Nature Red in Tooth and Claw: Part I

Well, I've seen all there is to see
And I've heard all they have to say
I've done everything I wanted to do
... I've done that too

And it ain't that pretty at all
Ain't that pretty at all
So I'm going to hurl myself against the wall
'Cause I'd rather feel bad than not feel anything at all

— Warren Zevon, Ain't That Pretty at All

Heaven forfend.

You must forgive me, Dear Readers, but I'm beginning to feel a little like Milla Jovovich in the Resident Evil movies. I have been trapped for what seems like years in a war to preserve myself and my fellow travelers from hordes of ravening killers lusting for blood. Yet no matter how many of these I dispose of, more just keep coming.

The difference, of course, is that the zombies hunting me and my kind have been infected with the anti-bonus virus, and they are hell bent on sucking every last drop of excess compensation and ill-gotten gain from my and my fellow investment bankers' bank accounts. Like normal zombies, however, I am sure some of them would be happy to drain us completely of real blood, as well.

Sadly, my analogy is not overwrought.

Like Ms Jovovich's cinematic antagonists, anti-bonus zombies come from all walks of life: taxpayer, union member, regulator, Congressman, economist. They are generally dim-witted, slow-moving, and awkward, and they are relentless in their pursuit of redistributive justice. Having no subtlety, strategy, or basic understanding of their prey, they prefer massed frontal assaults, and they cannot be dispatched without inflicting massive head trauma of some sort. What is more disturbing, the anti-bonus virus appears to turn whatever poor soul infected with it—no matter how intelligent, perceptive, or reasonable he or she might otherwise have been—into a raving, spittle-flecked lunatic who seems completely disinterested in the facts of the matter and who has no tolerance for any dissent. This virus has attacked and consumed persons great and small, from lofty public personages like the Financial Times' Martin Wolf all the way down to the twitching, ignorant pond scum infesting the comment boards of finance sites too cowardly or meretricious to ban them.

Most of these are lost to reason forever. But in the interest of perhaps slowing the tide of anti-bonus hysteria—stemming it would be too much to hope for—I would like to offer some balanced, fact-based commentary which might help those retaining their faculties come to a more reasoned conclusion on the subject. Since my extensive previous efforts have not done the trick, I will try to make my remarks as straightforward and simple as possible. We will see whether this has the intended effect.

— Part I: Investment Banking, A Love Story —

First, let us understand what investment bankers do.

Historically, investment banks have facilitated transactions of all types in the wholesale financial markets,¹ including mergers and acquisitions (the purchase and sale of businesses and their assets), capital raising or "underwriting" (of equity, debt, etc.) on behalf of corporations or their shareholders, and trading of securities, derivatives, and all other sorts of financial instruments. In this role, they act as agents. In other words, they take no material, non-temporary investment or ownership position in the entity or securities being transacted, but rather help match buyers and sellers who do. In return for this service—acting as a pure middleman—they take what they consider to be a relatively modest fee.

Investment banking fees depend on three things: the type of transaction, the size of the transaction, and the relative negotiating power of the client to bargain the fee downward. Barring securities trading fees, which are for all intents and purposes immaterial for institutional clients nowadays, typical fees range from a fraction of a percent for very large M&A deals and investment grade debt underwriting all the way up to 7%, which has been the standard rack rate for initial public offerings (for small companies, natch) from time immemorial.

A slight wrinkle to this description has to do with underwriting and trading securities. When an investment bank underwrites a security on behalf of an issuer, like an IPO, often the bank does take temporary ownership of the securities. In fact, the bank purchases the securities from the issuer directly, and then—if all goes according to plan—turns around and immediately sells them to investors it has lined up to buy. There is ownership, but it is temporary, and there is risk, but it is (usually) limited and well-controlled.

By the same token, when a sales and trading client (like a hedge fund or pension fund) wishes to sell an existing security or other financial instrument from its portfolio, the investment bank often buys it and takes it into "inventory" on its own balance sheet. There it stays, in the "trading book," until the bank finds another client who wishes to purchase those same securities. The bank makes its money by collecting the difference, which is hopefully positive, between what it paid to buy and what it collected upon sale of those securities. Traditionally, and still commonly today, the time securities spent on an investment bank's balance sheet was very short—sometimes milliseconds, if a buyer was found quickly—and rarely more than a few days. You see, holding securities on one's balance sheet exposes one to the potential risks and rewards of price changes typically borne by an investor, and historically investment banks did not aspire to be investors.

Now, the line between market maker—which is the term of art for what I have just described to you—and speculator—or investor who typically makes short-term, speculative bets on price movements—is a very blurry one.² In fact, the one line of business where investment banks historically did act as true principals—people who invest their own money, rather than just collect fees on others' activity like an agent—was in sales and trading. Enjoying a privileged position in the midst of constant buying and selling by hundreds of clients, and having the best information available on prices, market trends, and the like, encouraged investment banks to let their hair down a little and take advantage of their market edge. Banks began to hold positions in inventory longer than pure market-making would require, with the intent to profit from short-term price trends and information about potential buyers and sellers' appetites. Of course, information can be wrong, and trends can change—often with lightning speed—so this form of proprietary trading carried higher risks than simple market making and underwriting. That being said, investment banks were very cognizant of and sensitive to these risks, and they rode very careful herd on their traders' positions and risk taking. Notwithstanding the occasional blow up, this strategy worked, and generated very attractive, relatively low risk profits for its practitioners.

* * *

Of course, nothing lasts forever. Investment banks got bigger, their business lines and the securities and financial instruments in which they made markets became ever more diverse, and banks used their privileged understanding of markets and securities to create ever more complex instruments to trade. They did this for a combination of reasons. For one, they were following their customers, whose needs grew and became more complex. For another, they expanded globally alongside increasing globalization of the world economy. Third, they grew because they wanted to: more products and more scale meant more revenues, and investment bankers get paid on the basis of revenues, as described in our next installment. And finally they grew because they were the market participants best positioned to extend their reach: middlemen already in place and relatively well trusted by most market participants (or, what is the same thing, distrusted equally by everybody).³

Naturally, investment bank balance sheets grew as their business grew, which offered even more opportunities to profit from proprietary trading. Most big investment banks followed the path of least resistance and drifted further away from pure market making into trading for their own account. Envy and greed played its part, too, as some explicitly got into the principal business by building internal hedge funds and private equity arms in order to soak up some of the juice flowing to real hedge funds and PE firms during the Great Moderation. As they did so, they began to look more and more like a hybrid of agent and principal, with hybrid risk characteristics.

At the same time, the relaxation and eventual repeal of the old Glass-Steagall separation of commercial banking from investment banking saw the transformation of old line commercial banks into what are known today as universal banks, hybrids of commercial and retail lending and depositary businesses with traditional investment banking businesses. This turned a class of principals—for what is making loans to corporations and individuals but another form of investing?—into a very similar type of hybrid. Commercial banks began to admire and copy the "originate to distribute" form of lending (underwriting, as above) in preference to their historical practice of originate to hold. (Given that corporate lending is typically a low margin, capital intensive business, you can see why they might be attracted to fee-oriented businesses that utilized their capital more efficiently. Their shareholders didn't disagree at the time.) The biggest of these—Citigroup, JPMorgan, and several European banks which came from a long tradition of universal banking—crowded into the new market for investment/commercial bank hybrids.

And our pre-Crash financial ecosystem was formed.


Next: Part II: The Right Hand of Doom ...


¹ By which I mean transactions conducted by corporations, businesses, and institutional investors. This excludes, for my purposes, retail brokerage, retail lending, or any other practice which centers on what are euphemistically known as "unaccredited investors"; that is, the hoi polloi. Never mind that some traditional investment banks were also retail brokers: it affects my analysis not at all.
² Many principal investors like hedge funds have gone into market making from the opposite direction for the very same reason.
³ As opposed to another set of candidates with arguably comparable capabilities, the rapidly growing global hedge funds, for example. In their case, however, nobody would even consider entering the locker room, much less bend over to pick up the soap.

Photo credit for the series: Nathan Myhrvold's fascinating 2007 photo essay on lions in Botswana, Africa. Warning: as Nathan says, "some of the photos are a bit gory, and one shows explicit lion sex." Yawn. If that's explicit, I Dream of Jeannie should be rated R.

© 2009 The Epicurean Dealmaker. All rights reserved.

Supermassive Black Hole

A reader writes in response to my most recent jeremiad on the proper size of investment banks in our Brave New World:

I couldn’t agree more with the notion that what the world needs is more, smaller financial firms that have less ability to dominate the capital markets with their large balance sheets. But I must take issue with the following:

If I had to pick one decision which played the pivotal role in the financial crisis, it would have to be the SEC's agreement to waive leverage limits at the biggest investment banks in 2004. From traditional levels in the low teens, leverage ratios at banks like Lehman Brothers and Bear Stearns skyrocketed to the mid thirties and higher.

This statement is repeated over and over and couldn’t be farther from the truth. Look at the Bear Stearns financial statements for the 20 years they were publicly held and you’ll see that the firm was leveraged between 25 and 35 times for over a decade prior to 2004. Lehman was the same, made worse by the fact that their leverage came despite the fact that they did massive quarter-end window dressing to reduce their reported leverage; intra-quarter they were close to 50 times leveraged. And neither of these numbers nor the leverage numbers of their competitors even included off-balance sheet leverage on derivative transactions, foreign exchange and the like.

So please: the SEC has more than enough responsibility for our current crisis without dumping on them something that wasn’t of their making. Moreover, when we simplify the notion of leverage as being simply total assets divided by total equity without looking at the character and risk of the assets we ignore the real failure of the banks and investment banks to manage their risk.

Now, notwithstanding my employment in an industry which is not known for strict adherence to the facts—especially when those facts might interfere with the collection of a nice, juicy fee—I do somewhat idiosyncratically aspire to membership in the reality based community. Therefore, faced with cogent and forceful criticism such as this, I do what any self-respecting investment banker does: I force some pathetic sleep-deprived analyst to do some quick and dirty research.¹

This is what he found.

* * *

The balance sheets of the five largest "pure" investment banks² did indeed swell over the last decade. From fiscal year end 1999, total assets controlled by these banks grew at a compound rate of 16.3% per year, from $1.27 trillion in 1999 to $4.27 trillion in 2007. Given that the general economy was enjoying no such heated expansion, I find it rather remarkable that my elephantine peers almost quadrupled their asset bases over a period of eight years. This can be read as pretty clear and damning evidence that these investment banks, at least, strayed pretty far from their traditional mission as the handmaidens of capitalism and began to act like they owned the place.

And, pace my interlocutor's reasoned remarks, I find it telling that the balance sheets of the big five began to swell at an accelerated pace after the April 2004 SEC ruling I alluded to in my previous piece. The line graphs for total assets at each of the investment banks in the following chart mark a noticeable inflection point after fiscal year end 2003:



I am not dim enough to claim that correlation equals causation, but this data is intriguing, no?

As far as leverage ratios, however, my correspondent scores some valid points. First of all, my prior claim that investment banks toodled along modestly with leverage ratios "in the low teens" before the shift in SEC policy is clearly false. I apologize for my error, which I blame on a particularly fine Amontillado which unaccountably became corked during the composition of my earlier piece. (You didn't think I would accept full blame, did you?) Put it down to wishful thinking, if you choose.

Mr. X is also correct that the leverage ratios I bandied about in my post, and which are commonly used in the mainstream press, are incomplete and misleading. They do not include off balance sheet liabilities, most derivatives, and many other obligations which investment banks (and others) thought they had cleverly divested themselves of in their asset-gathering frenzy. (Thought incorrectly, it turns out.) However, full data on these non-disclosed items is not forthcoming from any source I know about. Therefore, even though I concede that the ratio of total assets to shareholders' equity is incomplete and simplistic, I would rather use it and its limitations to at least dimension the situation, rather than not speak at all.

Doing this, we discover some interesting results:



In fact, it does seem there was a noticeable pickup in leverage across all the major investment banks around the time of the SEC ruling. The five major investment banks seemed to maintain pretty consistent ratios of total assets to shareholder equity prior to 2004, ranging on average from the high teens to the high twenties, according to their different business models and appetite for disaster risk. (Note particularly that the two earliest victims of the crisis, Bear and Lehman, were also the two banks which maintained the highest leverage ratios historically.)

But note the material pickup in year-end leverage from pre-2004 averages at each of the five banks by year-end 2007:

	Average		Percent
	leverage	Leverage	change
	1999–2003	at FYE 2007	in ratio
Bear Stearns (BSC)	27.6	33.5	21.5%
Goldman Sachs (GS)	19.2	22.4	16.6
Lehman Brothers (LEH)	25.8	30.7	19.2
Merrill Lynch (MER)	18.5	32.0	73.2
Morgan Stanley (MS)	21.7	33.4	53.8

Based on this, the Vampire Squid everyone loves to hate looks almost diffident, but the rest of its peers look downright suicidal. Forget the hidden IEDs and unexploded ordnance squirreled out of sight by investment bank executives in off balance sheet waste dumps, these guys were on a tear. Strangely, I do not remember legions of diligent public shareholders banging on the podia at these banks' annual meetings demanding execs dial back their firms' risk profile. (Perhaps they were too fat and happy counting the excess equity returns these leveraged time bombs were generating to bother.)

The picture painted above does not even approach the full extent of operational leverage employed by some (all?) of the banks above in between audited reporting periods. My new best friend and pen pal writes in a follow-on note that:

The really fascinating story—and one with almost no discernable evidence—is what the balance sheets looked like intra-quarter. I once met someone from Lehman whose business card showed her to be part of the Office of Balance Sheet Management and whose role was to cleanse the balance sheet for the 4 quarter-end public financial statements so that they’d look less leveraged.

Fun!

* * *

So, based on this back-of-the-envelope historical analysis, I am disinclined to let the SEC off the hook for the relaxation of leverage limits as my correspondent urges me to do. Even if the SEC's action was not the primary reason that investment banks levered themselves up to ultimately ruinous levels, it certainly added fuel to the fire or, at the very least, did nothing to dampen it. Furthermore, a re-reading of the excellent piece in The New York Times about the fateful SEC hearing on leverage limits—complete with full audio recording, for the obsessive-compulsive among us—clearly indicates the Commissioners approved leverage relief on the understanding that the SEC was going to actively monitor and manage the situation. For various reasons, it did not.

Whether relaxing leverage limits for already highly-levered large investment banks and essentially allowing them to regulate themselves under their own recognizance was wise or not—and you might suspect how I feel about that, Dear Readers—it was clearly a massive dereliction of duty by Christopher Cox, the SEC Commissioners, and the SEC staff to undertake such a material change of the regulatory system without following through. Had they done so, and had the SEC Commissioners paid attention to the information generated by such close supervision, we might very well have slowed the speed at which the financial industry plunged over the cliff, if not stopped it entirely. The fact that they did not is borderline criminal.

The more I read about the SEC, the more I agree with those who would scrap it altogether and start over. Failing that, I think I will take my copy of the Times article on the 2004 decision with me the next time I visit Washington, D.C. and staple it to Mary Schapiro's forehead when I see her.

Maybe that will get her attention.

Ooh baby don't you know I suffer?
Ooh baby can't you hear me moan?
You caught me under false pretenses
How long before you let me go?
...
I thought I was a fool for no-one
Ooh baby I'm a fool for you
You're the queen of the superficial
But how long before you tell the truth?

— Muse, Supermassive Black Hole

¹ It's good to be the king, no?
² These are the five firms which petitioned the SEC for relief from previous leverage limits. I do not speak of universal banks like Citigroup, BofA, and JPMorgan, which also play a major role in the investment banking industry. We will save their sorry asses for another day.

© 2009 The Epicurean Dealmaker. All rights reserved.

Let a Hundred Investment Banks Bloom

Clive Crook nails it this morning in the FT:

At the recent G20 finance ministers’ meeting in London, Tim Geithner, the US Treasury secretary, won tentative, sometimes grudging agreement to his main ideas for stronger regulation. The single most important change, he believes, is requiring banks and shadow banks to hold more capital. He proposed higher capital ratios—higher still for systemically important firms, with new counter-cyclical components—and a cap on total leverage. To supplement these more demanding capital requirements, he also called for minimum levels of liquidity, and for “living wills” to allow the orderly winding up of failing financial firms.

All this makes excellent sense. If Mr Geithner’s proposals are acted on, the global financial system will be far better protected in future. ...

The global finance industry is in no position, yet, to mount a vigorous campaign against changes which, if they are adequate, will implicitly tax its growth. That is what higher capital requirements would do, and is precisely why they are needed. Checking the industry’s expansion must be seen as an aim of policy, not an unintended consequence.

The financial sector is, by wide agreement, too large in relation to the general economy. It must shrink in relative terms—not grow—as the economy recovers from recession.

More to the point, our biggest financial institutions are far too big. Of course, it will do us no good simply to force existing too-big-to-fail banks to shrink, since that will mean even less lending and credit provision on their part. Given ongoing asset bubble deflation and the fragility of the economic recovery, the last thing we need is for credit intermediaries to tighten the lending spigot further.

Instead, what we need is a period of deconsolidation in the financial industry to mirror what now appears to have been a risky and eventually ruinous period of consolidation and aggregation over the past three decades. I have pointed out before in these pages that financial intermediaries at every scale—individual banker, individual bank, and industry as a whole—comprise a dense and dynamic network for the connection of sources of capital to the users of capital. It just makes sense that this network would be more robust and less prone to catastrophic failure the more independent nodes there are in the system and the less network "traffic" (i.e., capital) flows through any one node or pathway. Such a network should be less costly to monitor and regulate than a more concentrated one, as well, since we would care less about the fate of any one bank within it.

Redistributing and rebalancing the nodes of distribution in the global financial system is job number one. Designing, imposing, and carefully monitoring relatively simple, risk-adjusted leverage limits based on the type of activity a financial intermediary conducts¹ is the best way to do it. While financial innovation seems to have played a significant role in the recent bustup, I am less worried than some about its inherent riskiness to the stability of the financial system. It was contagion across market sectors, accelerated by huge leverage at critical investment and commercial bank nodes of the system, which helped the looming collapse in real estate securities spill over into the broader economy, not the particular intricacies or flaws of CDOs, credit default swaps, or mortgage-backed securities.

If I had to pick one decision which played the pivotal role in the financial crisis, it would have to be the SEC's agreement to waive leverage limits at the biggest investment banks in 2004. From traditional levels in the low teens the high teens to high twenties, leverage ratios at banks like Lehman Brothers and Bear Stearns skyrocketed to the mid thirties and higher. I don't care how good a risk manager you are, if you only have three dollars in equity supporting $100 in assets, the merest market move or collapse in trading liquidity can kill you. If you fail with a balance sheet of $10 or $20 billion, a bunch of shareholders, employees, and counterparties will wipe away a tear and mourn your passing. If you're holding half a trillion to a trillion dollars, however, the collateral damage from your ruin will have everybody licking their wounds—and writing outraged letters to the Times—for years, if not decades.

* * *

The global banking industry is huge, and quite diverse. It will take time to bleed the air out of that bubble and reallocate people and capital to more productive pursuits. In the meantime, however, perhaps all the populist demagoguery and officious government interference is providing an important and unrecognized service in the industry's long-term transformation. After all, the more bankers and traders leave floundering giants like Citigroup and Bank of America for regional investment banks and independent advisory boutiques, and the more they divest high-risk proprietary trading operations like Phibro, the closer we will be to a system where the failure of either or both of those firms won't merit more than a shrug of the shoulders on Wall Street or Main.

Based on recent developments, many commentators contend we have become proto-socialists in this country (or worse). Given that, we could do worse than follow the sage advice on social transformation offered by one of last century's most successful proto-capitalists:

Letting a hundred flowers blossom and a hundred schools of thought contend is the policy for promoting progress in the arts and the sciences and a flourishing socialist culture in our land.

— Mao Zedong

Forward, Comrades! Let a hundred small- to mid-sized investment banks bloom!

UPDATE: A correspondent gently reminds me that I was a complete knucklehead when I asserted that historical leverage ratios in the industry were in "the low teens." I have done the research, corrected the error above, and managed to generate another War and Peace-sized chunk of prose in the process. Sigh. The gods of brevity are not pleased with me.

¹ Naturally, a firm which originates consumer loans and mortgages with the intention to hold them and funds its business with a large dollop of low interest-bearing consumer deposits should merit a higher leverage limit than a firm which conducts riskier activities funded solely by volatile wholesale funding markets. With leverage ratios, there is no reason to default to "one size fits all."

© 2009 The Epicurean Dealmaker. All rights reserved.

The Burning Ones

In memoriam, September 11, 2001:

Er ruft spielt süßer den Tod der Tod ist ein Meister aus Deutschland
er ruft streicht dunkler die Geigen dann steigt ihr als Rauch in die Luft
dann habt ihr ein Grab in den Wolken da liegt man nicht eng

He calls play death more sweetly Death is a master from Germany
he calls stroke the violins darker then you'll rise as smoke to the sky
then you'll have a grave in the clouds there one doesn't lie closely

— Paul Celan, Todesfuge

May all the innocent victims of unreasoning hatred and man's inhumanity to man rest in comfort and peace. Heaven knows there are far too many of them.

© 2009 The Epicurean Dealmaker. All rights reserved.

Never Say Never

I might like you better if we slept together
I might like you better if we slept together
I might like you better if we slept together
But there's something in your eyes
That says "maybe."
That's never.
Never say never.

— Romeo Void, Never Say Never

Goldman Sachs CEO Lloyd Blankfein gave a speech earlier today in Frankfurt, Germany at the Handelsblatt Banking Conference. As befitting an address delivered by an anointed power broker and Führer of vampire squiditude, it was an anodyne and uncontroversial exercise designed to smooth the brow of regulators, populist demagogues, and Rolling Stone correspondents alike. Even so obstinate a heretic in the despite of investment banking as Felix Salmon seemed to approve, or at least did not find it too objectionable.

While I personally did not object to the bulk of Mr. Blankfein's peroration, I would be less than candid were I to confess I had no reservations with his remarks. Of course, being Dedicated and Discerning Readers of mine, you already suspected that.

* * *

Amidst the other chestnuts which Lloyd chose to strew before the upturned gaze of his rapturous audience was this summation of Goldman's "detailed principles of compensation":

• The percentage of compensation awarded in equity should increase significantly as an employee’s total compensation increases.
• For senior people, most of the compensation should be in deferred equity. Only the firm’s junior people should receive the majority of their compensation in cash.
• An individual’s performance should be evaluated over time so as to avoid excessive risk taking and allow for a “clawback” effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.
• No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer term interests of the firm and its shareholders.
• To avoid misaligning compensation and performance, multi-year guaranteed employment contracts should be banned entirely. The use of these contracts, unfortunately, is a common practice in our industry. We should all recognize that they are bad for the long-term interests of our industry and the financial system.
• And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.

The first two points say the same thing: the more money you make, the more funny paper you get crammed down your gullet instead of cash. This makes complete sense, and amounts to a restatement of standard industry practice.

It's true that senior management expects its junior bankers to work so hard and so long they will not have any time to spend their disposable income or even rest their weary heads on a surface more closely resembling a pillow than the stained carpet under their desks. Nevertheless, common sense and common decency dictate that one should endow one's foot soldiers with enough legal tender to pay their rent and buy an occasional meal on their own dime. Paying 22-year olds pulling down $85 to $100 grand more than token amounts of unvested stock is guaranteed to be counterproductive, if only because they will be forced to commute to work from New Hampshire. (You try finding a halfway decent apartment in Manhattan for less than two grand a month.)

As a corollary, beyond a certain level, cash compensation—while nice for the recipient and his hangers-on—can only encourage a distorted worldview, negative social externalities like inflated real estate and luxury goods prices, and disturbingly louche behavior. Far better to align an investment banker's incentives with those of his firm and external shareholders by stuffing him to the gills with long-dated unvested stock and options and forcing him to hold onto them for years. Heck, this also has the neat side benefit of boosting the investment bank's equity capital base with the hard-earned sweat equity of its indentured servants most productive employees. (Too bad ol' Lloyd didn't follow his own advice back in 2007, when he took 40%, or $27.4 million, of his record $68.5 million total compensation in cash.)

Lloyd's third point is all very well and good, too, albeit a little vague. He does not really explain what this "clawback" mechanism looks like, or when it would apply. It could be explicit, and actively applied—for example, in the case of fraud or a profitable trade blowing up two or three years after it was booked—or implicit, and tied to the overall results and share price of the firm.¹ I think Goldman's senior executives are clever enough to leave it vague. It gives them more power over any employees who decide to get uppity or fractious.

Point number four is a fine, well-intentioned principle more honored in the breach than in the observance across Wall Street. Interestingly, Goldman Sachs is one of the few firms which pays more than lip service to this ideal. Compensation is one of the most powerful tools in the investment banking manager's arsenal, outside of firing someone and frog-marching their ass out the front door. If senior management uses it to explicitly reward teamwork—by, say, paying a good bonus to a banker who had a crappy year personally but helped out unselfishly elsewhere—and punish its opposite—by docking the pay of a productive banker who steals credit, backstabs, and generally acts like a complete asshole—then you will see marvelous improvements in the level of teamwork across the organization. You might even become Goldman Sachs in time.

Finally, Lloyd's last point strikes me as a little draconian. In my view, it's a little unreasonable to expect a 30-year veteran of the firm to live in relative penury because he can't withdraw any portion of the $250 million he's got socked away in Goldman stock until he retires in five years. If anything, such restrictions might encourage just such a seasoned, experienced banker to retire early in order to enjoy a little of his ill-gotten gains for a change (or at least get his wife and mistress off his back). This happened more often than not during Goldman's pre-IPO partnership days, by the way, when the compensation system followed just such a principle. You got fabulously rich as a Goldman partner, but you couldn't enjoy it until you were too old and tired to do so. We no longer live in such self-denying times, so it is silly to think such a plan would fly. Just make sure the locked up portion of the senior exec's stock is big enough relative to his total wealth, and you will definitely keep his eye on the ball. More than that will encourage cheating, borrowing against unvested stock, and other potentially risky and counterproductive behaviors.

* * *

Where Lloyd and I truly part ways is at his fifth, or penultimate point, about guaranteed employment contracts. He is not shy about declaring his dislike of them, and wants them banned. I disagree with him in principle (more later), but I also think it incumbent upon me to inform my Loyal Audience that the Grand Poobah of Broad Street is talking his book.

Goldman is well known across the Street for not offering multi-year guarantees to senior recruits (presumably single year guarantees are okay). There are sensible business reasons for resisting them: they increase fixed costs in a highly volatile business, they diminish short-term pressure to perform for their beneficiaries, and they increase resentment among the rest of the bankers who do not have guarantees. They also prevent managers from using compensation as a tool to enforce teamwork, at least while the guarantee is in place. I know for a fact, however, that Goldman has given very lucrative guarantees to senior recruits in the past, so it is not completely unheard of there. But mainly Goldman dislikes guarantees because they are more likely to have their producers poached by the competition than to be poachers themselves.

As befits a shop that focuses intently on building and preserving a strong and unique culture, Goldman prefers to grow its bankers internally. They are big enough, and successful enough, that they rarely need to search for senior bankers from outside the firm. The rest of Wall Street, on the other hand, views Goldman as its farm team: an outstanding source of well-trained, hard working bankers who make up for any personal shortcomings with an impressive carapace of mystique. Hence, when competitors come knocking on Goldman bankers' doors, they bring big, fat, multi-year guarantees to shake them free from the mother ship. If the banker is amenable, then Goldman must decide whether to counter the poacher's offer with a guarantee of its own or suffer a potentially painful defection. Neither is a pleasant alternative.

You can see why Blankfein hates them, but that is no general argument against multi-year guarantees.

* * *

Most investment banks use multi-year guarantees to recruit senior producers: Big Swinging Dicks, in the parlance of our time. They hire guys and gals with big clients and big Rolodexes to build new businesses or to ramp up penetration and market share in existing lines. They pay guarantees, and suffer the associated disadvantages and risks attendant upon them, because they have to.

I know it sounds hard to believe nowadays, but investment bankers are a surprisingly risk-averse bunch of people, at least when it comes to their own personal financial situation.² Getting one to jump ship from the sweatshop hellhole he knows—where he has history, understands the labyrinthine internal politics, and pretty much knows who is out to get him and who has his back—to another sweatshop hellhole he doesn't is no easy matter. The average banker would be a fool not to push for a guarantee, and, if he has been recruited to build a new business which will take several years to get off the ground profitably, he would be a fool not to press for a multi-year guarantee.

Recruiting banks pay it because it is an investment. By "buying" a revenue-generating banker, they are buying a producing asset, just like an offshore drilling platform or a new assembly line. Who wouldn't expect to pay a lump sum to get control of such an asset? Last time I heard, it was common practice to pay signing bonuses to new recruits across a wide range of industries, and senior executives have enjoyed multi-year guarantees for years as a perk of their job hopping. Proven assets of production are valuable, no matter the industry, and they cost money to acquire and maintain.

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More to the point, one of the most prevalent knocks against guaranteed compensation is that it supposedly increases investment bankers' risk appetite. This is just nonsense. If the bank has hired well, a guaranteed bonus allows the recruited banker to focus on all the things he was hired to do, like building a business, establishing and developing internal and external networks at his new employer, and contributing to a long-term sustainable franchise. By definition, he does not have to worry about short-term results, so he has no incentive to chase ambulances or pursue high-risk, high-reward opportunities. One of the tricks about guarantees you eventually learn as a banker is while the contract states they are guaranteed minimums, the reality is that they are guaranteed maximums, as well. There is absolutely no incentive whatsoever to hit the cover off the ball, or to chase bad business for short-term gain.

Of course, this caveat does not apply if the multi-year guarantee is not fixed, but rather takes the form of a percentage of revenue or operating profit.³ There, you can plainly see there is every incentive to pursue revenue at the expense of risk. Such arrangements could indeed worsen a bank's risk position if they are not monitored carefully. Nevertheless, as Lloyd himself states,

it is important to recognize that while incentive structures should be improved across our industry, that is no panacea for poor risk management.

Compensation is a necessary method of managerial control, but it is not a sufficient one. I continue to maintain that it was not even the determining one during the recent financial crisis.

I am not insensitive to the fact that the compensation figures we investment bankers bandy about as a matter of course seem outrageous, if not obscene, to the vast majority of citizens outside our incestuous little bubble. This has always been the case. What makes it different now is that everyone is paying attention, due to the not inconsiderable fact they have pulled my industry's collective chestnuts out of the fire at great and painful collective expense. Joe Sixpack now has a vested interest in how we do things, and he is not pleased by what he sees.

Nevertheless, far too much of the heat generated in the mainstream media and blogosphere about compensation is, for all intents and purposes, beside the point. Guaranteed compensation is just one more red herring in the net.


¹ If you doubt the efficacy of such a mechanism to claw back years of potentially inflated results and unwarranted stock price appreciation, I suggest you have a chat with your local Bear Stearns or Lehman Brothers employee over a few beers one evening. Just remember to bring lots of Kleenex, and expect to pay the bar bill yourself.
² It's not that hard to believe, if you think it through. If you had set up a lifestyle which cost north of half a million to a million dollars per year—not so outrageous for a family of four in New York City, by the way—and all you had to support it was a "guaranteed" salary of $400,000 plus whatever cash savings you could liquidate until your next bonus—which could be anything from $0 on up—you would be pretty damn conservative, too. It takes a lot of money in the bank—liquid money; cash money—to get your average investment banker to relax about money. Then again, given how much stock most big banks stuff their senior bankers with, why should any of them ever relax? Just ask former centimillionaires Dick Fuld or Jimmy Cayne to answer that one.
³ During the portion of my career when I worried about such things, these were relatively rare situations. Perhaps they have become the dominant form of multi-year guarantee out there, but I doubt it.

© 2009 The Epicurean Dealmaker. All rights reserved.