Tuesday, January 22, 2008

Bad Hair Day?

Stranger: "How you doing there, Dude?"
Dude: "Not too good, man."
Stranger: "One of those days, huh?"
Dude: "Yeah."
Stranger: "Well, a wiser fella than myself once said, 'Sometimes you eat the bar, and'—(Much obliged)—'sometimes the bar, well, he eats you.'"
Dude: "Hmm. That some kinda Eastern thing?"
Stranger: "Far from it."

The Big Lebowski

© 2008 The Epicurean Dealmaker. All rights reserved.

Monday, January 21, 2008

Just When I Thought I Was Out

... they pull me back in."

The Godfather: Part III

The Financial Times continues to do an outstanding job of ruining my long holiday weekend here in the States by dragging me back into the vexed and contentious issue of banker pay. This morning, they have goaded me into a response by posting a comment left by former economist/Harvard poohbah and current hedge-fund-honcho/commentator-without-portfolio Larry Summers on the FT Economist's Forum, wherein the Fine and Lofty have been debating Martin Wolf's recent provocation on the subject.

While I truly begin to tire of this issue, I feel it would be irresponsible to my Faithful Audience not to share with you the comment I left on the Alphaville blogsite (and Mr. Wolf's subsequent "response"), just in case you wanted to see more of my flashing teeth on the subject. I fear these words will fall on deaf ears among the F&L, but perhaps some among you will be able to perceive the validity of my arguments amidst the vitriol of my delivery.

This is what I wrote this morning:

This horse just won’t die, will it?

I find it both instructive and amusing to read the thoughts of the great men (no women yet) on the FT Economist’s Forum. The scent of academe lies heavy upon the conversation, whereas I could find little evidence that any of those learned men have actually spent any time earning a productive living in the finance sector, which might give me more comfort that they know what the hell they are talking about.

“Clawback,” as Mr. Rajan originally proposed and Mr. Summers seems to tentatively endorse, is both a ludicrous notion and so impractical as to rank only slightly above unicorn horn as a likely cure for the current financial ills Mr. Wolf and others so lament.

How, pray, would you implement such a scheme? Set up a government-supervised escrow account, into which all affected traders and bankers deposit a majority of their annual pay, which is only released over time when the regulators decide it is safe or appropriate to do so? To whom among the legions of individuals within the finance sector–whose jobs and responsibilities are so multifarious as to make the US Federal tax code look like a one-page precis–would it apply? Who would decide, for example, when it is safe to release the 2007 bonus for a mortgage trader, and on what basis? How about that for a CDO structurer, or a commodities trader? An M&A advisor? A senior executive? (Minor point: how in God’s name would you propose taxing such earnings?)

The mind boggles both at the size and complexity such a regulatory scheme would require and the self-delusion of those among its proponents who believe that Wall Street and City bankers will not innovate rings around such a system within the first six months of its establishment.

And why should investment and commercial banks be the only entities involved in such a scheme? I can think of many economic actors who had a direct hand in the frenzied bubble behavior behind the current credit meltdown and real estate crisis who are at least as influential and culpable in the resulting mess as bankers. Let’s set up compensation clawback mechanisms for them, too, by all means. Real estate brokers, fixed income portfolio managers, German savings banks, Australian municipalities, central bankers, and–dare I say it–economic prognosticators should all join the party, by this calculation.

Furthermore, if we agree the assets and securities being traded carry long-term risks of value diminution, why don’t we extract protection directly from the sellers of those assets? After all, the seller of a house, a mortgage portfolio, or a common stock share has absolutely no continuing exposure to the potential future reduction in value of that asset, and they typically make a lot more money off the sale than the banker who arranged the transaction. Outrageous! If we want to protect the financial economy from panics, crises, and destruction of value, why don’t we “incentivize” all sellers of financial assets not to sell any assets which have a risk of declining in value in the future? That’ll simplify things, mightily.

This is, and remains, nonsense. There are vast swathes of our global economy where people earn a living conducting transactions in which their pay has no long-term vesting mechanism even though those very transactions have substantial long-term economic risk to their participants. Wall Street, frankly, is one place where it does, through the cleverly designed market mechanism of deferred compensation tied primarily to the stock price of the individual banker’s employer.

Until and unless the economists of the world propose to set up a compensation scheme wherein their current compensation is deferred until we have had the opportunity to judge the correctness and efficacy of their economic forecasts and policy proposals over some multi-year time period, I will consider such proposals as these as no more than empty posturing.

Subsequently, Mr. Wolf was pleased to climb down briefly from his ivory tower and post a response for all of us unwashed commoners to chew on:

I find it impossible to take seriously someone who froths anonymously, though I suppose that, like most economists, I would be happy to take delayed pay in return for bankers’ levels of remuneration. The fundamental point, however, is that banks are already differentially regulated and for very good reason: they are the central institutions of the credit system, as this crisis has proved once again. And, as the central institutions of the credit system, they are uniquely protected and supported by the state.

It is perfectly reasonable for regulators to ask whether the incentives of those who operate these institutions are aligned with the public interest that the regulators exist to protect. Of course, it is quite likely that regulators will soon be looking at how other industries (real estate brokers, for example) have performed. But that was not my concern.

“Academic” is often used as a term of abuse. But pretty well all the fundamental ideas in modern monetary and financial economics were invented by academics. So it is a term of abuse I am delighted to accept.
* * *

I have rarely marveled at such an impressive cartload of arrogant, willfully misunderstanding codswallop as this. Mr. Wolf apparently persists in believing against all evidence that I am attacking his premises—that banks are central to the global economy, that their centrality justifies differential regulation, and that regulators have a valid interest in understanding the incentives which guide and influence banking market participants' behavior and actions. I am not. What I am attacking, however, is the proposal he has put forth to do something about it, which I find ill-considered, poorly thought-out, and completely impractical. Furthermore, as I alluded to in my post, the minute you start proposing the regulation of pay in one sector of the economy which concerns the destruction of value, you open the door for demagogues and scoundrels to revisit the compensation schemes of others. That way lies communism, Mr. Wolf, and I think few among your readership would follow you even a few steps down that road.

Finally, I find it impossible to take seriously someone who will not engage in the rough and tumble of the marketplace for ideas because his interlocutor chooses to conceal his identity. I am enough of an "academic" myself, Mr. Wolf—a moniker, by the way, which I in no way consider to be a term of opprobrium—to believe that the important points in a debate are the ideas under discussion, not the pedigree or position of the debater. Should you choose to discover it, you can know enough about me as matters: I am a practicing investment banker who has worked in the industry for almost two decades. That, and all else about me, does inform my argument but is frankly irrelevant to it. I have no other dog in this fight.

And, as far as "frothing" goes, Mr. Wolf, I think you will find that most of my readers are well able to extract whatever pearls of wisdom there may be in my arguments from the exaggeration, sarcasm, and humor in which I encase them. The academic virtues of dryness and moderation in discourse are not superior or even preferable to other forms of exegesis in all circumstances. Nor does my employment of the rhetorical arts lessen the force of my criticisms of the ideas you and others have put forth on the subject of banker pay.

Feel free to hide yourself in the cloistered echo chamber of the Economist's Forum, if you will. There, I am sure you can convince yourself that all disagreement is centered upon modest refinements to your most excellent idea. I, on the other hand, will continue to live and work in the real world, where ideas live or die based solely upon how well they work in practice.

And, in the common parlance of my country, Sir, your dog won't hunt.

© 2008 The Epicurean Dealmaker. All rights reserved.

Sunday, January 20, 2008

Stump Speech

WALL STREET, n. A symbol for sin for every devil to rebuke. That Wall Street is a den of thieves is a belief that serves every unsuccessful thief in place of a hope in Heaven.

FINANCE, n. The art or science of managing revenues and resources for the best advantage of the manager. The pronunciation of this word with the i long and the accent on the first syllable is one of America's most precious discoveries and possessions.

COMMERCE, n. A kind of transaction in which A plunders from B the goods of C, and for compensation B picks the pocket of D of money belonging to E.

— Ambrose Bierce, The Devil's Dictionary
* * *

Recent readers of these pages will be aware that I have been engaged in an ongoing dialogue of sorts with several market commentators concerning the vexed and contentious issue of banker pay, especially as it relates to the ongoing crisis in financial markets. While tempers may have flared, I do hope that we can quickly move beyond casting aspersions

ASPERSE, v.t. Maliciously to ascribe to another vicious actions which one has not had the temptation and opportunity to commit.

at each other and mutual backbiting

BACKBITE, v.t. To speak of a man as you find him when he can't find you.

about real or supposed injustices

INJUSTICE, n. A burden which of all those that we load upon others and carry ourselves is lightest in the hands and heaviest upon the back.

alleged by one and sundry to have been committed by our fellow participants in the financial economy. For the stakes are high for all of us, not just commercial and investment bankers, to prevent a more permanent and damaging disruption to the economy and the financial markets by precipitate and ill-conceived action in any one area, including that of compensation to investment banking employees and other financial middlemen.

While I fear it may be too late to keep this dispute out of the world of

POLITICS, n. A strife of interests masquerading as a contest of principles. The conduct of public affairs for private advantage.

and the interfering hands of that most fearful and meddlesome creature, the

POLITICIAN, n. An eel in the fundamental mud upon which the superstructure of organized society is reared. When we wriggles he mistakes the agitation of his tail for the trembling of the edifice. As compared with the statesman, he suffers the disadvantage of being alive.

I believe I echo the sentiments of many when I say I would prefer a thorough airing of the situation in public to the resolution of our various grievances through

LITIGATION, n. A machine which you go into as a pig and come out of as a sausage.

So, while I remain resolutely convinced that banker pay is far more symptomatic than causal for the bulk of the current problems under which we all suffer, I do wish to

APOLOGIZE, v.i. To lay the foundation for a future offence.

to my various interlocutors for any

INJURY, n. An offense next in degree of enormity to a slight.

I may have caused them with my intemperate language and scathing sarcasm.

After all, I believe a fine Hegelian conflict of thesis and antithesis to be the most effective way for all of us to discover the

TRUTH, n. An ingenious compound of desirability and appearance. Discovery of truth is the sole purpose of philosophy, which is the most ancient occupation of the human mind and has a fair prospect of existing with increasing activity to the end of time.

about this issue, and I also believe it will help us move past this valley of despond on to a bright and shining

FUTURE, n. That period of time in which our affairs prosper, our friends are true and our happiness is assured.
* * *

I thank you for your attention, Fellow Citizens, and I look forward to your vote in the coming primary election.

© 2008 The Epicurean Dealmaker. All rights reserved.

Thursday, January 17, 2008

The Pressure Room

"Mr. Bond, they have a saying in Chicago: 'Once is happenstance. Twice is coincidence. The third time it's enemy action.' Miami, Sandwich and now Geneva. I propose to wring the truth out of you."

Goldfinger's eyes slid slowly past Bond's head. "Oddjob, The Pressure Room."

— Ian Fleming, Goldfinger

[WARNING: This post has been rated VILE, for Very Interesting, Lengthy, and Educational. Read at your own risk.]

Let's cut the shite, shall we?

The time has come to face some simple truths.

With the publication today on page one of The Wall Street Journal of an article entitled "Deal Fees Under Fire Amid Mortgage Crisis," I now count three major salvos in roughly the last week which have taken aim at pay practices in the financial sector, broadly defined. I have already responded to the first two, which appeared in the Financial Times, here, here, and here. I am a firm believer in the Chicago gangland maxim which Mr. Goldfinger cites, so I believe it is time to respond to the third by delivering what I hope will be a knockout blow to the mass of misperceptions, misunderstandings, and sheer obstinate stupidity which I think underly both these articles and the political movement afoot to restructure compensation practices in the financial industry.

Unlike Auric Goldfinger, however, I do not propose to wring the truth out of anyone. Rather, I intend to beat some truth into those commentators, market participants, and spectators who are busily jumping up and down in the bleachers calling for the heads of all financial intermediaries and sundry. In addition, I believe it may be salutary for many of those same intermediaries in my audience to hear and remind themselves of some of these truths as well. After all, it would be better to have our stories straight before we get hauled before a Congressional subcommittee, wouldn't it?

Consider this post a public service, from Yours Truly. I assure you it hurts me more than it hurts you.

* * *


Before we get started, class, write down these two words: Agent and principal. There will be a quiz later.

Today's article in the Journal sets the stage for our little drama pretty well:

At every level of the financial system, key players—from deal makers on Wall Street and in the City of London to local brokers like Mr. Schmidt—often get a cut of what a transaction is supposed to be worth when first structured, not what it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a re-examination of how financiers get paid and whether the incentives the pay structure creates need to be modified. This week, Congress asked three prominent executives to testify about their pay packages.

Upfront commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar mergers are inked. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees on the front end.

Critics argue this system can give people a vested interest in closing a deal, regardless of whether it turns out to be a good idea over time.

This is all true, true, true. I don't deny it. From snooty investment bankers working on multi-billion dollar mergers to part-time real estate mortgage brokers, financial intermediaries get paid a commission for helping to originate, source, and close deals. These people are agents.

When they function purely as agents (more on that later), these intermediaries perform a function no different than that of any other agent or salesperson who gets paid a commission. This includes real estate brokers, car salesmen, telemarketers, etc. Whether they are employees or independent middlemen, all such agents are paid a fee for arranging a transaction between a willing buyer and a willing seller, or, for those cynics among you, for separating the buyer from his or her money.

Now, for those of you who have never tried selling something for someone else, or made a cold call to anyone to get them to buy something, trust me: it is hard work. It takes a lot of time and energy to find potential buyers and sellers, to persuade them to become willing parties to a transaction, and to hold their hands and make sure each party actually goes through with the deal rather than succumbing to buyer's or seller's remorse. It also takes a rather robust physical and emotional constitution, one which can sustain repeated rejection, one which can support extensive travel and work outside normal daylight hours, and one which does not implode from the daily grind of dealing with a never-ending parade of flaming assholes. I can guarantee you that you have no idea how prevalent these flaming assholes are in the general population, until you begin to try to sell something to them. (Who knows, maybe even you qualify as one in certain circumstances.)

Because it is hard work, and not for everybody, there is a scarcity of good and willing salespeople in the labor pool. Remembering your Economics 101, you will recall that scarcity of any resource factor means it can demand a higher price. We see this confirmed in practice, with sales jobs of whatever sort tending to command very good wages in relation to other jobs in any particular industry. Furthermore, unless you are a frequent and experienced buyer or seller of goods and services, with a comprehensive list of direct contacts among potential counterparties, and an extensive transaction experience encompassing many different types and circumstances of transactions, you will find real value in having an intermediary who does. When you hire such an intermediary—especially as a non-employee middleman for one particular deal—you are simply renting his or her experience, rolodex, and transaction skills. Expensive as it is, most companies and individuals tend to hire intermediaries in this way, on an ad hoc basis, because they do not need permanent sales or buyers reps on staff.

So, having clarified—I hope—the function and role of the agent or intermediary, and why they are hired, let us turn to the WSJ's poster boy for remorseful intermediaries everywhere, Shreveport, Louisiana mortgage broker Kevin Schmidt:

Mr. Schmidt arranges mortgages in Shreveport, La. [What did I tell you?] He earns his money upfront, taking a percentage of each loan once papers are signed. "We don't get paid unless we can say YES" to loans, his firm's Web site says.

The problem, which Mr. Schmidt says he sees clearly: Brokers have little incentive to say "no" to someone seeking a loan. If a borrower defaults several months later—as Americans increasingly are doing—it's someone else's problem.

Well, I must say I think Mr. Schmidt's moral scruples do him credit—assuming, of course, he is not just feeding the Journal a line to get his dot portrait on the cover of the newspaper—but I think he is a little confused. Of course he has little incentive to say "no" to potential mortgagees: it's not his bloody job.

He is hired/paid/taken golfing regularly by mortgage companies to 1) find potential borrowers and 2) persuade them to borrow money. Of course, the mortgage companies don't want Mr. Schmidt to waste his or their time, so I presume they give him guidelines to qualify potential borrowers, which I am sure he is diligent in applying. But the mortgage company decides whether or not to actually loan the borrower money, not Mr. Schmidt. The mortgage company makes an affirmative investment decision to lend out money to a homeowner every time it signs a mortgage, whether or not it actually applies any of its own judgment in lending to that particular individual or just relies on Mr. Schmidt and his colleagues to have properly screened the borrowers as good credit risks.

Now Mr. Schmidt or any other sales agent or intermediary can indeed do naughty things. He can misrepresent a transaction to the buyer and/or seller (fraud). He can pressure an unwilling buyer or seller into a transaction (high pressure sales tactics). Or he can arrange a transaction which is clearly unsuitable for one or more of the parties involved. All these misdeeds—plus countless others designed and practiced by unscrupulous salesmen ever since Satan sold Eve a bill of goods along with The Apple—are no-nos. Most in fact are already prohibited by law, and salesmen who commit them usually find themselves neck deep in hot water sooner or later. Such practices are and should be stamped out whenever they occur.

But let us not forget the material point. Mr. Schmidt brings the deal to his employer, but the mortgage company does the deal.

The mortgage company is a principal.

* * *


Figuring out what principals are is easy. You are a principal. Every time you buy or sell a stock, every time you take on or refinance a mortgage, every time you charge a purchase to your credit card, you are acting as a principal. Every time you purchase or sell an asset, and every time you assume or repay a liability, you are acting as a principal.

As a principal, because you have direct economic exposure to the potential appreciation or depreciation of the asset or liability in question, you are at economic risk for unfavorable movements in the value of that asset or liability. At the same time, you can benefit from favorable movements in the underlying item, like appreciation of an asset (think stock, or house) or depreciation of a liability (think mortgage). We undertake asset and liability exposure in our daily lives in all sorts of ways, many of which have as their principal purpose something quite different from expected appreciation, like having a place to live, or buying that new iPhone before your paycheck clears. When we choose to assume asset or liability exposure directly, for the primary reason of benefiting from favorable changes in its value, we call that investing.

Now, notwithstanding what you read in the papers and see on CNBC, being a principal is the only really effective way to get rich. "Wait a minute," you exclaim, "what about Lloyd Blankfein and Stan O'Neal and all those investment bankers making tens of millions of dollars every year?" Sure, they make a lot of money, but are they really rich, comparatively speaking?

Do a quick thought experiment: Without thinking, try to list ten of the richest people in the world. Let me guess: Warren Buffet, Bill Gates, the Sultan of Brunei, etc. I can almost guarantee you that no-one on your list is a commercial or investment banker. Even those of you who cheated and put down near- and putative billionaires like Bruce Wasserstein proved my point. For one thing, it is sad but true that several hundred million dollars, while being a whole lot of money by any normal person's calculus, is chump change in an era when you have to have multiple billions just to eke out a place on the Forbes 400. For another, guys like Bruce did not make the bulk of their net worth from salary and bonuses, they made it as substantial owners of large chunks of the investment banks they founded, ran, and sold (sometimes twice). They got rich as principals.

So, if you really want to get rich, be a principal. Realize, however, that by the same token you could lose it all. Accrued Interest puts it nicely in a recent post on Angelo Mozilo of Countrywide:

In any free market system, there will be failures. The dream of riches has to have a downside. With the potential for great success must also come the potential for great failure. Without a penalty for failure, economic agents would be incentivized to take inordinate risks. In private companies, this risk is naturally managed. Small business owners normally must put up their own capital, or borrow against existing assets, such as their homes. Obviously an entrepreneur believes in his new business idea if s/he is willing to mortgage his home and life savings to fund it. Whether the business winds up succeeding or not, the incentives are for the entrepreneur to create value.

So the divide between agent and principal is clear: the agent takes his or her cut off the top of your deal and sashays merrily away in search of the next transaction. In contrast, you are stuck with all the downside if the deal fails. On the other hand, if the deal succeeds, you get to book a tidy profit and start leafing through The Robb Report for a nifty new motor yacht. Your investment banker or real estate agent gets exactly bupkus in addition to his or her commission, unless you decide to send him or her an FTD bouquet and a nice thank you note.

* * *

"Agipals" and "Princigents"

It's the space where being an agent intersects and merges with being a principal that is the really interesting (and controversial) case to examine.

Because investment banks historically have been pure middlemen, which rarely if ever voluntarily took direct principal positions in securities or companies for love or money, many people still have that impression of their business. Indeed, certain functions in investment banking, like mergers & acquisitions advisory, securities underwriting, and trading for customer accounts, still take their traditional forms as almost pure agency businesses, where capital, if it is committed, is committed only temporarily to facilitate transactions, rather than as direct investment.

However, it has been many years now since most of Wall Street and the City have migrated to a hybrid model, where they have increasingly assumed principal risk in securities, commodities, and direct investments in companies (aka private equity) in order to boost their profitability. This principal business is where Wall Street has made most of its money until recently, and, being Wall Street, that is where the power has migrated within these banks. Just look at the CEOs of most major investment banks. They come from the Sales and Trading division, almost without exception.

After years of watching their clients at hedge funds and private equity firms get impossibly rich, investment bankers finally figured out what I shared with you above: that in order to get really rich, you have to be a principal. So, they doffed their timid, three-piece intermediary suits for polo shirts and chinos and bellied up to the table to play with the big boys. And they, and their shareholders, had quite a run, up until recently, when they (re)discovered that being a principal has its downside, as well.

But along the way, the big financial players with principal operations figured out that they had their own internal agency problem, as well. They (and their shareholders) wanted their proprietary traders to make aggressive bets, but they needed a way to discourage stupid or excessively risky behavior. So they implemented, almost without exception, the very long-term compensation plans certain market commentators have been urging from the sidelines recently. Traders at commercial and investment banks, plus anyone else who makes a lot of money (including top executives and poor little innocent M&A bankers like me, who never expose their firms to principal risk in the first place) have been getting the lion's share of their admittedly mouthwatering compensation in the form of long-vesting, restricted equity securities in their employers. They are tied to the long-term health and performance of their employers, big time. Believe me, there is no-one in the investor community or broader economy more motivated to improve the financial results at investment banks—and hence their utterly crappy stock prices—than investment bankers themselves.

So much for investment banks, investment bankers, and their shareholders. Their interests are indeed pretty well aligned. But what about other players in the investing world and the broader economy?

That is trickier, but the cleverer among you Dear Readers have already figured it out, based on the practices of investment banks. If you really want to align the interests of agents with those of principals, the principals have to give the agents some economic participation in the appreciation and depreciation of the underlying asset or liability. In other words, it's gonna cost you.

After all, all the whining and outrage I am hearing in the press has to do with why the financial intermediaries who helped investors and others get into sub-prime mortgages, CDOs, and the like aren't sharing in the downside of these transactions. What about the friggin' upside, goddammit?

If you want to keep all the upside in your vacation condo in Florida or your CMBS but have me cover your ass in the downside scenario, you, my friend, want me to sell you a put option. Okay, I'm game, but it'll cost you, and a lot more than my measly commission for putting you into the damn thing in the first place. Oh, and by the way: if you buy a put from me and I am not a complete enough idiot to sell it to you naked (i.e., unhedged), I am going to hedge that put by selling the underlying asset short. Guess what that'll do to your vaunted upside? That's right: your own little insurance policy is going to reduce your chances of striking it big. And the longer you want that downside protection, the more it's gonna cost you, as well.

Or, if you don't want to buy a put, then I'll take on some (not all) of the downside exposure alongside you, in exchange for some of the upside, too. (We'll pretend were Goldman Sachs.) That way I'll share your pain if the investment goes to hell in a handbasket. Or maybe, just maybe we'll both get rich together. You just won't be able to collect all the filthy lucre for yourself.

Bummer, ain't it? I guess there really is no way to reduce your risk as an investor without ... no, it can't be that easy ... reducing your return. Guess I should have said that at the beginning, and saved us all a great deal of time. Then again, the people among you who needed to hear this haven't been listening so far, so what the heck.

* * *

That's it, in a very lengthy nutshell. God forgive me for torturing so many innocent electrons in pursuit of your enlightenment.

I have never fully understood the following aphorism, but I will put it down nevertheless, in the hope that there may indeed be—dare I say it?—a kernel of truth in it:

The truth shall set you free.
* * *
* *


With this post, I think I now officially qualify as an apologist for the investment banking industry. Equity Private must be laughing her ass off.

© 2008 The Epicurean Dealmaker. All rights reserved.

Wednesday, January 16, 2008

Armageddon Outta Here

Food fight!

For those of you Dear Readers who nodded sagely at my most recent posts on the issue of banker pay, murmuring to yourself, "But of course. No-one could disagree with that clever chap TED, could they?," I have news for you.

Apparently Martin Wolf of the FT took umbrage at my scurrilous attack on his opinion piece on the topic today, and our little disagreement has spilled over onto the pages of FT Alphaville's comment section. I am sure that left to his own devices, Mr. Wolf would never have even known about my little drive-by blogging, much less respond to it. Nevertheless, those clever geezers at Alphaville saw a chance to stir the pot and generate more page views, so they incited Mr. Wolf to comment by drawing attention to one of the least flattering things I had to say about him in my post. (Naughty naughty, Mr. Murphy.)

Faithful Readers will already know that, because I cannot be bothered to defend my own irresponsible and intemperate jeremiads in these pages and because I do supposedly have a day job which normally consumes the bulk of my waking hours (except, sadly, in times like these), I do not offer a comments section on this weblog. I think it only fair, however, to share with you here a little of the badinage Mr. Wolf and I have exchanged as of this writing, if only so you can see how I defend the interests of my fellow financial parasites in a more public, and shall we say, more exalted forum.

So herewith is a direct transcription (copy and paste, for you youngsters) of our exchange for your amusement. Should you wish to see the original Alphaville post and its entire range of comments, you can do so here.

* * *

Martin Wolf's comment on my blog entry, posted at 16:32 GMT:

I really enjoyed Epicurean Dealmaker’s “hysterical and ranting” contribution.Indeed, to be called hysterical or ranting by this person is almost an honour.

I think he makes only one point that is worthwhile: investors desired high returns. How surprising! But, of course, the institutions made next to no effort to tell them that they couldn’t have these returns without taking on substantial additional risks.

Yet the heart of his contribution contains the following logic: Wolf’s proposal is unnecessary because it already happens; Wolf’s proposal is a mistake because it will impose massive and costly intervention in these institutions.Does this make sense to anybody else?

If we could abandon regulation of the financial system, that would be wonderful. But we can’t (for compelling reasons). So surely we must focus on incentives facing decision-makers, instead.

My response, posted at 17:46:

I will address Mr. Wolf’s comments point by point.

1) I am delighted and honored to confer hono(u)r wherever and whenever it is deserved. I am afraid, however, that Mr. Wolf appears to confuse my sarcasm, humor, and frustration with his article with the hysterical ranting I accuse him of. I concede that Mr. Wolf wrote a serious opinion piece in a serious publication, rather than a sarcastic hatchet job in a little-read, self-published weblog, but for that very reason I–and I assume many others–did and should hold him to a higher standard of argument than he demonstrated in his piece.

Really, Mr. Wolf, an unbiased observer (if he or she could be found) would find it hard not to conclude from a reading of your article that its tone and language is highly intemperate and inflammatory, given the facts at hand. Had I the time, energy, and inclination, I could write a lengthy response to your original article rebutting almost every statement you make, based on the facts as I know them, if for no other reason than to disabuse the less-informed among the FT’s readers of the facile exaggerations, elisions, and half truths scattered throughout.

2) Since when in bloody hell are the intermediaries in any financial system supposed to tell investors “they couldn’t have these [high] returns without taking on substantial additional risks,” as you say? Are we supposed to assume that every institutional investor out there is completely ignorant about the absolutely primary, fundamental fact about financial markets: that risk is inextricably entwined with return? Do not forget: it was supposedly sophisticated institutional investors which piled into “AAA”-rated CDOs, ABMSs, etc. 2007 is not 2000, when arguably clueless retail investors bought dot com fantasies based entirely on the recommendation of Wall Street analysts.

If these investors were too bloody stupid, or too bloody greedy, to wonder how and why supposedly AAA securities could consistently deliver market-beating returns, then I say it serves them right. Your comment smacks far too much of the unfortunate tendency among many investors to blame anyone but themselves for their own mistakes, and I for one won’t have it.

3) Well, yes, if you actually stopped to think about what I wrote in my two posts on the subject. First, yes, most major financial institutions already have long-term compensation schemes which tie bankers’ economics to the long-term health of their organizations. Second, and therefore, why would you propose to insert the government into a system which is already in place?

Government regulators, by your own example, have historically tried to regulate the financial services industry from the rear, and in many cases have worsened perceived problems by their very intervention. You may have faith in the perspicacity and effectiveness of regulators, but I have serious doubts. I would point out that it was your otherwise excellent FSA and the BoE which helped greatly to turn Northern Rock into a shambolic mess, and I would venture that both institutions lead by miles over our own SEC and Fed.

Furthermore, if you concede the fact that long-term compensation schemes already exist in the industry, I wonder that you still think they would be a panacea for the system’s current ills. Unless you are proposing–I shudder to think–that bankers’ compensation should be tied somehow to the performance and long-term health of the financial and economic system itself. If so, you should be receiving inquiries shortly from Vladimir Putin and Wen Jiabao about new openings in their Ministries of Finance.

4) I am all for regulation, believe it or not. I am firmly of the opinion that abandoning all regulation of the financial system would be a catastrophic error, as it would be for abandoning regulation of any significant part of the global economy. I just want to see sensible regulation, done with a light hand, that responds to and guides change and innovation in the industry in a measured manner. This has less to do with my (real) mistrust of the effectiveness of regulators than with the incontrovertible fact that no-one, including the bankers at the heart of it, knows how the global financial system will continue to evolve.

For now, I say everyone should take a deep breath, identify and acknowledge the mistakes that have been made (especially by oneself), and work together in a sensible, measured manner to find our collective way out of this.

For I assure you, Sir, that the old saying coined by one of the leaders of my country’s secession from yours so many years ago rings as true now as it did then:

“We must all hang together, or assuredly we shall all hang separately.”

* * *

Stay tuned to Alphaville to see if Mr. Wolf responds.

Now, really, I do have to get back to work.

© 2008 The Epicurean Dealmaker. All rights reserved.

Tuesday, January 15, 2008

Armageddon Rag

Paranoia strikes deep in the heartland
But I think it's all overdone
Exaggerating this and exaggerating that
They don't have no fun
* * *

Excuse me, did I miss something?

I had just finished mopping the blood off the floor this afternoon from today's little exercise in market hysterics—

NEWS FLASH!: Citigroup announces big writedown, reduction of dividend! Investors completely blindsided by totally unexpected news!

SHOPPING SHOCKER!: Wracked by rising mortgage debt and declining real income, consumers have the temerity to reduce spending in December! Hank Paulson "extremely disappointed" by fellow citizens' "lack of gumption."

—when I decided to surf to the Financial Times website for a little Old World perspective and reason. What to my wondering eyes did appear, however, but commentator Martin Wolf joining his voice to that of Raghuram Rajan in launching a second broadside against pay in investment banking.

Mr. Wolf starts calmly enough:

You really don’t like bankers, do you?” The question, asked by a former banker I met last week, set me back. “Not at all,” I replied. “Some of my best friends are bankers.”

But then, Mr. Wolf goes on to paint a picture of the global banking system which in olden days would have gotten the village populace out of their houses and into the woods with pitchforks and axes to dispatch the rampaging terror on their doorstep.

... the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.

That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation. Yet this combination can hardly be deemed a success. The present crisis in the world’s most sophisticated financial system demonstrates that.

I now fear that the combination of the fragility of the financial system with the huge rewards it generates for insiders will destroy something even more important – the political legitimacy of the market economy itself – across the globe. So it is time to start thinking radical thoughts about how to fix the problems.

And the "conflict of interest" at the heart of banking which drives this reckless and world-threatening behavior at banks? Why, banker pay, of course.

By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

Mr. Wolf concludes with a solution which can only be admired for its breathtaking audacity and sheer bloodymindedness:

All bonuses and a portion of salary for top managers [at banks] should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five. I understand that the bankers will not like this. Yet one thing is surely now quite clear: just as war is too important to be left to generals, banking is too important to be left to bankers, however much one may like them.


* * *

I don't believe what I read in the papers
They're just out to capture my dime
I ain't worrying
And I ain't scurrying
I'm having a good time
* * *

Because I am such a magnanimous individual (and modest, too), I will not take offense nor blame Mr. Wolf for failing to read my recent blog post on the topic of banker pay, which I penned in response to his co-cabalist Professor Rajan's jeremiad of a few days ago. I will simply observe that if he had, he might have saved himself and his readers a great deal of confusion on the subject. Of course, he could have done the same by actually talking to one or two of these "best friend" bankers he reassures us he canoodles with on a regular basis. Had he done so, he would have discovered that, in fact, most senior executives on Wall Street and in the City at the type of banks he criticizes already receive the vast majority of their pay in the form of long-vesting restricted stock and equity securities. While ten-year vesting schedules are unusual, it is not at all unusual to find four- and five-year tails on banker compensation. (Plus, do not forget that most of these banks force a banker to forfeit his or her unvested compensation from previous years if he or she leaves the firm.)

I will not regurgitate the rest of my arguments against the good doctor here, in the interest of space (and uncharacteristic restraint), but I will note that Professor Rajan fulminated against banker pay primarily as unfair to investors in those very same investment and commercial banks. I pointed out, I hope to convincing effect, that those investors are the very ones who provided the demand for the risk-taking behavior Messrs. Rajan and Wolf deplore and therefore had a direct hand in the level and form of compensation doled out to greedy little investment bankers and their minions. (By the same token, having enjoyed along with their banker agents the plentiful fruits of profitable investing and trading over the past several years, they now have very little cause to whinge now that the return pigeons have flown and the risk chickens have come home to roost.)

Mr. Wolf, however, makes a larger argument, that banker pay is not only the root cause of this evil but also the proximate source of a looming crisis threatening the global economy and even capitalism itself. Frankly, my first reaction to many of his claims was that they were simply over-the-top exaggeration for rhetorical effect. I have had this impression of Mr. Wolf's screeds in the past, most recently with one in which he described the global credit squeeze and a likely US recession as an unholy combination second only in terror and impending doom to the prospect of some rough beast slouching toward Bethlehem to be born.

Where the hell was I, I wondered to myself, when the "world ... witnessed well over 100 significant banking crises over the past three decades"? One hundred? That's over three per year, fer chrissakes. What does Mr. Wolf count as a crisis: more than two bank tellers getting a paper cut in one week? Or this beauty: "large financial institutions ... are virtually the only businesses able to devastate entire economies." "Devastate"? I find it hard to believe the financial disruptions currently spreading through the global economy can be dignified with such a moniker. Pain for many, surely. Hardship for some, undoubtedly. But devastation? I think not.

Given the size and recent growth and performance of the global economy, the reversal of a few hundred billion dollars—or even a few trillion—of previously booked profits in the form of realized and projected losses hardly strikes me as Armageddon. Comeuppance, maybe, for the legions of people both within and without the banking industry who temporarily forgot that the nubile young maiden Return is inextricably conjoined with her ugly sister Risk, but not the end of the world.

And why, for God's sake, is Mr. Wolf so trusting that governments and financial regulators could implement a highly intrusive, massively unwieldy, and extremely complicated regulatory regime to enforce long-term banker pay, as he proposes? Aren't these the same entities that in his opinion have fallen down on the job of overseeing and regulating the financial sector in the first place? Does he really believe that any such plan would not generate all sorts of unintended consequences for the banking industry, financial progress and innovation, and the global economy as a whole? Who are the experts Mr. Wolf proposes design and implement such a plan? (And where the hell, for conversation's sake, does Mr. Wolf get the ludicrous notion that 10 or 12 years is the proper horizon for evaluating the profitability of I presume all investing and trading strategies? Poppycock, Sir, sheer poppycock.)

Finally, if he thinks his best friends and their colleagues at "all systemically important financial institutions" are just going to shrug their shoulders and get back to work once the mid-level career bureaucrats have put his compensation scheme in place, I would like to know what he's smoking. (And the name and number of his dealer.) Anyone with half a brain and an ounce of ambition would light out for the territories before the ink was dry on the legislation. The only people left in banking to do the work would be the dull, the unambitious, and the idiot sons of US Congressmen, who would have discovered an attractive new career path.

Intellectual capital is like mercury, Mr. Wolf: very hard to contain and control. Besides, if things are as bad as you say in the world of high finance, surely we should keep our best and brightest chained to the wheel madly innovating our collective way out of this mess, no? And unless you propose using real chains—which I would venture to guess neither Adam Smith nor the ACLU would look kindly on—you had much better realize that talent flows where the money is. (And given that your average managing director already has way too much of his net worth tied up in the depreciated stock of his employer, he already has plenty of incentive to right the listing ship.)

* * *

I don't know, maybe we should be grateful that the Brits have their own crotchety curmudgeon spewing forth half-baked nonsense in the financial press. That way, we do not have to feel so embarrassed when Ben Stein proposes to nationalize our banking system in The New York Times.

Cold comfort, say I. But then, I'm just a reckless young whippersnapper, aren't I?

Maybe I'm laughing my way to disaster
Maybe my race has been run
Maybe I'm blind
To the fate of mankind
But what can be done?

So God bless the goods we was given
And God bless the U.S. of A.
And God bless our standard of livin'
Let's keep it that way
And we'll all have a good time

— Paul Simon, Have a Good Time

© 2008 The Epicurean Dealmaker. All rights reserved.

Friday, January 11, 2008

Canary Diamond in a Coal Mine

'E's not pinin'! 'E's passed on! This parrot is no more! He has ceased to be! 'E's expired and gone to meet 'is maker! 'E's a stiff! Bereft of life, 'e rests in peace! If you hadn't nailed 'im to the perch 'e'd be pushing up the daisies! 'Is metabolic processes are now 'istory! 'E's off the twig! 'E's kicked the bucket, 'e's shuffled off 'is mortal coil, run down the curtain and joined the bleedin' choir invisibile!! THIS IS AN EX-PARROT!!

— Monty Python's Flying Circus, "The Pet Shop."

Oh boy.

Fabled jeweler Tiffany & Co., also known as Wall Street's canary in a coal mine, just kicked the bucket this morning. It reported same store sales growth in the US of only 2%, versus analysts' expectations of 6%. This was in spite of a 10% gain in sales at its flagship New York store, where Ukranian oil field roughnecks, Polish construction workers, and Irish package tour operators used their surging euros to snap up $15,000 diamond rings like they were so many Disneyland pennants. Apparently, the only Wall Streeters to be found in the fabled bling-bling emporium this Christmas were either using the public toilets to throw up in after learning their bonus numbers for the year or applying for counter sales positions at the Short Hills expansion store.

Investors showed their typical charity and marked down TIF shares more than 12% this morning, to a new 52-week low of $35. After this, the only people who are still likely to get a warm glow in their private parts from thinking about little Tiffany blue boxes are those wives and girlfriends whose investment banker husbands have not broken the news that they will be shopping for jewelry at Zales this year, if at all. Sounds like 2008 should be a good year for divorce lawyers.

What makes me so certain that Tiffany's travails prefigure the lumbering footsteps of doom for the Kiton-clad legions of high finance? Forget the global credit crisis. Forget the slowdown in M&A. What really portends the return of the inevitable business cycle to Wall Street and the City of London is the fact that about half of their best business just got flushed down the toilet.

I refer, of course, to another Bloomberg article this morning on the substantial decline in fees paid to New York and London investment banks by private equity firms.

Buyout firms paid $5.4 billion to securities firms in the U.S. and Europe in the second half of 2007, 38 percent less than the first six months, data compiled by New York-based research firm Freeman & Co. and Thomson Financial show. The drop was steepest in Europe where fees fell 54 percent.

That's over three billion dollars less revenue that flowed into the coffers of Blankfein, Pandit, Thain & Co. I don't care how big your P&L is, that'll leave a mark. It goes on.

The pace of announced buyouts slumped in the second half, with private-equity firms announcing $202 billion of deals worldwide, about 66 percent less than in the record first six months, according to data compiled by Bloomberg.

Oh great: not only was the second half of last year crap, but there is every indication PE firms are decelerating into the new year. There's more.

Fees for arranging syndicated loans, the most lucrative business for banks, slumped to $867 million in Europe in the second half from $2.1 billion in the first half. KKR, run by Henry Kravis and George Roberts, Carlyle Group in Washington and London-based Permira Advisers LLP, Europe's biggest buyout firm, paid no fees for bond sales in Europe in the second half, the data show.

In the U.S., LBO firms paid $1.05 billion in fees for arranging loans in the second half, a drop of 27 percent from the first six months of the year.

Note carefully, Dear Reader, that KKR—which the article tells us paid $599 million in fees to investment banks in the second half of 2007—paid exactly bupkus, zilch, nada for Old World bond placements during the same period. Maybe it's not so bad after all to live in a beleaguered country with a lame duck President and a currency preferred to toilet paper almost nowhere else in the civilized world.

And why, you cleverly persist in asking, is this such a bad thing? Surely Gentle Ben will make the bad credit demons go away. And corporate acquirors will step up to the M&A plate, won't they? Perhaps. But even if they do, they simply will not pay the kind of fees Wall Street has loosened its belt to enjoy at the PE-led M&A banquet of the past several years. Corporate buyers can use stock to purchase companies, which PE firms generally cannot. They don't have to pay a cent to Wall Street to do that. They also tend to use a lot less debt than buyout firms in their acquisitions, and the debt they issue tends to be of higher average credit rating. Higher-rated debt means a lot less coin in the pockets of investment bankers.

But most importantly, they are just nowhere near as promiscuous dealmakers as private equity firms have been, especially over the past few years. From a global M&A market share of mid-single digits several years ago, private equity came to represent around a third of total M&A market volume, and that in a growing market. Furthermore—although they will not like you to hear this—buyout shops are some of the least price-sensitive customers investment banks have. They insist on really tight spreads from their banks on the debt they raise to fund deals, and they negotiate the price and terms of acquisitions with target companies like a wolverine with a squealing marten in its mouth, but they really don't care to haggle the last few basis points off the banker's fee. For one thing, they get to turn around and bill their limited partners deal fees and other goodies when they do a deal, so the general partner usually is not paying bank fees anyway. Besides, the failure or success of most buyout deals simply does not depend on whether you paid 2% or 2.5% for your high yield underwriting. Don't worry, though: PE firms have plenty of other ways to beat the crap out of investment banks, and they take advantage of every one. They're not getting soft in their old age.

As an aside, if you want corroborative anecdotal evidence that tumbleweeds are indeed rolling through private equity offices worldwide, just turn to PE insider blogsite Going Private. After falling off the grid (relatively speaking) in October, November, and December, sardonic memoirist Equity Private has surged back with a New Year's deluge of postings having a word count well in excess of last month's Congressional Record. (It takes one logorrheist to know another.) Given that fact, and the fact that she has spared very few of those words from flaying Andrew Ross Sorkin and praising activist hedge fund investors to write about her own business, methinks She Who Must Be Feared has a little too much time on her hands. (I can sympathize.) Besides, any time a blogsite resorts to instant messaging transcripts recounting the amorous misadventures of Wall Street legend Muffie Benson-Perella, you can be sure it's a naked grab for page views.1

So you see, private equity has been one of the biggest, fastest growing, and most profitable business lines for investment banks during this past cycle. You can bet your girlfriend's diamond-encrusted thong that the banks have staffed up big time to ride the money wave. Most Wall Street management is too sophisticated to rely simply on revenue per banker to manage headcount, but it's not that inaccurate a proxy. Furthermore, there are only so many bankers you can reassign to covering Sovereign Wealth Funds or the alternative energy sector. Things are gonna get ugly in the Financial Sponsor and Leveraged Finance groups this Spring. Lessee ... expected revenue down by half. How many FSG and LevFin bankers should we cut? You do the math.

I could be wrong, though. The busy beavers in the Wall Street coal mine might not be dead after all.

Maybe they're just pining for the fjords.

1 Like that, just there.

© 2008 The Epicurean Dealmaker. All rights reserved.

Wednesday, January 9, 2008

Eat the Bankers

You know, Dear Readers, having been an investment banker for lo these many moons, I long ago abandoned whatever starry-eyed dreams I might have entertained in my callow youth of obtaining a measure of social respectability for the stature and gravitas of my chosen profession (accompanied, of course, by a comfortable pile of shiny simoleons). Investment bankers, in modern capitalist society, seem to fall into that social class of people which everyone else despises vociferously as greedy, money-grubbing whores, unprincipled shills and hucksters who are only marginally less despicable than personal injury lawyers or Flavor Flav. Of course, this universally fashionable scorn is never in evidence when the citizen in question is desperately trying to get into Harvard Business School so he or she can become an investment banker, wheedling them to donate to his or her favorite charity, attempting to sell them an overpriced condominium in a brand new building stuffed to the gills with other investment bankers, or persuading them to marry their comely daughter (or him- or herself).

And yet—at the risk of incurring the opprobrium of the chattering classes by tooting my own horn—I will assert that there are indeed a number of admirable traits and characteristics which can be fairly laid at the gilded doorstep of Homo investmentbankicus. While it is true that many are venal, corrupt, and/or have the interpersonal skills of Mr. Hyde on a bender, it is also true that quite a few are charming, politic, and even genuinely nice people. I am sure I will strain your credulity somewhat less by also asserting that, as a group, investment bankers tend to be better-educated, more worldly, and harder working than the average capitalist wage slave. While they are neither necessary nor sufficient for a successful career in investment banking, native intelligence, grit, and ambition are character traits which are liberally sprinkled throughout the cohorts of Wall Street. And, the last time I checked, these traits tend to be the same ones which most Americans claim to admire as valid tickets to the good life.

Certainly, there is very little about the monetary rewards accruing to the successful investment banker which is due to nepotism, cronyism, or inherited wealth or position. (The pre-1973 days when investment banking was an undemanding profession populated by the dull and unambitious sons of wealthy WASPs is long gone.) If you can't cut it on your own pluck, skills, and drive, you have no place in this industry. There are no Rigas, Murdoch, or—dare I say it?—Bush or Clinton dynasties in investment banking: it's too bloody hard. Scratch your average investment banker's Kiton suit, and you will usually find a genuinely self-made man or woman underneath.

So what's not to like? Well, the common complaint is that we make too much money, and we add little value to the economy or society.

But I'd be careful, if I were you, about adopting such an opinion without thinking it through. After all, how much "value" does your little profession add to the common weal? By whose calculation? And since when has capitalism paid laborers for the value they contribute to the general good anyway? My economics professors taught me that wage rates are set by market forces, which follow their own internal logic almost wholly divorced from such concepts as social good, intrinsic value, or even the difficulty of the work in question. If that were not true, then surely the soldiers under fire in Iraq and Afghanistan would be making a hell of a lot more money than your (or my) sorry little ass.

And like it or not, investment bankers do perform a function which is inseparable from the proper functioning of a capitalist economy. At its most basic, investment bankers are middlemen: we grease the wheels of commerce, of investment, of capital formation and allocation, and of wealth creation. Strictly speaking, investment bankers perform none of those actions themselves. When we do, our role blurs, and we become investors, capitalists, or hedge funds. Some of us eventually become Goldman Sachs. But the point is that these wheels need greasing, and "The Market"—whatever the hell that is—pays handsomely for the service. Invent a magically self-greasing economy, and you will eliminate the investment bankers. Good luck. Finish that task, and I'll give you another assignment: get rid of all the cockroaches in the world, too.
* * *

"So," you're probably thinking to yourself about now, "what's got old TED tilting at this particular windmill?" Well, I'm glad you asked.

Current Chicago finance professor and former IMF economist1 Raghuram Rajan posted an opinion piece in the Financial Times today with the provocative title "Bankers’ pay is deeply flawed." (I dare you to disagree with that statement at your next cocktail party.) He seems to have struck a chord with the commentariat. In it, he trots out the usual objections to overpayment of investing professionals for "alpha" (manager-specific skill in capturing superior non-market-correlated returns) when in fact they are really only capturing "beta" (the returns naturally accruing to the market, like from an index fund), which they conceal or gussy up by shifting risk in time or using leverage to bolster (and mask) mediocre returns. Managers who generate high returns like this get paid whopping bonuses based on annual performance, but their investors get caught holding the bag when the strategy blows up and generates big losses, like we have seen in the CDO and subprime mortgage markets recently.

Professor Rajan wants to claw back these huge performance bonuses after the fact, when it turns out the stellar returns they were based on were just smoke and mirrors. For example, he does not seem happy that Morgan Stanley's John Mack declined a bonus for 2007, when MS's subprime chickens came home to roost, but still gets to keep all of his $40 million payout from 2006, when a lot of those chickens were being hatched.

You will not be surprised to learn, Dear Readers, that I have a few problems with the Professor's article.

First, the problem he describes is well known, and of long standing on Wall Street. Among many, it has been known as the "trader's option." This option is inextricably embedded at the core of an investment industry that employs and compensates agents to trade or invest other people's money. The concept is simple: the trader bets the ranch. If he hits a home run, he gets a huge "performance" bonus, and people who gave him the money to invest make a lot of money too. If he loses, he gets no bonus, and probably gets fired, but he can usually land on his feet at another firm without much problem. Meanwhile, the people whose money he invested are shit outta luck. The trader's asymmetric payout structurally encourages excessive risk taking. Unless the trader has a lot of his own money at risk, his incentives are misaligned with those of his backers. Expensive risk control systems, extensive monitoring, and the occasional blow up naturally follow.

But this is not twelfth level Masonic arcana. Everyone who fell off the turnip truck earlier than last week knows this. Why then, does it continue to happen? Why, to use a common metaphor making the rounds of Wall Street watering holes and mainstream media publications, do investors insist on paying traders to pick up pennies in front of steamrollers? Well, I'll tell you why: there are a hell of a lot of pennies out there for the taking. Not everyone can make money like Warren Buffett, investing in Main Street America with an investment horizon of Judgment Day. Not everyone can give a few billion Benjamins to Steve Schwarzman to buy illiquid restructuring plays of widget polishing companies. Markets get crowded, and market sectors have limits to the amount of money which can be invested in them before they become commoditized, so investors are always looking for the next pile of pennies to hoover up for their pensioners and shareholders. And, if you want to play the steamroller penny game, who else but a rabid, aggressive, fast-moving trader do you want to do the vacuuming for you?

Even if picking up pennies in front of steamrollers is no better in the long run than capturing beta, why does that make it such a bad strategy? If the returns to penny-vacuuming take so long to mean-revert—enabling, for example, traders to turn in years of double-digit returns—who is to say that an investor shouldn't pay a smart and aggressive trader a lot of money based on the premise that that trader can time the market better than someone else? After all, isn't that exactly what good trading is all about, good market timing? The only trouble is that an investor will find it difficult to identify the truly good traders (or truly lucky ones—frankly, does the investor care which?) before the blow up occurs, so he will have to pay everyone as if they were generating alpha. Perhaps this is just another tax on investing which a savvy investor takes as given.

Second, Professor Rajan makes the usual peanut gallery mistake of conflating a whole passel of different animals under the rubric "banker." The specimen he focuses his ire on—and which we discussed just above—happens to be of the species trader or hedge fund/portfolio manager, people who invest other people's money for fun and profit. The charges he outlines can be laid at the feet of SAC Capital and Citadel at least as easily as at the banks which are his target. But "banks" and "investment banks" like Citigroup and Morgan Stanley are constituted of many other types of animal which have no exposure to the types of irresponsible investing he excoriates, and whose fees face virtually none of the boomerang risks which he deplores. M&A bankers, for example. Market making traders. IPO underwriters.

Third, practicality. How the hell would the Doc propose we "claw back" compensation? Intertemporal incentives are difficult enough to structure and manage—think Corporate America and CEO pay—without creating the ex post measurement nightmares and ensuing litigation that any such plan would entail.

Fourth, while his argument is broader, Professor Rajan seems most irritated by high pay for employees at banks and investment banks, where he accuses managers and top bankers of extracting excessive annual payouts while the public shareholders are left holding the bag. Well I've got news for him. First of all, the total returns generated by most publicly held investment banks over the past several years—the Golden Age of Easy Credit—have been pretty darn good, and well in excess of total broad market returns. I do not recall many people complaining publicly while the investment bankers were making the shareholders rich. Now that the stocks have given a big chunk of those returns back, however, we're supposed to feel sorry for all the widows and orphans in MS, GS, and LEH? Sorry, my Sympathy-o-Meter is flickering at "Feeble."

Second, take a closer look at how senior investment bankers and executives actually get paid. I do not know the details, but I can guarantee you that of the "$40 million" John Mack "took home" in 2006, a distinct minority was legal tender he can actually spend at the local laundromat. Like any investment banker above the rank of First Year Analyst nowadays, Mack got the vast majority of his bonus "paid" to him in the form of funny money: options, phantom stock, stock appreciation rights, and/or plain old restricted stock in—you guessed it—Morgan Stanley. Furthermore, the restricted stock and other deferred compensation allocated to investment bankers is usually burdened by a punishing vesting schedule that can last many years. Investment bankers are "paid" the bulk of their "excessive" bonuses each year in name only. They only see the majority of the cash years later when the stock or options vest and they are able to sell the shit. (Subject, of course, to them still being at the same bank—most schemes make bankers forfeit unvested bonuses if they leave the firm voluntarily or for cause.) So in fact, for most investment bankers, a decline in their company's shares hits their net worth a lot harder than it hits that of their public shareholders. Besides, they cannot bail out of the stock at the first sign of trouble, like Fidelity, CalPERS, or Professor Rajan.

So have a little sympathy when you write about John Mack, Professor Rajan. I very much doubt that your personal net worth has plunged over 35% from May of last year.

1 Now, if that isn't a background which lends itself neatly to sniping at highly compensated finance professionals, I don't know what is.

© 2008 The Epicurean Dealmaker. All rights reserved.