Show Me the Money

“Money changes everything.”

— Some guy, probably without any money

Andrew Ross Sorkin, access journalist extraordinaire and alleged shill for the Great and Good,¹ put up a sensible op ed this morning to which I thought I would contribute a few brief supporting remarks. It seems Mr. Sorkin has taken somewhat of a shine to Antonio Weiss, a successful Lazard investment banker whom the current Administration has advanced as its candidate for under secretary of the Treasury for domestic finance, and he has been defending this paragon of sharp-dressed competence against detractors great and small.

Today’s fresh character assassination outrage comes from the capitalist shills [sic] at the AFL-CIO, who have apparently addressed a letter to the boards of several Wall Street banks which takes umbrage at the policy, to be enjoyed by Mr. Weiss among others, that employees leaving their firms for government service can take their unvested pay with them:

Why, the letter asked, do banks routinely pay out special compensation packages to executives who leave to take government jobs when those packages were intended to retain them?

“Unless the position of these companies is that this is just a backdoor way to pay off a newly minted government official to act in Wall Street’s private interests rather than the public interest, it is very difficult to see how these policies promote long-term shareholder value,” the letter declared.

Now Mr. Sorkin waxes poetic and high minded in response to this challenge, nattering on primarily about how we should encourage banks and other employers of bright, shiny, would-be technocrats to doff their gilded yokes of service to Mammon and don the austere chains of public service to the rest of us. He assures us that the interlocking web of influence, conventional group think, and apparent if not actual conflict of interest such revolving door practices engender are indeed problematic, but that the net gain of brilliant, accomplished, successful financiers to the government payroll is worth it, and the aforesaid conflicts can be managed with an unburdensome modicum of care and attention. This is all well and good, and even Your Altruistically Challenged Correspondent can recognize the merits of this argument in the chilly chambers of his frozen heart, but it does not go far enough. As a result, Mr. Sorkin has no compelling response to Big Labor’s additional complaint—bless their capitalist-friendly hearts—that such policies represent a squandering of shareholder value. The thrust of his reply seems to be, yes, these policies cost shareholders money, but they probably help attract some additional members of the Best and Brightest who might have a few public-service-inclined bones in their sleekly coiffured bodies, so that must be a non-numerically-quantifiable Good Thing.

This is unnecessarily weak sauce. Let me explain.

* * *

The principal issue seems to be that our intrepid financial journalist and the shrill harridan of special pleading for labor share a common confusion concerning the payments in question to Mr. Weiss and other would-be servants of the public good. For one thing, they are not special payments at all, as in, “Well done you. Here’s a couple of million or so leafy simoleons to stack alongside your Rembrandts and ill gotten bearer bonds in reward for your selflessness. Remember us kindly.” Rather, when Lazard hands Mr. Weiss a check for twenty million smackeroos give or take on his way out the door, it will be releasing into his sweaty hands money he has already earned.

The distinction which Ms Slavkin Corzo draws between this and what Mr. Weiss, e.g., would receive should he instead choose to decamp from the mahogany clad offices of Lazard for some other investment bank—bupkis, plus a swift kick to the seat of the pants—while correct, misses the point. As Your Tireless Explicateur of All Things Compensatory has often explained on this site, investment bankers are commonly paid substantial portions of the mouthwatering bonuses you read about in the form of what is affectionately known in my industry as “funny money” or “toilet paper”; i.e., deferred compensation. Such deferred compensation usually takes the form of restricted stock which vests over some period of time, phantom stock units, stock options, deferred cash payments, or some other such bullshit which replaces freely spendable legal tender with a conditional promise by one’s employer to pay one the money one has earned in the past sometime in the future, depending.

To illustrate a simple case, a modestly successful senior banker might get “paid” $2 million for her moneymaking efforts over the year, but receive only $250,000 of that in the form of biweekly salary, $500,000 in a cash lump sum payable shortly after the turn of the year, and the balance of $1,250,000 in the form of restricted shares of stock in her employer which vest in equal installments over the next three years.² Now, should she be so rash as to decide to jump ship from her existing employer to a competitor before the stock she earned by making money for the firm and its shareholders vests, in almost every case she loses it entirely. Given that most bankers stay with their employers for several years and have this or similar pay regimes inflicted on them every year, you can understand that most senior bankers tend to have quite a substantial “nest egg” of deferred pay locked up in restricted shares that are subject to forfeit in such circumstances. This explains why, unless a banker is desperate to switch employers (or, like most Lehman bankers post crash, has unvested stock which is largely worthless anyway), she is likely to extract a large payment from her new employer which is designed to replace the deferred compensation she is giving up by jumping ship. Sadly for her, such replacement payments are almost always granted in the form of—you guessed it—restricted shares with deferred vesting. So, no matter whether she hops from bank to bank like a Mexican jumping bean or stays with one her entire career, a successful senior banker is likely to have accumulated several if not tens of millions of dollars of deferred pay for her pains. The only way off this treadmill is to die, retire completely from investment banking, or, yes, join the government or some other non-competitive corporate entity.

Seen in this light, the forfeiture of unvested pay which a banker suffers when she leaves for a competitor is not the avoidance of further payment but rather the recapture or clawback of previously earned and allocated compensation. Little Muffy got “paid” those two million clams because she made, let’s say, ten million clams for her firm and its shareholders. Those ten million clams were real, deposited and cleared cash money,³ which paid real creditors and light bills and lap dance club dues and which, after said normal course operating expenses and the government’s rake were creamed off the top, were distributed to shareholders in the form of dividends and/or retained capital. Little Muffy only got $750,000 of that munificence and was forced, mutatis mutandis, to extend the balance as a long term interest free loan to the company.⁴ Sure, the shareholders face eventual dilution when and if Muffy’s shares vest, but until this happens they haven’t really fully paid her for her services. Other things being equal, shareholders should be delighted when bankers resign to work for competitors, because all those unvested share awards are cancelled and they retroactively get all those bankers’ revenue production for below market rates.

Of course, other things often are not equal, and investment banks usually have to replace the departed bankers with new ones, sometimes from other firms for which they have to allocate a lump sum of restricted shares out of treasury that negates all the wonderful savings shareholders got from the resignations. In this respect, deferred banker compensation is sort of like a hot potato: you can pass it around, but somebody is going to have to hold it as long as the banker is working in the business.

* * *

Ergo, paying Mr. Weiss and any other loyal bankers who decamp from our industry’s fetid shores for the sweetness and light of public service (or some other employment which does not try to take money out of the mouths of investment bankers) harms shareholders virtually not at all. It does normally accelerate payment of any unvested shares or other deferred compensation, which eliminates the present value discount of deferral which shareholders otherwise enjoy, but in point of fact all such payments do is give their departing employees the pay the firm has promised them for work already done. It is a greedy and incontinent shareholder who cannot agree to that.

In fact, politically ambitious investment bankers who have a notion they might like to try public service eventually usually negotiate explicit conditions in their employment agreements up front to pay all unvested compensation in just such circumstances, and banks are happy to agree to them. It is no skin off their shareholders’ noses, it renders contractual the right thing to do, which is to pay your employees what you have agreed to pay them, and it may even generate some goodwill or at least friendly feeling in someone who might be leaning over the dais at a future Senate probe or showing up to your Executive Suite with a raft of burly auditors on Christmas Eve. It’s not bribery. It’s just good business. Plus, as Mr. Sorkin avers, it’s probably socially constructive as well.

Only an ungrateful son of a bitch of an investment bank shareholder cannot appreciate that. But I’m being redundant.

Related reading:
Andrew Ross Sorkin, Encouraging Public Service, Through the ‘Revolving Door’ (New York Times DealB%k, December 2, 2014)
Defending the Indefensible (September 22, 2012)
Five Pound Box of Money (February 9, 2009)

¹ Hey, even the Great and Good need positive PR. Besides, notwithstanding populist firebrands’ complaints, it does add materially to the public weal to have someone reporting directly from inside the belly of the Beast, and the Beast needs to give someone access to his belly for that to happen. What, you think John Mack was going to recount his conversations with Tim Geithner during the financial crisis to Yves Smith?
² Don’t get hung up on the bigness (or smallness, bless you Executive Committee members) of these numbers, children. Yes, even modestly successful investment bankers can make what in normal circumstances can rightly appear to be a metric shit-ton of money, but that is not the point of this illustration. Think about all that money tied up in restricted shares which little Muffy Megabucks thinks is rightfully hers for revenues and hopefully profits she already earned for her employer. Can’t do it? Never mind, then, you might as well switch over to BuzzFeed.
³ For clarity and simplicity I am assuming these revenues were really earned funds, like fees from closed M&A transactions or security underwriting. The same argument carries less force when the money a banker “earns” for the firm is, e.g., the calculated and booked net present value profit for a long-term trade which remains at risk for the entire term of the trade, as my colleagues on the sales and trading side of the industry are so fond of claiming.
⁴ The “principal” of which, by the way, is tied to the actual, fluctuating stock price of her employer’s shares, which can work either to her benefit or to her lasting despair (Lehman Brothers). Deferred stock is calculated as a number of shares at the time when compensation is set, not when the shares vest. The holder is exposed to changes in the firm’s stock price over the entire vesting period.

© 2014 The Epicurean Dealmaker. All rights reserved.

Even Cowgirls Get the Blues

I want a girl who gets up early
I want a girl who stays up late
I want a girl with uninterrupted prosperity
Who uses a machete to cut through red tape
With fingernails that shine like justice
And a voice that is dark like tinted glass

— Cake, “Short Skirt / Long Jacket”

Those of you Charming and Intelligent Readers who have followed me at this opinion emporium for longer than a month will recall I am renowned for the consummate artistry and zeal with which I beat dead horses. Having already flogged the eohippine offspring of Perissodactyla mortua quite thoroughly on the topic of junior investment bankers’ excessive working hours and the growing trend by their employers to limit them, I thought I would circle back from another direction and sneak in a couple more licks on the moldering corpse for my amusement and your edification.

The proximate impetus for this odd-toed ungulate bashing was the recent release by Harvard economics professor Claudia Goldin of a research paper which attempts to identify the sources of the residual¹ pay gap between working men and women. Interestingly enough, she identifies a substantial source of the gender pay gap in professional positions like law and investment banking to be—wait for it—working hours:

What, then, is the cause of the remaining [gender] pay gap? Quite simply the gap exists because hours of work in many occupations are worth more when given at particular moments and when the hours are more continuous. That is, in many occupations earnings have a nonlinear relationship with respect to hours. A flexible schedule comes at a high price, particularly in the corporate, finance and legal worlds.

In other words, Goldin finds that in service professions like banking and law, some hours are worth more than others. Specifically, such employers demand continuous time at work and constant availability, whether in person overnight and on weekends or via email and phone. Employees who deliver this kind of total commitment are rewarded. Those who do not are paid less or hustled out the door. Goldin concludes that “face time,” long workday hours (even if unproductive), and heavy, near-constant demands on junior professionals to work late nights and weekends differentially handicap women, because they are often difficult to reconcile with many women’s other interests, particularly those connected with raising a family.²

I have written similar things in the past:

Another answer may be that the duration, timing, and demands of an investment banking career are simply incompatible with many women’s other important interests. In particular, while an analyst typically has a two- or three-year stint directly after college, after which most are encouraged to leave and get an MBA (and some elect to make the jump into private equity or hedge funds), a woman entering investment banking as an associate after business school can anticipate at least a decade before she can begin to exercise some measure of control over her life. Associates usually start in their mid- to late twenties, spend three to five years before promotion to Vice President, and then spend four to seven years or more getting to Managing Director. All during that time, they work incredibly long hours, travel like maniacs, and basically do not have any personal life to speak of. For many women, this span from their mid-twenties to their mid-thirties coincides with what they envision as the period when they will get married and start a family. While this is true for many men, also, I think most of us can agree that committing to a career in investment banking is a much more fraught and difficult decision for a woman than it is for a man. This stage is also one when junior bankers are not making enough money to make it feasible to hire full time help to care for young children. A female Vice President is certainly physically capable of having a baby while traveling 150 days a year and working upwards of 80 hours per week, but unless her spouse or partner is rolling in dough him- or herself (or willing to stay at home), she simply will not be able to afford to outsource its care.³

So the answer is clear, Ladies: it’s not you, it’s us. And we don’t want to change.

* * *

Now it should be relatively uncontroversial that taking an extended sabbatical from a personal network business like investment banking is prima facie unsupportable, because anyone who does so loses contacts, relationships, and market knowledge which are critical to the performance of the job. The only possible way a woman who takes 2, 3, 5, or 10 years off to raise Junior is going to get her high-paid, front-office, client-facing, revenue-producing job back in my industry is to bring a rolodex chock full of solid new billionaire client prospects she made at Lamaze and SoulCycle classes and while standing in the nursery school pick-up line at the 92nd St. Y. There are just way too many talented (younger) men and women chained to their desks on Wall Street who are qualified and eager to take your seat if you choose to give it up.

I think most people apart from the militant wing of La Leche League understand and accept this. However, I have seen a significant number of people who read research like Professor Goldin’s or digest explanations like mine about why working hours for junior bankers are so crazy who then turn around and declare it does not have to be that way. Some of these critiques take the form that our admittedly inefficient work practices have little to do with the actual amount of work needing to be done and much more to do with institutionalized hazing and brainwashing practices. Others concede that, yes, our cannon fodder young professionals do have to do a lot of work, but there’s no reason 100-hour workweeks can’t be split up among more workers. Like, say, into two 50-hour slogs by well-rested, culturally rounded, housework-sharing New Feminism poster boys (or girls) who can pass the baton back and forth.

But this is foolish. First of all, the nature of the work does not allow it. Anyone who has ever programmed a multi-page Excel model knows how massively inefficient and dangerous it is to use multiple authors. It takes even the best financial modeler a substantial amount of time to get up to speed on someone else’s model, time he or she could use to build the next model waiting impatiently in the queue.⁴ The same is true, to a more limited extent, of the PowerPoint and Word presentations novice dealmakers spend unconscionable hours of their youth editing, re-editing, and turning back and forth to Presentation Resources at three in the morning. Meanwhile, it is these same people doing the actual work late at night and on weekends who participate in the endless meetings and conference calls with their superiors and clients during the daylight hours where the intent and nuances of said models, documents, and presentations are hashed over minutely. How would you propose to brief the lobster shift on what needs to be done on all six of your live projects each and every night? How much time do you think it would take, and how many errors would be introduced in the communication? Corporate finance and M&A work just isn’t like a trading book, which can be handed over from one time zone to another relatively efficiently and with little chance of information loss or error. Introducing multiple hands also complicates the assignment and monitoring of accountability, which is a critical quality control device in a business that aspires to both speed and error-free precision.

One might counter that the various tasks investment bankers do could be more thoroughly split up along functional lines, with, for example, modeling experts just working on models and presentation mavens focusing solely on presentations. In fact, many large investment banks already do a limited form of this, which is why you will typically find the best financial modelers in a large bank keyboarding frantically away at midnight in the M&A or Leveraged Finance support groups. But while this improves efficiency and boosts quality control, it makes each young banker that much less knowledgable about the entire deal process, and one of the key reasons investment banks lure smart young children into their meat grinders is to find, train, and apprentice the next generation of senior client-facing bankers who are supposed to know everything there is to know about their trade. It is also worth noting that specialist juniors are often the most overworked cogs in the machine.

* * *

Lastly, and most importantly, the notion that you could replace a bunch of bright, hard-working, frazzled young troopers with armies of specialized clock-watching 9-to-5-ers runs straight into an insurmountable obstacle: the client won’t tolerate it.

Let me share another personal anecdote with you. Ages ago, when I was a mid-level Vice President at a global überbank, I was working around the clock for weeks on a very large, high profile transaction for one of my group’s best clients. At the same time, Mrs. Dealmaker was working around the clock to take care of Cost Center Number Two, who had recently arrived from the hospital to swell our merry band to four, slot number three already being occupied by toddler Cost Center Number One. Naturally, she was frazzled beyond belief (CCN2 was a colicky newborn) and begged me to come home at a reasonable hour one night just to take care of CCN1 while she took a deserved rest. So I did.

In so doing, I bowed out of running the routine nightly conference call on my deal and handed the baton to my very competent Associate, who I was confident could handle any trivia that might arise. Which he did, as expected. No worries.

But later that night I received a call at home from my client’s General Counsel, who proceeded to rip me a new one for having the audacity to bow out of a routine conference call on which nothing of note was discussed or needed to be discussed, simply because the client had a bunch of corporate Vice Presidents dialed in, too. In any rational sense, the General Counsel’s complaint was ridiculous, as it ignored both the outstanding job my team and I had been doing to keep the deal on track (and hence relatively immune to potential hiccups) and the fact there were, in fact, no hiccups to discuss. But investment banking is not a rational business. It is a client service business, and the client is always right. Mea culpa.

And this was the lesson I learned from this incident: investment banking clients expect to own you in exchange for paying your bank the ridiculously large fees it charges. They own you completely, at any time of day or night, for as long as they want to, and with complete and utter disregard for whatever may or may not be going on in your life. Let me tell you something: I have never yet been on a deal where the client hasn’t chuckled in satisfaction, usually more than once, at the long hours and hard work the junior bankers on his deal are putting in. It is a standing joke for every client who engages my services. They expect it.

* * *

So where this leaves young women who want to make a career in my business, I will allow you Clever and Insightful Ladies and Gentlemen to determine. I suspect, for myself, not very far ahead. It could be a very, very long time—read never—before women make up a larger portion of revenue-producing investment bankers. It is just not a profession which encourages or supports work-life balance of any kind. For what it’s worth, it’s not the investment banks which are driving this. It is our clients. Who are, you know, always right.

By the way, the General Counsel of the client in my story was a woman.

Related reading:
A Fine Disregard for the Rules (January 14, 2014)
The Invention of Leisure (November 12, 2013)
Go Ahead, Live a Little (May 12, 2013)
She’s Trading Her MG for a White Chrysler LeBaron (March 2, 2013)
Fingernails that Shine Like Justice (May 21, 2007)


¹ That is, that which remains unexplained after you adjust for identifiable sources of gender-based differences in pay, such as the fact many women tend to gravitate toward lower paying professions in the first place and many other women drop out of the workforce for extended periods of time to bear and raise their children.
² The going presumption here being that men either have no conflicting interests to balance or have learned as a gender to simply pound sand if they don’t like it. Or so I am told.
³ This finesses the issue whether most women are interested in outsourcing so much of the care and rearing of their offspring to relative strangers. Remember we are not talking about someone who can drop off her angel at daycare at 8:30 am on the way to work and pick her up in time for dinner.
⁴ And please don’t suggest this could be avoided by using standardized, error-checked models. First of all, every bank worth its salt already has them. Second, every model, no matter how comprehensive and detailed, has to be structurally modified to fit the particular variations of each individual deal. You find a real life deal that fits the standard bank model. Go ahead, I’ll wait. And third, using a 50-page standard leveraged buyout model to model first order effects of an M&A or capital raising transaction is like mosquito hunting with a howitzer: potentially effective, but way too much trouble and almost guaranteed to vaporize the mosquito you wanted to collect in the first place. You build a new, custom-purpose model instead.

© 2014 The Epicurean Dealmaker. All rights reserved.

Defending the Indefensible

Francie Stevens: “The man I want doesn’t have a price.”
John Robie: “That eliminates me.”

— To Catch a Thief

Lauren Tara LaCapra put up an interesting piece on Goldman Sachs’ declining employee compensation yesterday on Reuters. As part of it she interviewed a “prominent investor” in financial stocks who believes that Goldman is not doing enough to cut pay. He says

management is not seeing things the same way as shareholders because they have fared much better financially, even in bad times.

To illustrate this gap, he compared return-on-equity for common shareholders against compensation as portion of common equity. (For ROE, he divided pretax earnings by common shareholder equity and for the compensation measure, he adjusted pay for estimated tax costs and divided that by common shareholder equity.)

According to his calculations, Goldman employees have done better than shareholders by 10 percentage points, on average, since the firm went public in 1999. That equates to $34.7 billion over those 12 years, he said, not including what Goldman spends to repurchase shares issued to employees.

To put that figure in perspective, Goldman’s current market cap is about $57.5 billion.

But this is just bizzare, like comparing apples and carburetors.

* * *

When it comes to discussing compensation in investment banking, people seem to forget that bankers are a factor of production for the firms which employ them. At base, banking is a pretty simple business; we gather together a bunch of other people’s money and hand it over to employees who we hope will use it to make even more money. Our raw material is money, or capital, our finished product is money, or return on capital, and our primary operating costs are the cost of that capital, the cost of the labor which turns money into more money, and various other lesser doodads we supply our employees to help them accomplish this transformation, like information technology, real estate, travel and entertainment reimbursement, and lobbyists to keep the government and regulators off our backs. Our productive assets are people, highly skilled labor who wear shoes and walk out the door every day. Investment bankers are like the robots and machinery that manufacturing companies use to transform steel and plastic and energy into, say, automobiles. Unlike General Motors’ robots and assembly lines, however—or the loans and common equity in our own industry—labor does not show up on our balance sheets. Labor is simply an operating cost, a cost of doing business.

Common equity, on the other hand, is a residual claim on the profits of a business, after you have paid your operating costs and the claims of other capital providers like lenders and bondholders which are senior to you. Return on equity is an output of your business model; employee compensation cost is an input.¹ And, most importantly, the cost of labor in banking, like everywhere else, is determined at least intially independently of the cost (or required market return) of equity. If you want to run an investment bank, you have to hire and retain investment bankers, whether you are profitable or not, and you will pay the going rate in that labor market. Since we are fungible factors of production, if you cannot afford to pay us what your competitors will, we will leave and you will be unable to generate any profits at all. You might as well shut down.

Now of course the price of labor, like any factor of production, is sensitive in the intermediate and longer term to the returns on capital which employs it. If, as we may be witnessing now in finance, the long term returns to capital in an industry decline, there will be fewer capital providers who want to fund investment banks, banks will shrink, and fewer bankers will be employed. Aggregate and average individual banker compensation will decline. But this adjustment is not immediate, and the demands of inertia and wishful thinking will likely keep labor rates higher than otherwise justified for quite some time.

* * *

Another factor comes into play, which commentators, journalists, and investors seem to have trouble remembering when contemplating compensation in my industry. Even before new risk control mechanisms like clawbacks were implemented in response to the recent financial crisis, investment banks paid a very substantial portion of banker compensation in the form of deferred pay. A generic mid-level investment banker might be paid a fixed salary of $250,000 per year and earn an average bonus of $1,000,000 in a decent year. But of that $1,000,000, perhaps as little as $250,000 might be paid in cash, with the rest coming in the form of unvested stock in the company, restricted stock units, options, and other funny money which get paid out over a period of years. A simple such scheme might have the banker getting $750,000 in restricted shares of the bank’s own common equity which vest in equal installments over the next three years. (A few particularly nasty programs use what is called “cliff vesting,” in which the deferred pay vests all at once after three to five years.) The form such pay takes is often restricted stock, with the number of shares determined by the price of the bank’s stock on the award date, when the bonus is awarded. If Bank ABC is trading at $50 per share, for example, the banker in question would have 5,000 shares vesting on each of the first, second, and third anniversary of the award date.

A little thought will show you that such a scheme is far less favorable to the banker than it appears at first blush. While the banker gets headline pay of $1,250,000, she only receives $500,000 now and must wait to collect the remaining $750,000 over the next three years. Furthermore, she is exposed to the rise or fall of the bank’s stock price: she receives 5,000 shares on each anniversary whether the stock is trading at $50, $25, or $100 per share. Also, unlike the favorable carried interest capital gains treatment her former brethren and occasional nemeses in the private equity world enjoy, she gets taxed at full ordinary income tax rates immediately upon vesting, calculated on the value of the shares at the vesting date.

From the banker’s perspective, she is being forced to advance her employer a three-year interest-free loan for 60% of her nominal compensation, with the added disadvantage that she is exposed to the potential decline of her employer’s stock price, over which she individually has almost no control, to anywhere below $50 per share up to and including zero. From the bank’s perspective, this is a great deal: they have acquired zero-cost financing for 60% of their current year labor costs with no mandatory repayment risk. It is forced equity investment, the cheapest capital you can find. And, unlike true common shareholders who can take their money and run at any time, the banker cannot sell or hedge her stock prior to vesting. Lastly, if she leaves the bank voluntarily for a competitor, most banks automatically cancel her unvested shares; she only gets paid for past years’ work if she still works for the bank. Captive, costless, non-recourse capital. The true mark of my industry’s genius.^{2, 3}

* * *

This also means that the published financial reports of investment banks are practically indecipherable when it comes to understanding what is happening to current compensation policy and practice. Each year, the employee compensation expense line item on banks’ income statements reflects a combination of current cash compensation and the vesting of deferred compensation from up to three to five years previous. Goldman Sachs’ reported compensation expense in 2011 included pay from 2011, 2010, 2009, and perhaps even 2008 and before. There is a terrific lag to the data, and the reported number tells you almost nothing about current pay practices. In fact, if awarded pay is in fact declining, you can be certain that reported compensation ratios significantly overstate how much of the pie is being allocated to bankers now.

All of which is to say that the headline compensation ratios, and the ubiquitous average-pay-per-employee numbers that get bandied breathlessly about in the press—usually with a healthy helping of outrage, natch—tell you little about how banks are trying to control one of their biggest operating expenses. I cannot tell you what transpires in the executive suites of the biggest banks, but I guarantee you that investment banks have made a study and a science of squeezing their employees as hard as possible over pay for decades. The stated goal is to pay everybody the smallest number that will be sufficient to keep a dissatisfied banker from throwing up her hands in disgust and walking across the street to a competitor. The science comes in when designing the form such pay will take that will be the most advantageous for the bank itself while numbing the employee with reams of complex, one-sided terms and restrictions.

In my view, it is undeniably true that most investment bankers would accept significantly lower pay if it were paid 100% in cash. I know I would.

Which is not to say I’m a cheap date, mind you.


¹ This is not entirely true of investment banking, since the majority of our awarded pay depends in large measure on the current year profits we generate for the firm. But this is an ex post perspective; ex ante, to employ an investment banker, you have to budget the going rate. Read on.
² Just imagine if General Motors paid 60% of the money it owes its current vendors—robot manufacturers, power utilities, assembly line workers—with GM stock. Stock it would not have to deliver if it didn’t employ those vendors in subsequent years. The auto industry might even become profitable again.
³ And lest you think I am placing excessive emphasis on the cash-conserving nature of this practice, please note that non-cash deferred compensation in the form of restricted stock units and options at Goldman Sachs alone represented $2.8, $4.0, and $2.0 billion of total reported compensation expense of $12.2, $15.4, and $16.2 billion in 2011, 2010, and 2009, respectively. Those are some pretty sweet interest-free loans to the Squid from its squidlets.

© 2012 The Epicurean Dealmaker. All rights reserved.

The Root of Some Evil

“It has always seemed strange to me,” said Doc. “The things we admire in men, kindness and generosity, openness, honesty, understanding and feeling are the concomitants of failure in our system. And those traits we detest, sharpness, greed, acquisitiveness, meanness, egotism and self-interest are the traits of success.”

— John Steinbeck, Cannery Row

To greed, all nature is insufficient.

— Lucius Annaeus Seneca

Professor Ian Tonks—great name, by the way—put up an interesting column at vox today, in which he discusses recent research he and his colleagues have performed into the postulated links between banker compensation and the financial crisis. He cites a number of interesting results, including the fact that pay for all executives and directors at leading UK companies increased at a substantial rate during the decade preceding the crisis, and at a rate well in excess of pay for all employees, and that executives and directors at finance companies were second in total pay only to “non-cyclical services” firms (including food and drug retailers and telecom). But those looking for his research to confirm their belief that banker pay was tightly tied to company performance will be disappointed:

... contrary to the prediction that pay was over-sensitive to short-term performance, we find that the pay-performance sensitivity of banks is not significantly higher than in other sectors, and in general is actually quite low. Across all industries, we find a weak relationship between executive pay and company performance. The estimates suggest that a 10% additional increase in company share price performance leads to a 0.68% increase in the pay of the CEO, which translates into a £3,726 increase in CEO pay at the median level of £543,200.

We report that although the pay-performance relationship is slightly higher in the financial services sector for both total board pay and pay of the highest paid director, the additional sensitivity is not statistically significant, and is still economically very small. This tiny performance-related element of executive pay means that there is little evidence that executive compensation in the banking sector depended on short-term financial performance. In other words, executives were paid irrespective of performance. In which case, it seems unlikely that bankers were incentivised to take risks, and refutes the suggestion that incentive structures in banks could be blamed for the crisis.

In fact, Professor Tonks and his fellow Order of the Phoenix members¹ do find a meaningful correlation between executive and director pay in finance and firm size, which is noteworthy, but the slavering hordes of Occupy Wall Street and well-meaning-but-dim regulators must look elsewhere for evidence that greedy bankster bonuses led to Grandma’s condo in Boca Raton being repossessed.

Problem sorted, right? Not so fast.

* * *

Now, uncredentialed peons like me, who merely work in the industry which everybody and their pet Chihuahua seems to have developed a fully formed opinion on nowadays, do not have pre-publication access to high-powered academic research like that produced by Messrs. Tonks and pals, which is being embargoed from all but fellow travelers in academia. Accordingly, I must read into the Doctor’s slender note some key assumptions about just exactly what sort of data it examined. But, if I read him correctly, I perceive at once a couple of key methodological assumptions which are clearly wrong, and which could have been avoided had the merry researchers simply called a couple of real-life bankers, rather than sallied forth to prove something which makes no sense.

The first problem may be inferred from the Professor’s passing reference to the insignificant correlation between increase in CEO pay and “share price performance.” But if the researchers truly measured “company performance” simply and solely by share price performance, they have got the relationship almost completely ass-backwards. For one thing, everyone who has an even passing acquaintance with the equity markets realizes that public company share prices have only a tenuous, intermittent, and volatile relationship with actual company financial performance.² For another—and because of this—even the dimmest bulb on the compensation committee of a public company realizes that the CEO and other key executives have only limited direct influence on the evolution of the firm stock price, usually limited to jawboning the market that it is underpriced. Accordingly, they prefer to pay executives for performance entirely (or mostly) within their control. The metrics they use to measure performance are financial ones, including but not necessarily limited to net income growth, return on equity, and perhaps others like asset growth and credit strength, as appropriate. Simplifying greatly, the compensation discussion at most firms—public or private, financial or non-financial—usually boils down to a version of this: “Make a lot of money for the firm, chum, and you’ll get paid a lot of coin.” It is company financial performance which matters most to executive pay, not stock price performance.

This is a common failing of many real and pseudo-academic (i.e., consulting firm) approaches to measuring pay for performance among public companies in general. Researchers get confused by the fact that many firms pay executives with heavy allocations of restricted and unrestricted stock and stock options into believing that stock price performance is the chief or even a major criterion Boards use to pay them. But what you pay somebody does not necessarily have much to do with how much you pay them. This is particularly true in finance, where bankers have traditionally been paid oodles of funny money in order to conserve corporate cash, tie their wealth to the future performance of the firm, and prevent them from leaving the firm voluntarily without suffering material damage to their net worth. I also suspect researchers default to share prices as an input variable to their correlation studies because they are easily available. This is a misleading and lamentable bit of laziness which deserves to be stamped out.

Take it from me: stock prices are an unreliable way to measure corporate performance, and they are an absolutely shitty way to predict executive compensation.

* * *

The second methodological problem which this study seems to suffer from is perhaps more common to finance than other industries, especially in the more highly paid investment banking and corporate banking subsegments. For it is an absolute fact that a very large number of employees in your typical investment bank make enormous amounts of money. Not only do many more bankers than populate the executive suite bring home pay packages which could support small villages in Central Austria comfortably—that is, money which looks like “executive-level” pay anywhere else—but often the CEO and other executive officers of an investment bank are by no means the highest paid employees there. In a decent year, hundreds of employees at large investment banks make millions of dollars, and a substantial subsegment of those bring home tens of millions, if not more. If Messrs. Tonks and friends only collated and computed compensation data for named executive officers and non-executive directors—who, by the way, as non-producers are, relatively speaking, low-paid irrelevancies—then they missed the lion’s share of actual compensation going out the door in my industry. That is certainly the impression I get when I peruse Professor Tonk’s slim précis.

And here is the problem with that: all those uncounted flow traders, M&A bankers, structured products professionals, prop traders, leveraged finance bankers, and derivatives marketers—not to mention all the non-executive group and division heads above them—get paid buckets of simoleons for making money for the firm.

* * *

And this is where I part ways with our dear Herr Professor Doktor regarding his conclusion. If I have correctly identified his study’s methodological weaknesses, not only has he measured the wrong independent variable, but he failed to apply it to the entire set of relevant dependent variables. He doesn’t collect the proper financial performance data—the gross revenue and gross profit metrics upon which investment bankers are paid in the real world—and he doesn’t correlate it against the revenue-producing employees who are producing them. Based upon how my industry actually conducts business and pays its employees, he hasn’t proved anything.

Sadly, Your Dedicated and Evenhanded Bloggist, like many others, would still like to see a comprehensive, data-based investigation of the question which Professor Tonks addresses. Unfortunately, I do not know how one could go about this without at least acquiring time series of aggregate payroll data for all revenue-producing employees at each financial firm, correlated against preferably group or divisional level revenue and profit results. You can just imagine how well that request would go over in the offices of Jamie Dimon or Lloyd Blankfein.

For my part, I continue to believe some banker bonuses were indeed contributory to the financial crisis. My industry’s pay practices and culture were built over decades when the vast majority of business investment banks conducted was agency business. Business like M&A, where you earn a fee for helping a client buy or sell a company, or security underwriting, where you earn a fee for placing client securities with outside investors, or securities market making, where you earn a spread for standing between buy- and sell-side investors as a middleman and temporary warehouser. None of these businesses entailed any material amount of persistent or hidden financial risk to investment banks: we did the deal, we got paid, and we moved on. There are no meaningful, dangerous “tail” exposures from such activities. Accordingly, investment banks got used to toting up the profit and loss for each banker and each business line at the end of each year and paying out a percentage of that as compensation to the people who either brought the money in or who could argue most persuasively they had. Simple.

The problem arose when investment banks (and their bastard cousins and often ultimate owners, commercial or universal banks) began conducting business as principals, either explicitly and in full knowledge, or—most dangerously—in total ignorance. Mouthwateringly profitable leveraged lending, structured products, complex derivatives, and proprietary investing of all kinds meant that investment banks no longer conducted business as short-term conduits of temporary risk, but began accumulating long-term financial risks on or off their balance sheet, often without their own knowledge. But when this happens, the old view that Joe in Structured Products should get a massive bonus in February because he brought in $100 million of fee revenue to the firm this year cannot cope with the fact that Joe’s fabulous trades expose the firm to $1 billion in potential losses over the next five years. Even if some investment banks did develop robust and accurate risk-pricing models which accurately tallied and kept track of the massive tail risks metastasizing on their balance sheets—and recent history puts this assertion in considerable doubt—almost none of them drew the connection to compensation practices. Projected firm profits on trades like Joe’s should never be totaled up front when determining Joe’s pay; they should be amortized over the life of the potential risks the ongoing trade poses to the firm. Most banks just didn’t seem to get this important point.³

* * *

There really is a story to be told in here, somewhere, about exactly how and how much banker bonuses contributed to the aggregation of huge hidden and misunderstood risks in the global financial system. From what I can glean from limited evidence, Professor Tonks’ study is not it. Perhaps one day some academic will actually make the effort to understand how my industry works before they design a study to explain it.

Naahh.

Related reading:
Ian Tonks, Bankers’ bonuses and the financial crisis (vox, January 8, 2012)

UPDATE January 10, 2012: Subsequent to the initial publication of this piece, certain readers inside the sanctum sanctorum of the academic priesthood (or their acolytes) were so exceedingly kind as to direct me to the prepublication version of Professor Tonks et al.’s paper, here. As I suspected, this merry band of scholars only looked at aggregate director pay and highest director pay (usually, but not necessarily, the CEO) as dependent variables, and did not examine compensation to revenue producing ranks within financial institutions. This, as I explain above, is simply and irrevocably wrong. I also can confirm these scamps measured company performance primarily by calculating total shareholder return, based upon the following logic:

The most important measure of company performance is the total shareholder return, since the purpose of performance-related pay is to align the interests of the directors with those of the shareholders.

But this, as I outline above, completely begs the question of how bankers actually are paid and replaces it with the hoary old shibboleth about how they should be paid. This is not research; this is theology. The academics also did try to correlate director pay to slightly less silly measures, like earnings per share, return on assets, and revenue growth, but presumably they found little enough correlation between these variables and Board pay either. As I explain at nauseating length above, they were simply looking in the wrong place(s).

My arguments and conclusions remain unchanged.


¹ Gratuitous Harry Potter reference. Sorry.
² Consider, for example, what happens when a company posts impressive, even record, financial results (most usually net income growth) but fails to meet or exceed investor expectations: the stock price goes down. Consider, as well, a company which posts exceptional results in a falling market: more likely than not, the stock price falls then, too. Stock price is a lousy short-term and even intermediate-term indicator of absolute financial performance, if for no other reason than stock price is (supposed to be) a forward-looking measure, and financial performance is backward looking. Lots of academics seem to have trouble grasping this distinction.
³ And paying Joe 30–50% of his total compensation in unvested stock and options didn’t help much either. Sure, he had to stick around to cash it in, and therefore he was concerned with the continued existence and good stock price performance of his employer, but neither of those things are much that Joe, or anyone else not in the executive suite (and sometimes even there), can do much about. Long-term stock compensation is a pretty weak disincentive to risk-taking; producers like Joe focus much more on booking huge profits—and hence huge bonuses—right now, and devil take the hindmost. I confess I have occasionally argued the opposite side of this too strenuously in the past.

© 2012 The Epicurean Dealmaker. All rights reserved.

Twilight of the Übermenschen

This is the true joy in life, the being used for a purpose recognized by yourself as a mighty one; the being thoroughly worn out before you are thrown on the scrap heap; the being a force of Nature instead of a feverish selfish little clod of ailments and grievances complaining that the world will not devote itself to making you happy.

...

Beware of the pursuit of the Superhuman: it leads to an indiscriminate contempt for the Human.

— George Bernard Shaw, Man and Superman

* * *

Steven Davidoff opens a recent piece at The New York Times DealBook blog with the following words:

Reputation is dead on Wall Street.

This is powerful language. What does he mean?

Well, for one thing he means that the reputations of individual investment banks are no longer coterminous with the reputations of their executives and employees. He ascribes this to the tremendous growth in scale and complexity of financial markets over the past three decades:

Today’s Wall Street is not the Wall Street of 1907 when J.P. Morgan single-handedly used his reputation and wallet to stem a running financial panic.

Until the 1980s,... Wall Street was made up of traditional partnerships. These were small groups of investment bankers who represented companies in offering and selling securities and occasionally acquisitions. These bankers put their individual reputations on the line, because there were so few of them. Morgan Stanley, for example, had only 31 partners in 1970 and fewer than 1,000 employees.

But this began to change in the 1980s. Trading markets became much more sophisticated, and trading and brokerage became the investment banks’ primary business. This is a technology game. The better the technology, the better the trading and brokerage operation. Individuals became less important.

The growth of more complex capital markets and a global economy also created much larger financial institutions. Morgan Stanley now has more than 62,000 employees. These banks could use their assets and position to compete in the market for finance and trading. Again, individuals were less important as size dominated. A client now trades or does business with a bank based on its positions or ability to make a market or loan. The executive at the bank executing the transaction is unimportant.

In one respect, this is true. Lazard is no longer Felix Rohatyn. Goldman Sachs is no longer Sidney Weinberg. The First Boston Corporation is no longer Bruce Wasserstein and Joseph Perella. But this is old news. All those investment banks (or their successors) have become institutions in the sense that no one larger-than-life personality defines its image, its reputation, or its capabilities.

Professor Davidoff also points out the inverse: that an individual's reputation is no longer irrevocably tied to that of his or her current or previous employers. Both of these observations make intuitive sense. The tremendous scale of large global investment banks normally renders one individual too small and insignificant to make much of a difference. Rarely does a customer deal with one person when they transact with an investment bank nowadays; there are teams and teams of faced and faceless individuals who do a client's bidding. Even in the case of senior executives, who arguably should make a difference and presumably direct and/or set the tone of their firm's operations, the organization is too large and diverse to imbue most individual transactions with significant impact on those executives' reputation. Most customers nowadays are smart enough not to lay the blame for every botched JP Morgan mortgage at Jamie Dimon's feet.

In fact, investment banks have followed the lead of the rest of Corporate America and become brands. This is simply a natural evolution of the economy, in which people no longer purchase goods and services based on the local, individual reputation of a merchant known directly to them. Brands separate reputation from individuals and make it portable across geography, time, and whoever happens to be preparing your Jamba Juice across the counter. Some investment banks—notably Goldman Sachs in the 1980s and 90s—used to make a concerted effort to sublimate individual bankers' reputations and even identities to that of the mothership. Others cultivated the star culture, to greater or lesser success. But now, even a well-educated insider would be hard pressed to identify a material number of individual superstars on Wall Street. Every bank has become a brand first. In my business nowadays, the name on your business card that matters most is not yours; it's the name of your employer.

* * *

But the Professor's description of investment banking is incomplete. If superior technology and gobs of capital were all it took to compete, my industry would have been taken over years ago by the lumbering behemoths of commercial banking. They have always been bigger than investment banks, have much more capital, and have plenty of money to spend on technology and plenty of experience automating financial transactions. And yet the past few decades are littered with examples of huge commercial banks—mostly foreigners—spending lavishly to buy their way into investment banking, only to trip over their own genitals and transfer billions of shareholder euros or yen into the pockets of footloose investment bankers (and thence to their wives, mistresses, and Maserati dealers). Where investment banks and commercial banks have successfully merged, it has almost always been the case that the investment bankers came out on top.

Furthermore, if automation and capital were the only factors which mattered, we should expect to see much more price competition among investment banks than we do. For, as I have mentioned in these pages many times, virtually everything investment banks do is highly commodified. There is almost no transaction, product, or service that Goldman Sachs can deliver to their customers which Morgan Stanley, JP Morgan, or any number of competitors all over the globe cannot deliver that is indistinguishable in terms of perceived quality and actual price. This is particularly true in the areas which Professor Davidoff focuses on for his examples: capital markets lending, underwriting, and trading. We can't even distinguish our product offerings by flavor, like Coke and Pepsi can.

Finally, Professor Davidoff's image of global investment banks as well-funded, highly automated factories staffed by faceless automatons fails to answer a nagging question: Why do investment bankers make so much money? If labor is so interchangeable and replaceable, how come 50% or more of revenues in my industry has historically gone and continues to go toward compensation? If we bankers are so meaningless to our customers, how are we able to skim so much cream off the top? Do not forget that the average Goldman Sachs employee makes roughly ten times the median income of a family of four in this country. And there are plenty of clerks, washroom attendants, and janitors in that average. The average investment banking professional—supposed faceless cog in a vast financial factory—brings home pay which would make the average pasha blush.

If superior technology and vast capital were all that mattered, the Gucci-clad wage slaves would not be bringing home so much of the bacon. If something else wasn't at work, investment bankers who sell non-proprietary, commodified financial services like leveraged loans, equity underwriting, and, yes, even mergers & acquisitions advice would get paid like glorified bank tellers; that is, like corporate lending officers. The only ones who would make any serious money in such a firm would be the topmost executives and the shareholders, just like most of the rest of Corporate America.

Why isn't that the case? Because Professor Davidoff has missed the key, defining feature of investment banking which differentiates it from other financial activities, which provides the "value add" that our customers are so willing to pay so much for, and which explains why labor captures so much of the firm's value. He has missed the fact that investment banks are not factories.

Investment banks are networks.

* * *

I have made this point many times 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.

When our clients ask us to underwrite a debt or equity offering, they want access to our network of contacts among buy side investors and our network knowledge of the capital markets. When counterparties trade financial instruments like securities and derivatives with us, they want access to the breadth and depth of our trading network and the capital of our trading counterparties and our own proprietary books. When a client asks us to advise them on a merger or acquisition, they want access to our network of potential buyers and sellers and our network knowledge of the M&A markets in their industry. Networks are absolutely central to the power and value which investment banks bring to their clientele. It's what we're selling.

And networks lie at the nexus of the conundrum we have been considering. For having a differentiated network in a particular area can enable a bank to distinguish itself from its competitors. While any bank can underwrite an initial public offering, a bank which develops a reputation for being the best at, say, health care IPOs can attract new business and maintain market leadership in that area. The peculiar power of networks is well known: they derive their power and effectiveness from their completeness, breadth, and depth. And these features make it easier to attract new connections into the network to make it stronger. Network strength builds upon itself.

The other particular feature of networks is that they consist of interconnections made among nodes. A moment's thought will convince you that, in the case of networks comprised of constantly changing information and personal relationships, the nodes of an investment banking network are its people. Investment bankers are powerful—and get paid a lot of money—because they are custodians of their firm's power: its networks. You simply cannot automate the most interesting market knowledge or access to external aggregations of people and capital which are constantly forming and reforming, much less the personal relationships and insights which most of these are based on. Furthermore, that knowledge is portable. If a banker ups and leaves, he or she takes his or her network of contacts, knowledge, and relationships with him or her, usually to a competitor.

This is the source of the peculiar tension between individual investment bankers and the "platforms" from which they operate. Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.

* * *

So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.

One last thing is worthy of note. The network of relationships and market knowledge which each investment banker carries is a local one; that is, it is limited in scope and power to the industries or markets he or she participates in. My knowledge of M&A, capital markets, and the participants and dynamics of Industry X is valuable to my clients in that industry, but it is largely meaningless to a proprietary trader on my firm's govvie desk or a structured products banker packaging and selling mortgage derivatives, much less to their clients or customers. This has always been true. What has changed is that banks have gotten so big, global, and interconnected that the network of any individual employee—no matter how prominent—has become incrementally less important to the overall picture.

Which is only to say that, were he to work at a big global investment bank today, living legend and networker extraordinaire Felix Rohatyn would probably be just another schmuck with a corner office.

Of course, he'd probably be paid a lot more, too.


© 2011 The Epicurean Dealmaker. All rights reserved.

For Every Action ...

Christopher Columbus: "Hello there, hello there. Heh, heh. Ahh ... We white men. Other side of ocean. My name ... Chris-to-pher Co-lum-bus."
Indian chief: "Oh? You over here on a Fulbright?"
Christopher Columbus: "Hah? Uh, no, no. I'm over here on an Isabella, as a matter of fact. Which reminds me: I wanna take a few of you guys back with me in the boat to prove I discovered you."
Indian chief: "What you mean, discover us? We discover you."
Christopher Columbus: "You discovered us?"
Indian chief: "Certainly. We discover you on beach here. Is all how you look at it."
Christopher Columbus: "Ah, I never thought of that."

— "Columbus Discovers America," Stan Freberg Presents the United States of America, Vol. 1: The Early Years

It looks like Alistair Darling is going to have a quiet Christmas.

The UK finance minister unveiled a nasty Christmas surprise for bankers in the City yesterday: a 50%, non-deductible tax on discretionary bonuses in excess of £25,000 (or $41,000), to be levied against their employers' net income. This scurrilous government attack against chalk stripe suits, Soho strip clubs, and London property values landed with a sickening thud in Old Blighty. Many a banker's wife summarily cancelled their holiday plans and started contacting real estate agents in Geneva.

Today, Nicolas Sarkozy of France had the unmitigated gall (Unmitigated Gaul?) to pile on with a parallel policy proposal for his country's budget and an editorial in The Wall Street Journal, co-authored with famously dyspeptic Scot Gordon Brown. The fact that France agrees with the UK and is proposing a similar policy is proof positive that either La Republique has been secretly taken over by a stunted Englishman pretending to be French or the UK's Labour government is so desperate to retain power that it's turning Gaullist. Probably both.

In any event, the policy—as do all new tax policies at the end of the day—has triggered a desperate surge of scurrying about by bankers and banks, as they attempt to discover ways out of the trap. Their prospects do not look good.

London contacts report senior investment bankers stacked three deep on the pavement outside advisory boutiques' offices this morning, banging on the custom paneled mahogany doors to get entrance for interviews. One Vice President remarked he hadn't seen that many bespoke suits in one place since he stumbled into Gieves and Hawkes' basement storeroom on Saville Row by mistake. I predict independent UK advisors will quintuple their headcount by Christmas.

The bankers they don't hire will all get fired by their employers and rehired immediately with guaranteed bonuses—which are exempt from the new tax, for now—or put on retainer as fiendishly well paid independent contractors. The Freelancers' Association of Great Britain should see its membership rolls and dues receipts increase 10,000%, and HM Treasury will no doubt promptly reclassify it as a bank for tax purposes. The stately annual dance of new tax regulation, evasion, and counter-evasion will begin to resemble a cage match at the Ultimate Fighting Championships.

The only parties for whom this will be an unalloyed benefit will be tax lawyers, accountants, and corporate relocation specialists. Their spouses and families won't see much of them over the Christmas holiday, but at least they'll be able to console themselves with frozen rum punch and figgy pudding in £10,000-per-night suites on St. Barts.

* * *

Despite all the frantic squealing by outraged bankers, it is clear the UK government enacted this policy not to "recapture" excess compensation from individual employees through personal taxation, but rather to dissuade banks from paying more than nominal bonuses at all. Instead, it wants them to use the money they save to bolster their weakened balance sheets. Chancellor Darling could not have been clearer:

“I’m giving them a choice. They can use their profits to build up their capital base, but if they insist on paying substantial rewards, I’m determined to claw money back for the taxpayer,” he said.

And, as the following little spreadsheet indicates,¹ he plans to do this by making banks choose between their employees and their shareholders:

Given a hypothetical bank with operating profit before discretionary compensation of one million pounds and one employee which management intends to pay half a million quid, the three rightmost columns show the effect on both employee and net income under the new policy under three different scenarios. Under the first, "equal bonus" scenario, the employee still walks away with his £500,000 pre-tax bonus, but instead of earning £360,000 as before, shareholders take a 66% hit to net income, to £122,500. Under the second, "equal net income" scenario, bank management preserves shareholder income at the pre-policy level of £360,000, but the banker walks away with 39% fewer pre-tax shillings. Finally, in the third, "equal pain" scenario, the bank tries to share the pain of the new policy equally between employees and shareholders, and each take a 24.5% hit to their earnings.

Of course, a stubborn bank could go right ahead and pay full discretionary bonuses to its employees, and under the new policy HM Treasury would drain half the excess straight out of the bank's equity account. This hardly seems conducive toward strengthening capital ratios in the financial sector, however. Presumably the government is relying on bank shareholders to scream bloody murder should management try this, not to mention bank creditors, who will scowl with disapproval as their obligors' creditworthiness looks to sneak out the door to a Ferrari dealership in the pockets of its employees.

Interestingly enough, this scenario is also one in which HM Treasury maximizes its own tax receipts, from the personal income and National Insurance tax paid by individual bankers on larger bonuses plus the direct corporate tax on excess bonuses. The silly thing about such a scenario, however, is that the UK government would be far more likely to have to plow its higher tax revenues right back into the newly weakened banking sector in the form of more direct support. Talk about a "doom loop."

Another complicating factor in this whole discussion is that employees often make up a substantial portion of their employer's shareholder base, especially at investment banks. At the extreme, if a bank had only one employee who also happened to be the sole shareholder, a proper tax minimization strategy would be to forgo a discretionary bonus entirely and book that amount into net income. This is because the standard UK corporate rate of 28% is far less punitive than the new 50% top personal rate for high earners, plus National Insurance deductions. But how would Mr. Eddington-Smythe pay his local grocer? Borrow money from his employer, perhaps? Oops, there goes the leverage ratio again.

* * *

On this side of the pond, the evil genius cephalopods at Goldman Sachs have come up with a different approach. The firm announced today that its 30 top executives will take all their discretionary compensation this year in the form of restricted stock, which they cannot sell for five years.

In principal, this strategy actually makes more sense than the UK tax policy does in terms of bolstering banks' and investment banks' balance sheets. For one thing, it implicitly acknowledges that a bank probably should pay something more than a £25,000 bonus to highly productive employees if it expects to keep them, and it puts no explicit upper limit on that pay. For another, it conserves the gajillions in cash a bank would otherwise pay out in bonuses and replaces it with common stock, and unvested common stock at that. That bolsters both the cash and shareholders equity accounts by the amount of deferred bonuses and strengthens the company's credit position. Furthermore, as I have pointed out before, bankers who receive deferred stock compensation are the best kind of shareholders to have, from a credit standpoint, because they are involuntary, long-term providers of permanent capital. No high frequency traders, these.

However, it's worth noting that as announced this policy only applies to the thirty Executive Committee members at the Squid. So, while it may conserve $300 or so million extra cash which would otherwise have been paid out as the cash portion of these executives' bonuses under prior policy, it says nothing about the up to $10 billion in cash which could presumably get sucked out the window in the pay packets of its non-executive employees. As a public relations stunt, and a sop to Congressmen and other populists on the warpath, it is genius, and Lloyd Blankfein and the other 29 sacrificial lambs probably have enough liquidity to weather the privation. But as a credit bolstering event for Goldman Sachs, it probably nets out close to a wash.

In addition, Goldman's new policy carries a real cost, too: increased dilution for non-employee shareholders. For, as our hypothetical little exercise above should have illustrated, there is a natural struggle over the spoils within a bank between its employees and its outside shareholders. The Goldman announcement makes no disclosures on this topic, but I can assure you top management is having heated discussions with major shareholders right now over just how many basis points of net revenue will go to investors and how many to the hired help.

* * *

This argument may be quite interesting to the parties involved—and their wives, mistresses, and household staff—but it has little practical import for those of us on the outside looking in. In fact, strong arguments can and have been made that an excessively large portion of the filthy lucre Goldman and other US banks' investors and employees are arguing over this year doesn't properly belong to them. A huge portion of the outsize sales and trading profits which have been fattening domestic banks' income statements is due to cheap funding provided both directly and indirectly by the government, direct subsidies from the US taxpayer, and the selective elimination of industry competitors through direct and indirect government action during the height of the financial crisis.

People who object to this situation claim the only sensible thing to do is for the taxpayers to claw back a chunk of these profits in the form of a windfall profits tax. Properly designed, such a tax would be levied against operating profits before compensation expense. Then, taxpayers would get back a portion of the outright subsidy they have been handing to the bankers, and bank employees and outside shareholders would be free to squabble over the remainder. The biggest challenge here, of course—apart from worrying about how to prevent politicians from making a temporary windfall profits tax permanent—would be to determine the proper amount of subsidy, and hence tax, to recover. The answer will always be somewhat arbitrary at the end of the day, but there is no reason a sensible number could not be figured out by a couple of accountants with a calculator and a bottle of scotch.

* * *

In any event, the policy tensions both here and abroad are clear: do we want banks to reduce employee payouts, retain capital, and bolster their weakened balance sheets, or do we want reparations of unearned, "excess" profits in the form of corporate, personal, or windfall profits taxes to the public purse? For conundrums like these, we have few instruments available except tax policy. But tax policy is a blunt instrument, and it acts on the economy a lot like a water balloon: every time we squeeze one end, the other end swells up bigger than before.

Moreover, I am sad to say that all available evidence seems to indicate our water balloon is a whoopee cushion, too.

¹ Please, please, UK types—especially accountants and tax advisers—cool your jets. I know this example is a gross oversimplification, and it simply does not reflect all the relevant details, the intense value added which you and your firm can bring to the discussion with your extensive expertise, blah, blah, blah. It is meant to illustrate a relatively simple point, for which task I believe it is perfectly adequate. As usual, regular readers of this site know not to take my scribblings seriously in any respect, much less in the cloistered thickets of taxation and accounting.

© 2009 The Epicurean Dealmaker. All rights reserved.

Character Study

Alfred Pennyworth: "A long time ago, I was in Burma. My friends and I were working for the local government. They were trying to buy the loyalty of tribal leaders by bribing them with precious stones. But their caravans were being raided in a forest north of Rangoon by a bandit. So we went looking for the stones. But in six months, we never found anyone who traded with him. One day I saw a child playing with a ruby the size of a tangerine. The bandit had been throwing them away."
Bruce Wayne: "Then why steal them?"
Alfred Pennyworth: "Because he thought it was good sport. Because some men aren't looking for anything logical, like money. They can't be bought, bullied, reasoned or negotiated with. Some men just want to watch the world burn."

— The Dark Knight

I have argued elsewhere at length that the bulk of commentators and regulators confronting the Panic of 2008 and its aftermath put far too much emphasis on the supposed causal effect misaligned compensation incentives had on these events. While these no doubt added to the problem in some instances, for the most part the focus on banker pay is poorly judged. Some of this error can be laid at the foot of natural envy, but some of it can be attributed to a fundamental misreading and simplification of the investment banker's character.

People continue to be excessively worried about investment bankers who are greedy, grasping, and covetous. Bankers who think of nothing but money. Bankers who are just like Joe and Ethel Sixpack, only richer, more ruthless, and less constrained by conscience.

But these are not the bankers we need to worry about. These bankers—who, make no mistake, do indeed exist—can be bought. If we cannot chase them out of too-big-to-fail banks where they make stupid or greedy decisions that harm our society and economy, we can encourage them to repay our bailouts to get out from under our yoke. These bankers are easy. We understand their greed and motivation, because it is essentially logical, and most of us share the same motivation to some degree, if only in paler, more attenuated form. These bankers are no challenge whatsoever.

But anyone who has spent real time in the trenches of investment banking knows that this description does not come close to exhausting the character of its practitioners. There are people in the industry who, when you get right down to it, have no real interest in money. People who couldn't give a flying fuck in a rolling donut whether they make $3 million, or $10 million, or $100 million a year, as long as they make more than the next guy. People who look at income, and bonuses, and aggregate net worth as a scorecard in the great game of life. People who want to make the most.

Or, those rare birds who do the business because they love it, because it's there, and because they can. People like a mentor I used to have who never should have worked a day in his adult life, according to any normal person's calculus. Someone who married into vast wealth, but who spent thirty years in sweltering Boardrooms, shitty motel rooms, and executive committee meetings which would make a dockside knife fight in Calcutta look like afternoon tea with the Queen of England because he loved the work.

Finally, do not forget the psychopaths.

Do you really think some bureaucrat's compensation limits are going to effectively constrain such people? Do you really think they will care? (I grant you, most of their wives will care. But that is what mistresses and prenups are for.) They will bitch and complain, but at the end of the day they will commiserate with compatriots over a 20-year single malt and a Cuban cigar and say "Fuck it." After all, most of these veterans were happy making 50%, 60%, or even 70% less money doing the same damn thing twenty years ago before Alan Greenspan turned on the liquidity spigot.

At best, Kenneth Feinberg's compensation rules for the seven TARP firms and the Fed's proposed guidelines on pay for the entire industry might chase out the opportunistic rabble who poured into the industry over the last decade to take advantage of its well-advertised pay and growing social prestige. People who, in other times, would and have flocked to law, or medicine, or technology startups and who, like rats off a sinking ship, will swarm onto another platform as soon as Michael Porter, or Seth Godin, or Sergey Brin identifies it for them.

Goddamn sheep. Extraordinarily well paid, well-dressed, and well-coiffed sheep, but sheep nonetheless.

Good riddance to them, I say. Let them go "add value" to some other poor misbegotten segment of society. Just watch your wallet when they show up on your doorstep.

* * *
But once these johhny-come-latelies leave, who will remain? I'll tell you who: people against whom your pitiful, transparent little compensation levers will have no effect whatsoever. People who do the business because they love it, because they are good at it, and because there are only so many slots open in the natural ecosystem for pinnacle predators, and the Great White Sharks and Polar Bears got most of them first.

People who will work with their counterparts in law, accounting, taxation, and Corporate America to extend the edge of the envelope and push the legal and regulatory barriers as far as they can go, because that is what they are paid to do and because they can. Because they are smart enough, and driven enough, and because they love the game. Because they take pride in their work. Just like any goddamn pipefitter.

These people are dangerous because they are smarter than you, because they are smarter than any regulator likely to be sent to control them, and because they hold in their hands the map and the controls to the vast and intricate system of pipes and valves which undergirds the global economy. Give them any reasonable set of legal and regulatory constraints—more stringent than the recent past, by all means, I implore you—and they will happily adapt and innovate around them in the future. Push them, and box them in, and reinstate Glass-Steagall if you must: they will grumble, but they will get over it.

But can you imagine what would happen if you pressed them too far? If you tried to turn the entire financial industry into a bunch of unionized, rule-bound clerks? These are personalities who do not go gentle into that good night. All you would need would be for one or two of them to decide they would rather watch the world burn than crawl into a hole.

And believe you me, you do not have enough water to put out that fire.

Not that I'm making threats, or anything. I am a reasonable man.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part IV

Westley: "Who are you? Are we enemies? Why am I on this wall? Where is Buttercup?"
Inigo Montoya: "Let me 'splain. ... [pause] ... No, there is too much. Let me sum up."

— The Princess Bride

* *

EDITOR'S NOTE: This is the fourth and final installment of a multi-post treatise on investment banking compensation. Previous entries include:

• Part I: Investment Banking, A Love Story, about the evolution of the industry;
• Part II: The Right Hand of Doom, about the drivers and structure of banker pay; and
• Part III: Seed of Destruction, about risk factors and risk management in the industry

This post attempts to tie together the preceding entries and come to some sort of reasoned conclusions. Fasten your seatbelts.

* *
— Part IV: Darkness Calls —

We have covered a lot of territory already. Let me sum up.

Traditionally, investment banks acted as intermediaries or agents for wholesale capital markets transactions, not principals. As such, while they did perform services that exposed capital to risk, traditionally these risks were of short duration, relatively small, and very well contained. Risky activities such as these are concentrated on the capital markets (or sales and trading) side of the business, and consist of using the bank's capital on a temporary basis to facilitate securities issuance or securities trading by their institutional customers. Due to investment banks' privileged position at the nexus of market flows and information and their ability and inclination to trade rapidly in and out of positions, banks have historically been able to conduct such business pretty successfully using relatively small amounts of equity capital.

Because their business is designed to make money off the flow and volume of transactions in the marketplace, rather than off sustained price appreciation or direct investment, investment banks have a business model and a culture which focuses almost exclusively on chasing transaction fees, or revenues. Since markets are often volatile, and revenue opportunities are fleeting, there is an institutional bias within investment banks to chase and book revenue first and worry about consequences later. With its low fixed salary component and theoretically unlimited upside incentive bonus, compensation for revenue-producing investment bankers is explicitly designed to encourage this pursuit.

On the other hand, investment bankers historically were very good at managing their business risks. Capital markets risk used to be managed by senior partners who had been traders themselves, and who had complete visibility and understanding of the risks in the bank's trading book.¹ Encouraging and supporting this hands-on supervision was the fact that senior trading partners typically had a major portion of their own personal wealth tied up in the equity capital of the firm, along with that of senior management and other partners. Accordingly, risk management was a very high priority for all of the firm's key decision makers, and it acted as a powerful and effective brake on the countervailing tendency for bankers to pursue revenues at all costs.

Using this time-tested model, traditional investment banks used to do pretty well for themselves. They ate what they killed, feasting in times of plenty and tightening their belts in times of famine. Because the bankers were the owners of the firm, they kept a pretty tight balance between revenue generation and capital preservation. Accordingly, firm-threatening or -ending mistakes were rare.

But this was not a model suited to rapid growth or global scale. And as the capital markets continued to grow, and the global economy became more connected, the old partnership model of investment banking began to disappear.

* * *

In its place arose large, publicly-owned global investment banks and—with the gradual erosion of Glass-Steagall barriers between commercial and investment banking—large, integrated "universal" banks. Banks funded their expansion with increasing doses of outside capital—other people's money—and merged and acquired their way to greatness with their peers. Unfortunately, with increased scale many of the built-in checks and balances of the partnership model began to break down.

Large public banks did retain much of the partnership compensation model, which deferred ever more of a banker's pay the higher up he got and the more he made. But keeping risk management a central concern for every banker was never a principal reason for this. Instead, banks were much more concerned with preserving cash and attempting to lock up bankers with deferred equity so they could not leave for a competitor. More importantly, deferred pay lost its effectiveness as a distributed risk management tool. As investment banks grew ever larger and more complex, each banker had less and less impact on the overall results and health of his bank, almost no matter how much he made. A banker's deferred equity nut began to look more and more like a ball and chain, rather than a direct link and meaningful incentive to control the overall risk of his employer.

Exacerbating this was the professionalization of risk management at large investment banks. As banks got bigger, and their trading books swelled with ever more complex securities, grizzled old traders with big equity stakes in the firm no longer had the experience or the bandwidth to monitor their underlings' trading positions. Instead, professional, dedicated risk managers—who often came from a structuring or academic background, not sales and trading—took over the role of trying to say "enough" or "no" to the hotshot revenue producers. Given the revenue-worshipping culture embedded at the core of every investment bank, such a system was bound to fail, as the big swinging dicks with real skin in the game ignored, bullied, or coopted the sniveling little (equity-less) PhDs sent to rein them in.²

Adding to the problem, the only people with enough skin in the game and the power to do something about firm risk—senior executives—became increasingly beholden to outside public shareholders. Because most of these outsiders were big, diversified institutional investors, they had an even more aggressive risk posture than the investment bankers themselves.³ They pushed the bank CEOs and Boards for ever more growth and return on equity, and the senior executives, being investment bankers who worship at the altar of revenue anyway, complied.

Finally, the growth in investment bank balance sheets and the increasingly complex securities either demanded by customers or manufactured "on spec" by revenue hungry bankers led to increasing concentrations of opaque and badly understood risk in many banks' trading books. Market making shaded into speculative trading, which morphed into full-blown proprietary trading (and even internal hedge funds at some banks). Investment banks began to accumulate—apparently without their full knowledge—poorly understood contingent obligations that hinged upon their traditional market-making role as buyer of last resort for securities they underwrote. Risk seems to have been misunderstood and significantly underestimated by almost everybody in the financial markets, but when the shit hit the fan, investment banks were uniquely positioned to have most of it blow right back onto them.

Of course, increasing leverage and lax regulatory oversight played a role, too. But leverage acted as an accelerant and a conduit for contagion across market sectors, and sloppy supervision added to the general haze of ignorance and the thicket of unintended consequences. Neither was the ultimate source of the breakdown in the financial markets. Had they not been present, the fire might not have spread so quickly or so broadly. But make no mistake: the fire would have started anyway, and it still would have burned down a pretty big swath of the financial forest.

* * *

So, what can we conclude from all this?

Well, for one thing, the need for traditional investment banking services—intermediating capital flows and financial transactions for all comers—is not going to go away any time soon. It is simply impractical to imagine a world without investment bankers, no matter how eagerly the torch and pitchfork crowd would love to do so. But it seems to be a somewhat paradoxical business, one best suited to entities which combine extremely aggressive pursuit of revenues with a highly developed aversion to risk. The old partnership system, where the revenue producing bankers were also the owners and providers of equity capital, seemed to work pretty well. The currently much-maligned system of investment banking compensation is a relic of that earlier time, but it does not seem to balance these tensions well in today's huge, publicly-owned global investment banks.

Instead of the old integrated risk model, we now seem to have one where outside investors have high risk tolerance, revenue producing employees have low risk tolerance but cannot effectively influence it, and professional risk managers tasked with controlling it are politically and economically disenfranchised. This is not an unavoidable outcome of the current model, but it certainly makes the whole system far more difficult to manage. Unfortunately, there is absolutely no way to recreate entities the size of Goldman Sachs or Citigroup with purely private partnership capital. Even if you could, I am not sure you could avoid the span of control, scale, and complexity issues bedeviling these enterprises.

One solution, of course, is to shrink investment banks down to a more "manageable" size, whatever that means. The immediate question this raises, however, is whether such smaller banks could perform their systemic function in today's highly integrated global financial system adequately. The next question, if we determine they cannot, is whether we would miss them. My crystal ball is too cloudy to offer an opinion on that one, although I can guess what Matt Taibbi would say.

* * *

In any event, I hope I have convinced those hardy souls who have soldiered along with me this far that investment banking compensation was not the sole source of our current troubles. It is part of the puzzle, make no mistake, but it is not the only piece. Therefore, fixing it and nothing else will not right the ship.

Notwithstanding what legions of indignant and self-righteous commentators contend, the incentive system currently in place operates exactly as most of them propose: a large portion of banker pay is deferred for years and is tightly tied to the overall health and success of the firm. Bankers are not incentivized to print huge risky trades and run away as soon as they collect their bonus at the end of the year. In fact, they are more closely tied to the long-term health of the firm and its stock price than any other stakeholder. They just can't do anything about it. Unfortunately for them and for us, such a system does not seem to have prevented anything.

Perhaps a solution could be structured which balances all of the competing pressures and strains that the modern investment bank encounters. It would be complicated, involve multiple variables, and require constant monitoring, adjustment, and correction to adapt to ever changing market conditions. It sounds like a fun project for Larry Summers and crew.

Sadly, they never taught multivariate optimization techniques on the savannah when I was coming up in the business. I guess I'll just sit here, gnawing a wildebeest bone, until somebody tells me what to do.

— THE END —

¹ Capital markets activities are the only significant source of firm-wide risk for the traditional pure investment bank.
² This was made worse by the fact that the huge expansion in most banks' capital markets operations during the Great Moderation meant that Capital Markets grabbed the political reins of power from their partners in M&A and Corporate Finance. (Investment banks allocate power based on the Golden Rule: He who brings in the gold gets to make the rules.) Since M&A and Corp Fin bankers enjoy little direct upside from increasing sales and trading revenues but face a lot of downside if sales and trading blows up, they tend to be strong advocates for clear risk limits and controls in the trading book. But the traders were the ones bringing home most of the bacon, so M&A and Corp Fin bankers had no choice but to shut up and view the ballooning risk with increasing disquiet.
³ If Fidelity or another outside investor got worried about Lehman Brothers, they could (at least theoretically) sell all their shares. Dick Fuld and most of the other bankers at Lehman had to watch helplessly as a lifetime's worth of deferred compensation evaporated into thin air when the firm collapsed.

Photo credit for the series: Nathan Myhrvold's 2007 photo essay on lions in Botswana, Africa. Warning: blood, gore, and sex galore. Now do you see the connection?

© 2009 The Epicurean Dealmaker. All rights reserved.