve the suppliers of capital—investors—by delivering new investment opportunities and products through underwriting new issues and originating new securities and by helping them reallocate their investment portfolios through making markets in securities and other financial instruments. This is done on the sales and trading, or capital markets, side of investment banks. Investment banks also serve the users of capital—corporations, governments, and the like—by selling their securities to investors and by helping them reallocate their business portfolios via mergers and acquisitions. This happens on the corporate finance and M&A, or investment banking, side of the same banks.

Each side of the bank derives a substantial part of its revenue, access, and value from the other side. Sales and trading and investment banking share information (subject to confidentiality restrictions), access to each other’s clients, and revenue from transactions arranged between them. Banks act as middlemen, and we make our daily bread by mediating transactions across the capital user–capital provider divide. This is core to what traditional investment banks do. It is a network business. Accordingly, anything which weakens the network—especially between capital markets and investment banking—seriously undermines the business.

I have sounded this warning before:

Notwithstanding what they like to tell you, investment bankers don’t really sell “ideas.” They sell connection, and access, and they are successful to the very extent they can maintain themselves in the flow of market information. Investment banks derive their market power and importance by maintaining dense and robust information networks across the numerous markets they participate in. This makes them better traders, better investors, and better advisors.

In the overall scheme of things, a successful bank should prefer to have strong networks, rather than strong bankers. Take a banker with excellent network connections out of his or her supporting environment, and he or she becomes dramatically less effective. Allow individual bankers to weaken the network by hoarding clients, refusing to communicate, or actively undermining their rivals within the firm, and you weaken the bank materially. Encourage the hiring and creation of “superstars,” and you shift power away from the bank into the hands of individual mercenaries. All of these things make an investment bank less valuable to its clients, as well.

I don’t care if Morgan Stanley’s investment bank had a blowout quarter. If Taubman and Kelleher are wasting time, energy, and opportunity pissing on each other’s shoes, they are fucking up. Morgan Stanley could do better.

* * *

Now I don’t mean to minimize the real structural conflicts between investment banking and sales and trading. They each serve different client bases with different needs and objectives. They each make money in different ways. The desires of their respective clients are rarely in sync, and sometimes the way each division makes money conflicts directly with the goals and profitability of the other. It is not so simple as one firm, one income statement.

Underwriting new securities is one area where corporate finance and capital markets cooperate directly, to source capital for issuers and sell securities to investors. But even there the alignment of interests is not complete. The corporate finance client wants to issue securities at as high a price as possible, and the capital markets clients want to buy low. This tension plays out daily in internal discussions between the bank’s departments, and believe you me it can get pretty heated on occasion. Market making is a capital markets business line independent of corporate finance, but it does have potentially positive (or negative) secondary effects on the latter, since a firm’s market position trading certain securities can affect whether bankers can win a particular piece of underwriting business or not. Be the number one trader of social networking stocks, for example, and your bank stands a good chance of leading Groupon’s IPO. Be number 15, and you can forget it. Corporate finance always wants sales and trading to make deep and active markets in certain areas, but capital markets often pushes back, because market making requires capital, and capital is expensive. The influence runs the other way, too: a bank which is active and successful in originating or underwriting securities in a particular market is far more likely to become the “axe” in that area. This drives greater sales and trading volume and, hence, greater capital markets profits. But if a bank has little track record issuing securities into a particular market, it becomes difficult for sales and trading to make money there independently.

You can see the potential for conflict even among pure agency business lines like underwriting and market making. This conflict is thrown in stark relief when an investment bank begins to assume a principal position in a particular trade. The example cited in the Bloomberg article is where Morgan Stanley’s capital markets group tries to sell derivatives in connection with a security underwriting, like interest rate or currency swaps on a bond issuance. But, as Bloomberg points out, while such a “deal can bring in significant trading revenue, it can also place the bank in the position of being a counterparty to a client it just advised.” Let me tell you something: as a corporate finance banker and advisor, this gives me the heebie-jeebies. I always worry my sales and trading guys are ripping my client off, and I shudder to think what would happen to the multi-million-dollar relationship I have carefully cultivated with my client over many years if things go pear-shaped. This is true of any transaction where an investment bank assumes the role of a principal—whether trading counterparty, lender, or direct investor. From a corporate finance banker’s perspective, the risk usually isn’t worth the potential gain, especially since all the profits from such proprietary trades seem to magically disappear into the capital markets budget before corporate finance gets its cut.

* * *

In fact, the organizational dynamic between a traditional investment bank’s sales and trading and investment banking divisions resembles nothing so much as an iterated prisoner’s dilemma. This is a game theoretic formulation of a situation in which two parties, who have some interests in common and some in conflict, must decide whether to cooperate or compete for desireable outcomes. Those readers among you who share little sympathy or liking for my profession will be delighted to learn that the traditional formulation used the example of two criminals:

Two men are arrested, but the police do not possess enough information for an arrest. Following the separation of the two men, the police offer both a similar deal—if one testifies against his partner (defects), and the other stays quiet (cooperates), the betrayer goes free and the cooperator receives the full one-year sentence. If both remain silent, both are sentenced to only one month in jail for a minor charge. If each ‘rats out’ the other, each receives a three-month sentence. Each prisoner must choose to either betray or remain silent; the decision of each is kept quiet. What should they do?

Sadly, perhaps, for those of you who would prefer all investment bankers to be thrown in jail, there is a fairly well-established solution to this dilemma, especially when it occurs over and over in an extended game of multiple rounds of unknown number. The best strategy appears to be a variation of “tit-for-tat,” in which a participant is nice, retaliatory, forgiving, and non-envious. I will leave it as an exercise for my Clever and Esteemed Readers to determine whether these behaviors strike you as consistent with the personality of your average investment banker.

In any event, the material point is that, like the traditional prisoner’s dilemma, the interaction between capital markets and corporate finance can, with proper focus and strategy, be elevated from the suboptimal, default outcome of mutual betrayal and non-cooperation into a stable, cooperative solution that benefits both parties. And if, in the case of Morgan Stanley (and investment banking generally), the participants are not wise, patient, or sensible enough to arrive at the best solution themselves, it is the job and obligation of senior management to drag them there kicking and screaming, or fire their sorry asses and promote somebody else.

Sounds to me like James Gorman needs to give a couple of guys a dope slap or two.

1 Playback.
2 Throughout, I employ industry-standard but often confusing terminology, in which “investment banking” = “corporate finance (and M&A)” and “capital markets” = “sales and trading.” Oh, and “investment bank” means the whole damn firm. Alles klar?

© 2011 The Epicurean Dealmaker. All rights reserved.