Fooled by Arrogance

Where are all the good men dead
In the heart, or in the head?

— Grosse Pointe Blank

Nassim Nicholas Taleb is at it again.

Apparently he was not content simply to inflate an interesting and thought-provoking little metaphor for our habitual blindness to randomness into a globe-straddling causal mechanism explaining the entire social, cultural, and economic history of the human race, as well as all the most interesting bits of our personal lives.¹ No, our one-man Black Swan licensing machine and talk show bête noir has now turned to pontificating on public policy.

The results, I am sad to say, are less than illuminating.

Were I more confident of Mr. Taleb's capacity for self-criticism and self-awareness than his writings and public appearances have led me to be, I might point him to the credo he so proudly displays on his own website and homepage [emphasis his]:

"My major hobby is teasing people who take themselves & the quality of their knowledge too seriously & those who don’t have the courage to sometimes say: I don’t know...." (You may not be able to change the world but can at least get some entertainment & make a living out of the epistemic arrogance of the human race).

Based on this avowal, it does not strike me as too cheeky to suggest he make a little fun of himself.

I will not hold my breath.

* * *

Mr. Taleb spends the bulk of his time on the soapbox stomping rather loudly and self-importantly over the well trodden ground of what he calls the trader's "free option," the allegedly mismatched and corrupting compensation scheme which Yves Smith calls the "heads I win, tails you lose" syndrome. As certain members of the sniping class have observed, this is somewhat akin to announcing that the sky is blue, or, perhaps more aptly, that Adolf Hitler was a very naughty man. Few people nowadays will be a) surprised or b) tempted to disagree with you.

I have written on this topic before, as well, and usually not sympathetically. Nevertheless, while I am not now nor have ever been a trader, and while the bulk of my career as an investment banker has generally been spent at various kinds of loggerheads with traders—either because they have not given me what I want, or have seized political power from me and my kind at my employer, or have torpedoed my annual bonus with yet another one of their boneheaded trading mistakes—I would like to take this opportunity to mount a little defense of traders and their compensation system. In all fairness, I believe that a little clarification and correction of certain misconceptions furthered by Mr. Taleb and his fellow travelers is called for at this juncture.

First of all, for those of you who have stumbled onto this site from Perez Hilton and who have no conception what a "trader's option" is, I offer the following brief explanation. Traders at commercial and investment banks (and elsewhere) trade stuff for a living. They buy, they sell, they cross-breed CDOs with Persian longhaired cats—whatever. At the end of the year, their boss totes up the profit and loss in their trading book to see how much money they have made (or lost) for the bank. If they made a lot of money—let's say $250 million—they will usually get a big bonus—let's call it $10 million, just for laughs. If they lost a lot of money—for symmetry, let's also call it $250 million—they usually get a $0 bonus and a swift kick in the pants out the door toward the unemployment line.

This is why people call it an option: the trader gets an asymmetric payout depending on his results: $10 million if he wins, and bupkus if he screws up. His bank, on the other hand, unfortunately has a roughly symmetric payout: a $240 million gain before expenses and taxes if the trader wins, and a $250 million loss if he fucks up. Replace the term "bank" in the preceding description with "investor," and you have a general description of the dynamics of a trading operation. Traders, in their purest form, are simply employees, or agents, of their investors, who are the people who have the money to invest.

Now, a careful reader of the preceding will see that the provocative and tendentious characterization of this incentive scheme currently in vogue—"heads I (the trader) win, tails you (the investor) lose"—is not completely accurate. To be fair, one should characterize it as "heads both of us win, and tails you lose but I don't." The mismatch of returns is still there, and the trader still has every incentive to swing for the fences rather than play it safe, but it becomes more apparent why investors and banks have been willing to enter into this kind of bargain with traders from time immemorial.

It also should be clearer why a good trader—one who consistently makes money and avoids or minimizes losses—is worth his or her weight (and then some) in gold.² (At $1,000 per troy ounce, a consistently successful trader who weighs 185 pounds should clear the market for around $2,697,855³, by my calculations.) Adjusting for risk, good traders such as these are cheap. Every investor or bank with money to put to work should hire one.

* * *

Of course, "adjusting for risk" is not a trivial thing. A trader who makes $250 million a year trading a risk-neutral, matched book of stocks or bonds really is worth far more than his weight in gold, whereas a trader who made $250 million a year trading risky, long-tailed mortgage-backed securities should have been handled more like radioactive plutonium, at least in retrospect. It is also a measure of how efficient securities trading markets have become—thanks to the free-market, private enterprise magic of all those would-be $10 million a year traders competing for bonuses—that the former are practically extinct nowadays. This same efficiency is also why so many banks and investors looking for $250 million a year in profits per trader began gravitating toward riskier, more complicated markets which presumably compensated for their greater risk. It turns out, sadly, that many of them did not.

Now, given the differing motivations and incentives of pure traders and pure investors, there are really only two proven ways for the investor to control his trader's assumption of risk. The first is close supervision, monitoring, and control: the investor limits what securities and positions the trader can assume, he monitors daily trading activity and marks positions to market daily, and he intervenes when things go off the rails. This is the simplest model, and it is the one that used to obtain back in the dark ages before investment banks became large, externally funded, global trading houses. Yves Smith points out that this is the model the old Goldman Sachs partnership used to use, before it went public. There really is nothing better to keep some young Turk under control than some grizzled, grouchy old bastard seated next door who used to trade the very same markets you do and whose personal partnership stake you are trading for a living.

This model, as we have seen over the past 18 months, begins to break down when the span of control gets too broad and the chain of supervision becomes too attenuated, like it did in today's huge global banks. Complicated Value at Risk models and professional risk managers are no match for crafty and devious traders, particularly when the money they are trading belongs to some absent, passive institutional investors whom no-one gives a damn about. Markets are too fast today, and securities are too recondite, to make supervision at a distance very successful.

The second way for investors to control their traders' assumption of risk is to make them investors, too. Make a trader eat his own cooking, so to speak, and you will see a marked change in how he handles and assumes risk. The trader will supervise himself. After all, it's his money too. Many hedge funds do this, by paying their important traders in shares of their own trading book, or the overall book of the firm. Investment and commercial banks have been doing this for some time, too, by paying traders—along with everyone else—substantial portions of their annual compensation in long-vesting restricted stock of the firm.

The problem with this method is twofold. First of all, you need to make sure that enough of the trader's compensation and total net worth is tied up in this way; otherwise, he will just view unvested compensation as "house money" to play with, and he will have little incentive to care. The temptation to swing for the fences, or assume dangerous risks, will overwhelm any proprietary instincts for preservation of personal capital. Second, even if the trader has a substantial portion of his wealth tied to the overall results of his firm, the firm cannot be too big in relation to his stake, or he will feel that nothing he does will matter anyway. The rubber band tying his personal trading performance to the price or value of his employer's equity will be too elastic and contingent on the actions of others to act as a real incentive. This is the problem faced by large investment banks, where a trader holding even $50 million in unvested stock feels that nothing he can do—good or bad—will make a difference to the price of Citigroup stock.

Finally, neither of these methods controls for another importance source of trading risk: ignorance. It does not require a dishonest trader and an incompetent risk manager to screw up a trading book (although I am sure some instances of these happened). All it takes is for both of them to be honestly unaware of the real risks embedded in their positions. I think this fairly characterizes a helluva lot of the blowups we have been suffering over the last year and a half. It does you no good to have perfectly aligned incentives and top-notch supervision and control if both your trader and your risk manager haven't a clue about the risks they are running. Here Taleb and I converge a little, although I disagree with his implicit assumption that most traders consciously pursued short-term profits (and current bonuses) at the expense of long-term catastrophic risks. I think most of them just didn't know.

* * *

Pace Mr. Taleb's casual invective about invidious incentives and "capitalism for the profits and socialism for the losses," I am unpersuaded that he has come up with an effective solution to our current dilemma or even an accurate description of the problem. The trader's option and its variants have been the preferred method of compensating traders forever, even by banks and investors who are fully cognizant of the risks they entail. (And no, investment banks and commercial banks are not comprised entirely of traders, so their corporate interests and incentives cannot be so neatly identified with those of their traders.) Does he think he has a better way, one no-one else has thought of in the last 50 years? Please, don't keep us in the dark.

He wants traders and banks to be subject to disincentives that counteract the trader's option, citing as justification the claim that "[e]ntrepreneurs are rewarded for their gains; they are also penalised for their losses." But how, in fact, are entrepreneurs—and capitalist firms in general—penalized for failure? They lose their jobs, their investments, their savings, they go bankrupt. Which of these things has not already happened to multiple investment and commercial banks and perhaps hundreds or even thousands of individual traders and other investment bankers? Virtually all traders' incentives have been aligned with those of their investors for quite some time now. The fact that this did nothing to prevent the multi-car pile-up we are digging ourselves out of now gives me little comfort that the problem was misaligned incentives in the first place, and even less confidence that fixing it is a simple matter of designing "better" incentives.

He wants to nationalize "the utility part of banking," whatever that is, without specifying how government control would offer a better solution, rather than just an opening for the intrusion of politics into the relatively less compromised world of finance. Where would we draw the line around "utility" finance: commercial lending, retail lending, residential lending, commercial real estate lending, leveraged finance, asset-backed lending, securities underwriting, securities trading, insurance? How could we prevent contagion from the unnationalized bits—where, presumably, private banks would be free to succeed and fail relatively unconstrained—back to the nationalized ones? At what cost in efficiency, the price of money, political interference?

Those private individuals who commit their capital to the pursuit of risky returns, investors, pay taxes on their gains (at least most of the time). When they make money, we taxpayers benefit, and when they lose money, we taxpayers suffer, even if we are not investors ourselves. It is willfully shortsighted to deny that we already have an extremely robust, multifaceted system in this country for socializing both gains and losses from the activities of private capital. (Job creation, anyone?) It is appallingly disingenuous to assert that investment and commercial banks were the only entities which benefited from the multi-year credit bubble, and therefore should suffer disproportionately. And it is laughably ludicrous to compare military and security personnel—much less Roman legionnaires—to finance professionals. For the same reason I do not want to pay soldiers for the number of enemies they kill and security personnel for the number of threats they forestall, I do not want to pay a commercial banker for the number of loans he declines.

It is the height of epistemic arrogance to claim otherwise.

Back to the drawing board, Nassim.

¹ You think I exaggerate? I do not:

A small number of Black Swans explain almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives. Ever since we left the Pleistocene, some ten millenia ago, the effect of these Black Swans has been increasing. It started accelerating during the industrial revolution, as the world started getting more complicated, while ordinary events, the ones we study and discuss and try to predict from reading the newspapers, have become increasingly inconsequential. ...

Fads, epidemics, fashion, ideas, and the emergence of art genres and schools. All follow these Black Swan dynamics. Literally, just about everything of significance around you might qualify.

— Nassim Nicholas Taleb, 2007, The Black Swan: The Impact of the Highly Improbable. New York: Random House, p. xviii.

I am particularly impressed that Mr. Taleb can claim with confidence that these effects have been increasing since the Pleistocene. He must be older than he looks on TV.
² Good luck trying to figure out whether a "good" trader has generated superior returns because he is skilled, or just because he is lucky. Some people, channeling Napoleon, might claim that you shouldn't care: good is good. Then, even if you can figure out the source of his outperformance, decide whether you want to bet that his skill or his luck will continue in the future. That way lies madness.
³ Correction, 27 Feb 2009: A kind reader has gently reminded me that gold is priced in troy ounces, whereas humans are priced weighed in avoirdupois pounds. At approximately 14.583 troy ounces per avoirdupois pound, my previous calculation overpriced said trader by $262,145, for which you could purchase a couple of decent analysts or the services of a Ukranian hooker for a couple weeks. This sort of error is inexcusable: I abase myself before you for epistemic ignorance.

© 2009 The Epicurean Dealmaker. All rights reserved.

To Catch a Thief

I'm very well acquainted with the seven deadly sins
I keep a busy schedule trying to fit them in
I'm proud to be a glutton, and I don't have time for sloth
I'm greedy, and I'm angry, and I don't care who I cross

I'm Mr. Bad Example, intruder in the dirt
I like to have a good time, and I don't care who gets hurt
I'm Mr. Bad Example, take a look at me
I'll live to be a hundred, and go down in infamy

— Warren Zevon, Mr. Bad Example

Watching Barney Frank and the House Financial Services Committee attempt to grill the heads of the eight largest bank recipients of TARP funding in front of the cameras recently, I was reminded of a conversation I had with the Chairman of a very large and prestigious private equity firm several years ago.

It transpired at a small dinner party, held at the Chairman's summer home in the Hamptons. Wives, children, and sundry other non-combatants were present, so the occasion was strictly social. Nevertheless, amidst the introductory chit-chat, Your Humble Correspondent revealed the slightly tawdry fact that yes, he was indeed employed at a certain not-to-be-named investment bank and therefore responsible for all sorts of reprehensible behavior. The Chairman chuckled indulgently at that—being, by virtue of his own profession, no stranger to unarmed robbery—and turned the discussion toward those individuals at NTBN Bank whom we might know in common.

Naturally, being a relatively lowly worm in the vast and ever-expanding bowels of NTBN at the time, I could not profess close acquaintance with many of the senior grandees the Chairman was familiar with—people he knew from their frequent trips to his Midtown offices to lick his shoes—but I offered a diplomatic comment or two on a couple of them. I ventured that one particularly poisonous specimen was indeed extremely bright, successful, and ambitious, and we both agreed that he was blessed with quite a remarkable quantity of self confidence.

Apropos of nothing, the Chairman turned contemplative for a moment. Then, looking straight at me, he remarked that, in all his many years in the business, he had never met anyone who had risen to head an investment banking operation who possessed the least measure of humility. I think, in retrospect, this was his kind way of warning me away from ambitions above my station, given my deplorable failure in our conversation to claim sole credit, as a junior investment banker, for more than 50% of NTBN's annual earnings.

* * *

Since that evening, Dear Readers, I have become older, wiser, and more traveled in my industry, and I have seen nothing or no-one that disproves my old friend's comment.

In fact, I will go further and say that I have yet to encounter a senior executive manager at a large investment bank who does not demonstrate a very substantial number of the commonly accepted markers for psychopathy.

From Wikipedia:

Common characteristics of those with psychopathy are:

• Grandiose sense of self-worth
• Superficial charm
• Criminal versatility
• Reckless disregard for the safety of self or others
• Impulse control problems
• Irresponsibility
• Inability to tolerate boredom
• Pathological narcissism
• Pathological lying
• Shallow affect
• Deceitfulness/manipulativeness
• Aggressive or violent tendencies, repeated physical fights or assaults on others
• Lack of empathy
• Lack of remorse, indifferent to or rationalizes having hurt or mistreated others
• A sense of extreme entitlement
• Lack of or diminished levels of anxiety/nervousness and other emotions
• Promiscuous sexual behavior, sexually deviant lifestyle
• Poor judgment, failure to learn from experience
• Lack of personal insight
• Failure to follow any life plan
• Abuse of drugs including alcohol
• Inability to distinguish right from wrong

Looking back over my career, I can recall encountering individuals who were clearly destined from a very tender age for greatness in investment banking. With the exception of the tendency toward physical aggression and violence—investment bankers, as a rule, are the wimpiest and most cowardly of creatures, when it comes to nonverbal violence—and sexual promiscuity and deviancy—for which one only has the self-reported "evidence" of these supposedly superhuman young Lotharios—I find it hard not to ascribe some measure of all these characteristics to those individuals I know who have risen to high management responsibility within an investment bank.

As I have written elsewhere, investment banking is a business which both attracts and rewards individuals with cast iron egos who can stab their closest ally in the back minutes after buying them a drink. (Not everyone in the industry is like this—in fact, the vast majority are not—but the ones who claw their way to the top either are that way to begin with or become that way on the climb up.) People outside the industry decry its participants as slaves to greed, but the real truth is that money is primarily a measuring stick and an enabler for an investment banker's self worth. This is entirely consistent with behavior at the top, where we have seen senior executives grant themselves bonuses and guarantees so large as to be effectively meaningless, except as a way to keep score. This is narcissistic personality disorder writ large, and the nastier aspects of psychopathy are simply the tools necessary to survive and thrive in the free-for-all cage fight that is the executive suite of a major investment bank.¹

* * *

But if this is true, it poses a particularly tricky challenge to the government's new program to rescue and regulate the financial industry from the current economic crisis.

Careful watchers of the hearings this week will have noted that the US Congress came away from the proceedings at least as badly damaged as the investment and commercial bankers nominally on the hot seat. The hearing format—anodyne opening statements from the eight banks involved, followed by an apparently endless series of five minute time slots for Congressmen to fit moral outrage, political grandstanding for the constituents back home, and a couple of desultory questions into—was patently ill-designed to get to the root of the problems which have occurred and the culpability and behavior of the banks involved. Many Congressmen and women came off as woefully, even laughably ill-informed about the very basics of finance, much less the tortured intricacies of the securities, markets, and practices which led us into our current predicament.

In contrast, the bankers for the most part kept their cool, answered idiotic questions patiently, and avoided revealing any information that could be of real use magnificently. They came across as smooth, smart, and plausible.

Psychopaths.

* * *

Many observers of the smoking wreckage which now passes for our banking system have opined that, in addition to being hobbled by a fragmented regulatory system riddled with overlapping and ill-defined responsibilities, the regulators who were supposed to be watching the chicken coop were woefully overmatched by the foxes. Staffed primarily by lawyers, on government pay scales, the SEC almost by definition is not up to the task of monitoring Goldman Sachs, JPMorgan, or anyone else, if by "monitoring" we should expect true informed oversight and control. If Harry Markopolos couldn't get the SEC Enforcement Division to understand and investigate what appears to have been a particularly simple—if breathtakingly successful—Ponzi scheme, how can we possibly get comfortable that our government watchdogs can effectively oversee the hugely complicated, mind-numbingly sophisticated, globally distributed trading operations of a modern investment bank?

This shortfall in regulatory intellect has been exacerbated by what the Japanese call amakudari, or "descent from heaven": from time immemorial, a steady stream of former regulators has resigned their posts to assume positions on Wall Street, sometimes at the very firms they had been charged with overseeing. There is very little incentive to push a little harder or dig a little deeper into a question if it irritates a powerful firm that might be your future employer. Furthermore, this practice provides a steady stream of inside knowledge on current regulatory focus, practice, and ignorance that is of tremendous value to oversight-minimizing investment banks.

The answer, of course, is obvious, if politically difficult to put into effect. Staff the SEC, or whatever "Super Regulator" the government decides to deputize to oversee this mess, with a bunch of highly-paid, tough-as-nails, sonofabitch investment bankers. You will have to pay them millions, just like regular bankers. (You can tie their incentive pay to improvements in the value of securities held under TARP and TALF, if you like.) Pay them well, and investment bankers won't be able to treat them like second-class citizens at the negotiating table. Pay them like bankers, and your regulators won't hesitate to read Jamie Dimon or Lloyd Blankfein the riot act, because they won't give a shit about getting a job from them later.

Trust me, these are the kind of people you will need on your team: highly educated, financially sophisticated, psychotically hard-working, experienced professionals who know or can figure out CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit. Leading your enforcement and supervision teams you need a bunch of smooth, smart, plausible, grandiosely self-confident senior bankers who will not hesitate to tell Vikram Pandit to go fuck himself, his mother, and the cow she rode in on if he ever tries to fuck with the United States government, the US taxpayer, or the pizza delivery boy again. You know: psychopaths.

This is not a new idea. For yonks, the Brits have known that the best person to hire as gamekeeper on your ancestral estate is a former poacher, someone who knows what they know, how they think, and where to punch them in the genitals to get maximum negotiating effect.

Or, as I like to think of it, the best person to send to kill a bunch of mercenaries is another mercenary:

Roland the headless Thompson gunner
Norway's bravest son
Time, time, time
For another peaceful war
But time stands still for Roland
'Til he evens up the score
They can still see his headless body stalking through the night
In the muzzle flash of Roland's Thompson gun
In the muzzle flash of Roland's Thompson gun

— Warren Zevon, Roland the Headless Thompson Gunner

Sounds like fun. Where do I send my resumé?

¹ Fun fact: "According to DSM-IV (in a 1994 publication by the APA), Antisocial Personality disorder is diagnosed in approximately three percent of all males and one percent of all females." Hmm. Do you think this might help explain the persistent underrepresentation of women in investment banking? Come on, girls, get your freak on!

© 2009 The Epicurean Dealmaker. All rights reserved.

Five Pound Box of Money

Hey Santa Claus,
You want to make me happy this year?
Listen to me, honey:
Give Pearl something that'd be of some use to me, like a ...
Like a five pound box of money.

Now, now there’s a little gift
That’s loaded with
Lots of sentiment.
See, when uh ever I get blue, Santa,
I’m gonna think of you,
But at the same time have a little change to pay my rent, you see?

— Pearl Bailey, Five Pound Box of Money

Compensation, O Dearly Beloved, is a complicated thing.

I say this without fear of contradiction, because I have been thinking carefully about this subject for quite some time. In particular, I have been thinking and writing about compensation in the investment banking industry on this site for many moons, ever since a rag-tag collection of highly-credentialed yet woefully uninformed pundits began taking potshots at the source of my livelihood early last year. However, whenever I think I have the broad outlines of the conundrum clearly in my sights, I find that concentrating my attention on any one aspect of it tends to make the problem skitter away like mercury on a mirror. At other times, I feel like I am trying to nail jello to a wall.

In other words, Dear Friends, figuring out compensation is a bitch.

* * *

I should know this, of course, from my many years in the industry, both as a junior investment banker hanging breathlessly on some pompous Managing Director's pronouncement of the one number which represented the culmination of a year's worth of difficult, demeaning, and exhausting work and as one of those aforementioned MDs watching the frightened eyes of my junior bankers as I delivered the news. It is indicative of the tension and emotions boiling beneath the surface of the annual bonus discussion that the firms I worked for discovered they should separate the announcement of a banker's annual compensation from his or her year-end performance review. They soon figured out that once a banker heard The Number, all prior and subsequent conversation might as well have been conducted in Swahili.

People who do not work in investment banking simply cannot relate to this process. That is because, for most workers in most other industries, an annual bonus is a purely discretionary award, given to acknowledge good or exceptional performance, and one which they learn not to expect as an entitlement. Furthermore, a normal bonus outside the investment banking echo chamber is something like 10% or 20% of an employee's annual salary. For the big cheeses, sometimes you will even see a bonus of 100% or more of salary, for a year in which senior management really knocks the cover off the ball.

In banking, by contrast, bonuses—except for the most junior footsoldiers—can range from 200% up to 100 times or more of base salary. This is because bankers' base pay is a comparatively tiny proportion of their expected annual compensation. No matter how senior or how well-compensated a banker expects to be at the end of any year, it would be hard to find anyone in the industry who makes a salary in excess of $650,000 per year, including my favorite balding squintillionaire, Goldman Sachs CEO Lloyd Blankfein. This system is an historical artifact, dating back to the annual "draw" members would take from the equity of the original investment banking partnerships to pay personal expenses until they could divy up actual profits at the end of the year. (It is also a dusty relic of a time when $200,000 was a lot of money, even in New York City.)

While this legacy plays havoc with the personal finances of all but the most wealthy of investment bankers, it actually makes a good deal of sense. By paying even the most senior investment banker a relatively small percentage of his or her expected earnings as salary, the bank not only keeps the banker honed to a keen, aggressive, business-getting edge but also maintains a call on revenues the banker expects to bring in with a relatively low-cost option. If the banker doesn't deliver, poof!: he is fired, or paid a pittance as an option on next year's revenues, and told to pound sand if he doesn't like it. It is about as draconian a system of pay-for-performance as can be found anywhere.

It also makes sense because many business lines and forms of revenue at an investment bank are highly lumpy and extremely volatile. In any one year, a highly effective client-facing MD in traditional M&A or corporate finance can bring in anywhere from a few million to $100 million or more in revenue (net of direct expenses), depending on luck, fate, timing, and a million other circumstances beyond his or her control. It makes good economic sense to keep people like this on a small retainer, in the expectation that sooner or later they will hit the cover off the ball.

In contrast, what is an outstanding performance at a typical consumer goods company, selling another 500,000 units of Huggies to WalMart? Not to denigrate Huggies, or WalMart—God forbid—but you can see why a run-of-the-mill banker without management responsibilities can earn a $10 million bonus, while a consumer goods product manager is happy with a 20% bump to his salary.

* * *

Now this venerable system of paying your revenue-generating partners just enough to keep them solvent until the end of the year, when the bank's net profits after expenses were divvied up and distributed, began to change when investment banks began taking corporate form and retaining equity to fund their growth. Participation in growing global capital markets became a necessity, according to the heads of most of the leading investment banks, and funding that balance sheet and income statement growth was increasing leverage that required a growing cushion of equity. Eventually, of course, most of the old partnerships went public, and got public shareholders to fund their growth. But before that, and afterwards as well, they accumulated substantial equity by deferring a substantial portion of their bankers' annual pay in the form of restricted stock and options (or, as cynics like me like to think of them, interest-free loans).

As this practice spread, there was at first some lip service paid to the notion that bankers holding stock in their own firm aligned their interests with those of the public shareholders. Certain firms—most notably (and sadly for their employees) Bear Stearns and Lehman Brothers—developed very strong employee ownership cultures, and thousands of employees ended up retaining large holdings in their firms even after they vested. But no matter how much stock a banker might have, if he or she isn't in a position to make decisions which directly affect the management and direction of the firm, this "alignment" is mere window dressing, a canard. (You tell me: would you really feel like an owner if you held $10 million of unvested equity in a firm with a $50 billion market cap? Would you feel that almost anything you did or didn't do would have any noticeable effect whatsoever on such a behemoth? I wouldn't.)

Later, banks began imposing more and more onerous vesting schedules and restrictions on bankers' deferred pay, typically preventing them from taking delivery of deferred stock for up to three years (or even more) from the year it was granted, and forcing any banker who resigned to join a competitor to forfeit unvested awards. Management's nominal argument for these practices was that they encouraged employee retention, making it difficult for bankers to job hop around the Street.

But if this was indeed the reason, it was a very blunt and usually ineffective instrument in practice. It certainly did little to prevent other banks from hiring your star performers, since all they had to do was "buy out" a banker's unvested pay with an equivalent amount of unvested stock and options of their own. The only people these practices really encouraged to stay put were the average and even poor performers, who could not dream of getting bought out by a competitor. There was no clawback option in these plans, either, other than the nuclear option of confiscating an employee's unvested pay if he or she was fired for "cause," usually criminal. On the positive side, a bank which lost a star performer to a competitor could take some consolation by canceling the departing employee's deferred pay—thereby reducing past and future compensation expense—or, more commonly, turn around and use the freed-up stock to poach some other bank's rainmaker.

* * *

The thing which really broke the old Wall Street compensation system beyond repair, however, was the rise of proprietary trading at investment banks. As these banks bulked up their balance sheets to take advantage of larger and larger trading opportunities, traders on the prop desks began making bigger and bigger bets with more and more borrowed capital. Investment banks began emulating hedge funds, albeit highly leveraged ones, and the traders who placed these bets began pulling down enormous paychecks, even by the jaded standards of the dusty old i-bankers in corporate finance and M&A. Twenty-five, fifty, even sixty million dollar paydays became regular occurrences, and caused no end of envy and hate among the traditional investment bankers who used to rule the roost on the Street.

Of course, based on the old system of eating what you kill, those paychecks did make some crazy kind of sense. If a prop desk booked a billion dollars of net profit in a year—as the Salomon Brothers traders who later founded Long Term Capital Management were reputed to have done—why shouldn't they share a $75 or even $100 million bonus pool? Top management of investment banks, who increasingly came from the capital markets side of the house themselves as profits from that division ballooned, began to rely heavily on the supercharged profits successful proprietary trading generated to meet growth targets and satisfy shareholders. They did all they could to keep prop traders fat and happy, which became increasingly difficult as the independent hedge fund industry blossomed and any trader worth his salt could get a better bid away just by picking up the phone.

In addition to corrosive pay envy from bankers on the other side of the wall, this system also exacerbated the age-old tensions between the agency side of the business and the principal side. Client bankers may have groused when a successful prop trader took home a $25 million windfall in a good year, but they screamed bloody murder when he lost $300 million the following year. The injury that an M&A banker with a blowout year could see his bonus halved because some knucklehead on the govvie desk blew a half a billion dollars was only compounded by the insult that his unvested stock got slaughtered when the news hit the tape. It was no consolation that the offending trader was usually fired without a bonus.

Agency business—advising companies on mergers, underwriting stocks and bonds, and trading securities for clients' accounts—generates very little downside risk: whether you think it's right or not, the M&A advisors on the AOL Time Warner merger were not held liable when that deal went down the toilet. Similarly, an investment bank is usually only on the hook for its commission and incidental losses if an IPO tanks immediately after the offering. In contrast, principal activity can generate enormous losses, as we have all seen. This problem was compounded by the traditional Wall Street practice of paying bankers each year for the results they generated that year. When proprietary profits begin to act like insurance premiums, and a $100 million "profit" in year one carries a substantial risk of a $1 billion loss in year three, traditional pay-as-you-go comp practices—even with heavy emphasis on deferred pay—simply break down.

In fact, one could easily accuse the old system of making the reckless risk taking which has landed us in our current soup even worse. A clever trader who built up a $50 million position in unvested stock at Lehman Brothers on the back of risky long-tailed mortgage trades and who saw trouble coming had every incentive to jump ship and get another bank to buy him out. That way, when Lehman blew up, he was sitting pretty with stock in a firm not subject to those risks. One wonders whether some of these job-hopping superstars would have been quite so cavalier with their own bank's balance sheet if they knew that their net worth would remain exposed even if they swapped employers.

* * *

Anyone with half a brain realizes that Wall Street, with few exceptions, is badly broken. Its compensation practices either contributed to the mess or did nothing to prevent it. So where do we go from here?

First, I think we must realize that putting arbitrary pay caps on investment bankers and traders will be counterproductive. Our financial system is in a deep and muddy hole, and I, for one, have no interest in demotivating M&A advisors, capital markets bankers, and prop traders from making lots and lots of money for the US government and the banks' shareholders to fill in the hole. I don't think the Treasury does either, which is why the plan it proposed last week governing pay for senior executives at financial institutions suckling at the taxpayer's teat imposes no explicit limitations on total compensation for CEOs or anyone else. Sure, the plan imposes a $500,000 limit on annual cash compensation for "senior executives," but it makes provision for potentially unlimited amounts of deferred compensation for them and non-senior execs.

Believe it or not, my friends, half a million in cash, before taxes, is a pretty skimpy wage to support a CEO-type lifestyle in New York City. Nevertheless, most of the people who will be looking for these jobs are rich already, and I am sure their personal fleet of accountants, compensation experts, and tax advisors will be able to find them enough of the folding to keep the wife and mistress in Prada. As long as they can margin the Degas to pay the rent, I can think of a hundred guys who would love to book $25 to $50 million in deferred stock every year for three to six years, especially at the ridiculously depressed levels at which the banks in question currently trade.

As long as they repay the Treasury, and repair their institutions, I see no reason why we shouldn't wish them Godspeed. Furthermore, deferring the bulk of every banker's pay in like fashion makes eminent sense, too. M&A bankers, corporate security underwriters, and other investment bankers whose revenues carry no long-tail risk might legitimately complain that they are being tarred with the same brush as proprietary traders, and deferring the bulk of their pay constitutes an unfair hardship. But there are two reasons to disregard their complaints. First, one of the first things the walking wounded banks subject to these rules must do is re-equitize their balance sheets, and what better captive source of interest-free loans common equity is there than your employees? Second, while bankers like these on the agency side of the business contribute little risk to the overall organization, they definitely draw a substantial portion of their legitimacy, stature, and revenue-generating capabilities from their firm's franchise. Locking them up with long-term deferred comp seems a modest price to pay for renting Goldman Sachs' or JPMorgan's good name, in my humble opinion, especially since the bid away is practically nonexistent.

Prop traders, of course, should be locked up until Kingdom come, or at least until the cows come home. The ideal solution, actually, would be to set up internal hedge fund accounting at each bank. Track prop traders on their individual results, and pay them with long-vesting "shares" in their own trading book, just like real hedge fund managers. That'd align those little buggers, alright. Unfortunately, this solution is probably administratively unworkable, even if it is theoretically very neat. As a distant second best, pay them in restricted shares of the parent bank that vest on a schedule which matches as closely as possible the long-term risk profile of their trading activities. Effectively structured, such a program would render bonus "clawbacks"—and all such similar proposals being floated in the court of public opinion right now—effectively moot. (Given their position at the top of the food chain, and their responsibility for using proprietary trading to dig their banks out of the holes they have put themselves in, senior executive management pay should be structured in the same way.)

Of course, pushing the entire industry to deferred compensation will work much better if bankers can take their stock with them when they move. Let a banker jump ship to a competitor, if he or she wants to. Let them keep their currently unvested stock, with all restrictions and required holding periods intact, and the incentive to jump off a sinking platform onto a new one will be replaced by a clear self-interest in helping right the ship. Competitors who want to poach a rainmaker from another bank won't have to buy out his lifetime earnings from the previous employer, and the pressure to make big guarantees will moderate at the margin, too. The additional fact that no-one is hiring, and any bankers still employed will feel lucky just to have a seat, won't hurt either.

Finally, if the Treasury really wants to align incentives for banks under the TARP umbrella, they should stipulate that each bank's Chief Risk Officer should be compensated no less than the CEO for the duration of the restrictions. Some meaningful portion of the CRO's pay should be tied to the maintenance of low volatility and low net losses at the bank.

* * *

Does all this sound excessively simple, or naïve to you? It probably is. If there is one truism we can take to the bank, it is that well-designed and well-managed compensation systems are never simple. There are unintended consequences from every decision on pay, and comp systems must be constantly tweaked and adjusted to achieve their primary objective of motivating employees to effect the company's goals. The involvement of the government as regulator, lender, and shareholder only complicates a muddied picture even further.

But there is a simple solution for this, too. Employ executive compensation expert and gadfly Graef Crystal to review every compensation plan drafted by a bank receiving TARP funds. Bill his services at a rate of $500,000 per hour, and deduct his charges from the aggregate bonus pool available to senior executive management.

I bet you will see some of the shortest compensation plans ever drafted come out of Wall Street then.

© 2009 The Epicurean Dealmaker. All rights reserved.

The Dirt Bag Chronicles

'N every gimmick-hungry yob digging gold from rock 'n roll
Grabs the mike to tell us, he'll die before he's sold.
But I believe in this—and it's been tested by research—
he who fucks nuns, will later join the Church.

— The Clash, "Death or Glory"

Seriously, now, can we all just agree to put a stake once and for all in this Goldman Sachs reputation-thingy?

I have repeatedly shaken my head in wonder over the years at Goldman Sachs' apparently preternatural ability to maintain an absolutely spotless public image while simultaneously soiling itself in full view of everyone in the most miserable and abject manner possible.

The white shoe investment bank has slip-streamed for years on its hoary reputation as the industry's premiere, incorruptible bastion of unbiased advice for corporate clients, even as it has led the industry in self-dealing and unprecedentedly egregious conflicts of interest, like the famous example of being on all three sides of the NYSE/Archipelago transaction. Its proprietary trading operations continue to awe and terrify spectators and participants alike in the capital markets, even as its internal hedge funds have tripped over their own genitalia more times than can be recounted in a family newspaper. And, most impressively of all, the storied house has developed a reputation for grooming leaders and senior executives for high position in industry, academia, and government which even David Halberstam's Best and Brightest would envy.

Unfortunately for its boosters and acolytes, however, the wheels seem to be rapidly coming off the last carriage in this juggernaut. Henry Paulson, who looked like he stepped right out of Central Casting on his way to Treasury, proved himself not only tongue-tied and inarticulate in his role as chief spokesman for the American financial system but also shortsighted, ill-prepared, and inept in dealing with its burgeoning collapse. Robert Rubin, who has been walking on water for, oh, the last ten years or so, not only tripped and fell headfirst into the soup but also made a fool of himself by arguing indignantly that he is not even damp. Today, we get the spectacle of former Golden Boy and Christopher-Reeves lookalike John Thain getting frogmarched out of Bank of America on the back of an $87,000 rug.

How far the mighty have fallen.

* * *

There was a day, I grant you, not too long ago, when Goldman's reputation was frustratingly well-earned. Speaking from my long experience as a competitor and collaborator with GS on many deals, I rarely met anyone from its investment bank who ranked better than a B+ player in terms of intelligence, transaction skills, or client management capabilities, no matter what his or her resumé might lead you to believe.¹ But those boys (and girls) were disciplined, and they communicated the hell out of each other all the time. They were fierce about protecting and burnishing their firm's reputation, and they arguably spent more time managing and massaging their clients' perceptions about Goldman's performance than they did actually serving them. This, plus the firm's no-star culture, gave most clients a tremendous sense of security and institutional competence that assuaged any doubts they might have had about the individual bankers on their own deal.

As for themselves, Goldman Sachs bankers below the level of Partner were famous on the Street for being both significantly underpaid (and sometimes even overworked) relative to their peers at other firms. The firm did not hire or tolerate prima donnas. Before the firm's IPO, the prestige and set-for-life wealth which accompanied a Goldman partnership were what kept most of the rank and file slaving away in relative obscurity. Its employees had tremendous esprit de corps, and top management did an outstanding job both harnessing and preserving that resource. Goldman bankers were like the Borg, and that's who most clients wanted in their corner.

But it has been some time now since Goldman's reputation has outstripped both its capabilities and its intentions. Gus Levy's brilliant strategy that GS should be "long term greedy" is clearly a dusty relic honored in name only within the confines of 85 Broad Street. More than a year and a half ago, before Wall Street and the rest of the global economy decided to skydive without a parachute, a grizzled veteran of the ancien régime, John Whitehead, launched an unprecedented broadside at his former colleagues and mentees. His basic criticism: in a futile attempt to keep up with pay levels at hedge funds and other principal investing firms, Goldman executives were gutting the institutional culture of their firm by stoking the destructive fires of personal greed.

Nineteen months later, I find it hard to argue with Mr. Whitehead's analysis or predictions.

* * *

I don't know about you, Dear Readers, but I find the spectacle of Mr. Thain spending over $1.2 million to redecorate his already palatial office at Merrill Lynch at the same time he was cutting back on employees' use of car service, business travel, and client entertainment—expenses normally made in the service of revenue generation—a wee bit tasteless. Certainly, the sense of entitlement implicit in such behavior seems of a piece with the fat signing bonus Mr. Thain negotiated for himself when he jumped to head Merrill and the packages he arranged for chief lieutenants as well.² (Capital markets head Thomas Montag, another Goldman alum shitcanned today, will walk away with the tidy sum of $39.4 million in cash for less than six months' work, plus accelerated vesting, also in cash, of the restricted Merrill stock he received for the Goldman shares and options he gave up when he joined the Thundering Herd.)

Some people might ask what's the big deal. Surely Bank of America negotiated these employment packages at arm's length, and Thain and Montag simply demonstrated their excellent banker skills by negotiating great packages for themselves, no? And, in the context of Merrill Lynch's then-monstrous income statement, a $1.2 million redecoration expense cannot have even risen to the level of a rounding error. The CEO of a global investment bank needs an impressive office to wow clients and cow subordinates, doesn't he?

Yes, but.

* * *

Thain is certainly not alone in exploiting his position atop a gigantic global investment bank to indulge his personal pleasures at shareholder expense. During his empire-building phase at Citigroup, Sandy Weill installed wood-burning fireplaces in both his Midtown and Tribeca offices for a rumored cost of several hundred thousand dollars apiece, continuing a tradition he had begun all the way back to his stint at Shearson.

During good times, no-one seems to notice or mind such extravagances, because they are so small in the scheme of things. When the worm turns, however, as it is doing now, the long knives come out, and it is an entirely different matter.

Perhaps Mr. Thain is simply unlucky, someone who rose to power at the best-reputed investment bank on Wall Street during a time when shareholders, lenders, and prime brokers could not wait to throw their money at the money spinners of 85 Broad Street and who now does not know how to behave in these straitened times. Perhaps Goldman itself is an institution whose time has come and gone, and whose reputation now faces a long, hard decline from the pantheon of banking greats. Messrs. Thain, Paulson, and Rubin certainly rode Goldman's coattails into positions of wealth, power, and reknown. It does not seem unreasonable to expect Goldman's own reputation will wither as its former demigod alumni crash and burn all around it.

In any event, I think it fair to let everyone at Goldman in on a secret the rest of us have known for quite some time: Your shit does stink, after all.

¹ Lest my Patient Readers suspect an unalloyed case of sour grapes in their Dedicated Correspondent, be it known that I claim no special gifts in these areas either, just the ability to judge them in others, which is not that difficult. Also, for full disclosure, I admit that I too tried to get into Goldman Sachs as a wee bairn fresh from business school, but I tested too high for independence and insubordination, which were not viewed kindly by the firm at the time.
² And of a piece, as well, with the approximately $115 million Bob Rubin siphoned out of Citigroup since 1999, in recompense for performing an advisory job with no explicit duties, responsibilities, or even—as he currently insists—accountability, all the while helping persuade the Board and CEOs to steer the company into a ditch.

© 2009 The Epicurean Dealmaker. All rights reserved.

The Choice of Herakles

A dialogue, from The Memorabilia, or Recollections of Socrates, by Xenophon, translated by H.G. Dakyns:

I. Duty, or Virtue:

"I will not cheat you with preludings of pleasure, but I will relate to you the things that are according to the ordinances of God in very truth. Know then that among things that are lovely and of good report, not one have the gods bestowed upon mortal men apart from toil and pains. Would you obtain the favour of the gods, then must you pay these same gods service; would you be loved by your friends, you must benefit these friends; do you desire to be honoured by the state, you must give the state your aid; do you claim admiration for your virtue from all Hellas, you must strive to do some good to Hellas; do you wish earth to yield her fruits to you abundantly, to earth must you pay your court; do you seek to amass riches from your flocks and herds, on them must you bestow your labour; or is it your ambition to be potent as a warrior, able to save your friends and to subdue your foes, then must you learn the arts of war from those who have the knowledge, and practise their application in the field when learned; or would you e'en be powerful of limb and body, then must you habituate limbs and body to obey the mind, and exercise yourself with toil and sweat."

II. Happiness, or Vice:

"I see you, Heracles, in doubt and difficulty what path of life to choose; make me your friend, and I will lead you to the pleasantest road and easiest. This I promise you: you shall taste all of life's sweets and escape all bitters. In the first place, you shall not trouble your brain with war or business; other topics shall engage your mind; your only speculation, what meat or drink you shall find agreeable to your palate; what delight of ear or eye; what pleasure of smell or touch; what darling lover's intercourse shall most enrapture you; how you shall pillow your limbs in softest slumber; how cull each individual pleasure without alloy of pain; and if ever the suspicion steal upon you that the stream of joys will one day dwindle, trust me I will not lead you where you shall replenish the store by toil of body and trouble of soul. No! others shall labour, but you shall reap the fruit of their labours; you shall withhold your hand from nought which shall bring you gain. For to all my followers I give authority and power to help themselves freely from every side."

III. Duty, or Virtue:

"Nay, wretched one, what good thing hast thou? or what sweet thing art thou acquainted with—that wilt stir neither hand nor foot to gain it? Thou, that mayest not even await the desire of pleasure, but, or ever that desire springs up, art already satiated; eating before thou hungerest, and drinking before thou thirsteth; who to eke out an appetite must invent an army of cooks and confectioners; and to whet thy thirst must lay down costliest wines, and run up and down in search of ice in summer-time; to help thy slumbers soft coverlets suffice not, but couches and feather-beds must be prepared thee and rockers to rock thee to rest; since desire for sleep in thy case springs not from toil but from vacuity and nothing in the world to do."

* * *

The long and fevered pursuit of Happiness we have followed in this country for many years is over. We have woken with a start from our beguiling dreams of effortless success, enduring fame, and endless wealth, nursing a raging hangover. Before us lies the dispiriting vision of a steep and stony road out of a dim and drear valley.

Many have speculated on the various reasons we have come to this pass. Commentators, spectators, and participants all flog their pet theories, and the only thing more certain than their pointing of fingers at every culprit they can imagine is that virtually no-one is pointing his finger at himself.

But the moralist in me—repressed, ignored, and ridiculed most of the time, I grant you—begs to differ.

It has been a long time in this country since the ideals of sacrifice, honor, courage, and integrity were both admired and aspired to by the common man. (These words sound so dusty and awkward that I am almost—almost—embarrassed to write them here.) What is admired now is fame and its idiot cousin, celebrity, and wealth and its bastard offspring, money-for-nothing. How else can you explain the millions of column inches wasted on the vapid self-promotion of a brainless, talentless, beauty-less hotel "heiress?" Or the fact that Steve Schwarzman is mostly known outside financial circles for the egregiously self-congratulatory 60th birthday party he threw to crown himself the new King of Wall Street?

Sure, we make an occasional nod to the old virtues, like when we applaud the tense and wary knots of servicemen and women passing through an airport on our way to a Disneyland vacation or a billion-dollar closing dinner. We know we are supposed to admire such things, and the people who embody them. At some level most of us probably do. But what have we Americans sacrificed lately? When did you last act with honor, courage, or integrity?

Much is made by everyone about the greed and rampant, unbridled speculation that convulsed Wall Street over the last several years. Billions, if not trillions, of dollars were squandered in pursuit of ever-increasing bonuses for bankers and ever-increasing profits for shareholders (many of whom were the very same bankers in charge of the asylum). Of this, there can be no doubt. But these bankers did not act in a vacuum. Everyone who purchased a stock, or mortgaged a house, or took out a home equity line over the last seven years helped inflate the bubble which continues to burst.

Do not plead ignorance to me. No matter how far you were from the centers of finance, did you really believe it was your God-given right to enjoy 20+% annual price appreciation in your cookie-cutter Vegas mini-mansion? Did you really think it was clever or even prudent to treat your home like an ATM, withdrawing cash every quarter to purchase the cars, clothes, and plasma televisions your bog-standard middle management job wouldn't allow you to afford? Really?

I didn't think so. Just as all those rich pals of Bernie Madoff knew, at some level, that something just wasn't right with his year-in, year-out 10–12% returns, come hell or high water. But they took the plunge anyway. Who wouldn't want into a sure thing, even if it smelled to high heaven? Who, indeed, would turn down money for nothing?

* * *

Well, the days of the apparently free lunch seem well and truly over. Masters of the Universe face the prospect of working for years just to get back to breakeven, much less earn performance fees, and Titans of Wall Street are busy helping the Missus shop for bulk toilet paper at Costco, if they are not testifying in bankruptcy court.

Tomorrow, we will witness the swearing-in of the first black President of the United States. Many of us in this country voted for this man under the rubric of change. Most of those who voted for his opponent advocated change, as well. But now that we have it, just what sort of change have we voted for? Do we even know?

I don't know, and I refuse to make any predictions about this administration or the next few years in our economy. But what I will say is that the change we should be looking for—the change that will ultimately make a lasting difference in our country, our economy, and our lives—better come first from within.

It is not too late to take the high and stony road to Virtue. It is not too late to remind ourselves what it means to exercise restraint, to celebrate the old virtue of simple competence when we undertake a job. To do well, to work hard, because it is our job; to take pride in a job well-done, not because we think we're going to win the lottery. It is also time, in my humble opinion, for integrity to replace unprincipled greed, for humility and modesty to replace hubris, and for honor and courage to replace opportunism. The good news—and the hard news, as well—is that all of you get to make your own decision on the subject.

And there, Dear Readers, is the rub. For, in the immortal words of Pogo:

"We have met the enemy and he is us."

© 2009 The Epicurean Dealmaker. All rights reserved.