And Now for Something Completely Different

One of the great errors in modern policy is to confuse disclosure with information.

— Steve Randy Waldman

After an extended and much-regretted absence, a voice of reason has returned to the econoblogosphere. Steve Randy Waldman has put up a post about the Administration's recent decision to drop the requirement that financial institutions provide "plain vanilla" (i.e., standardized, simple, understandable) financial services to consumers from its proposal for the creation of a Consumer Financial Protection Agency. This reversal is a serious mistake, and Steve explains why. While his post is lengthy (sound familiar?), it is a model of clear exposition and sound argument. Go read it, and learn something. I did.

Dedicated Readers of this blog already know that I do not write about consumer finance. It is not my area of expertise. I work in the wholesale financial markets. But I am a consumer of retail financial products and services, like everybody else. And I can say, in all moderation and fairness, that the state of consumer finance—revolving credit, mortgages, retail brokerage, etc.—in this country is appalling. The kind of crap, bullshit, obfuscation, misdirection, misinformation, and just plain awful customer service you have to put up with to transact personal financial business nowadays is a national disgrace.

And, as Mike Konczal points out elsewhere, financial sophistication is no defense. Hell, I write, read, and negotiate extremely complex, lengthy financial contracts between highly sophisticated institutional counterparties for a living, and even I can't understand half the shit in a typical credit card application or "account terms update" mailer. Plus, even if I could, why the hell would I want to spend the time to do so? Consumer financial products are supposed to be about convenience, right? Too bad they're all about information asymmetry and rent extraction instead. I shudder to think what a normal person—who (correctly) believes the use of the phrase ;provided, however, as a transitional modifier in a 300 word sentence in the middle of a 20-page contract is a Sign of the Devil—does in such circumstances. I imagine they just close their eyes, sign on the dotted line, and hope for the best. That is no way to run an economy.

* * *

Anyway, read Mr. Waldman and come to your own conclusions. I wish there was a way to convene a panel of intelligent economics bloggers like Mr. Waldman, Felix Salmon, and others before a joint session of the US Congress and have them debate such policy issues in front of them. Attendance for legislators would be mandatory, and there would be a quiz afterwards to check their absorption and comprehension of the issues discussed. I would be happy to attend as well, but I think the purpose of the gathering would be better served if I eschewed direct participation in the policy discussion. Instead, I propose to roam the aisles of Congress carrying a large, metal-edged yardstick, muttering curses to myself, and glaring menacingly at the Congressional numbskulls in attendance. I might need a substantial supply of yardsticks—to replace those I would break over the heads of idiotic or recalcitrant legislators—but I would be happy to absorb all other expenses.

Hell, investment bankers like to work pro bono on occasion, too.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part II

You know, I just had a short vacation, Roy
Spent it getting a root canal
"Oh? How'd you like it?"

Well, it 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

* *

EDITOR'S NOTE: When last we left our Intrepid Reporter, he was explaining how he lusts after Milla Jovovich investment and commercial banks evolved into their current hybrid principal/agent form and what they actually do for a living. You are joining his massive, multi-post treatise on investment banking compensation currently in progress.

* *
— Part II: The Right Hand of Doom —

Second, let me explain how investment bankers get paid.

Compensation is actually one of the simpler elements to understand in the entire discussion of the origins of the recent financial dust-up.¹ However, the details matter, and moreover they have some interesting implications for investment bankers' motivations and behavior, so try to keep up. For my part, I will continue to try to restrain myself to words of three syllables or less. (You know, like a real investment banker.)

There are two important elements to investment banking compensation: how much bankers get paid, and what they get paid with. The first is pretty easy: they get paid a lot. Now, I could caveat this statement up the wazoo: not everyone gets paid a lot, not everyone gets paid the same, and not everyone gets paid (i.e., some get fired). But the simple fact is that, on average, on the whole, and by comparison to almost everyone outside the charmed circles of elite professional athletes, world famous movie stars, and certain Russian oligarchs, we get paid a fucking shitload of money. I mean, let's not beat around the bush: we're loaded.

There, I said it. There's no reason not to, really. It's not like its a secret anymore, if it ever was. But I have too much respect for both myself and the benighted Everyman to even try to pretend that an industry in which all 30,000 employees of über-investment bank Goldman Sachs are "on track to earn an average of $700,000 this year" does not qualify as an industry whose employees are extremely well paid. I mean, seven hundred grand is 14 times the real median family income in the United States for 2007. I think that safely counts as a lot.

By the same token, I will make no effort to defend the huge pay investment bankers bring home, either on the basis of the complexity of the work we do, its real and imagined hardships, or the investment most of us make in an expensive graduate education in order to break into the inner circle.² By virtually no measure are any of these criteria exceptional, or even especially rare. Nor will I attempt to rationalize stratospheric pay in the industry on the basis of some sort of self-aggrandizing claim to the particular socioeconomic utility or virtue of what I and my peers do (and, if you are honest, neither will you).³

No, I acknowledge unreservedly that the level of my pay is set according to one thing and one thing only: the demand in the marketplace for my services. Most of my (more honest) peers would admit the same thing. Investment bankers get paid a lot of money because that's what the market will bear. That's where the labor demand curve intersects the labor supply curve.

It's all Adam Smith's fault.

* * *

Drilling a little deeper, I can say that investment bankers make a lot of money because investment banks make a lot of money. For historical reasons shrouded in the mists of time, i-banks tend to pay out around 50% of their revenues as compensation and benefits to their employees. Therefore, when my bank makes a boatload of simoleons, I and my partners make half a boatload, which adds up fast.

Why do investment banks pay half their revenues to their workforce? I don't know. It probably has to do with similar, time-tested compensation arrangements prevalent in any sales-intensive industry, going all the way back to Mastodon rib vendors. Virtually all investment banking services consist of extremely expensive, variably episodic, and highly customized intangible services, which in my limited experience of other industries tend to require highly motivated, extremely well-paid salesmen to flog. Notwithstanding what a casual reader of The Wall Street Journal might conclude, $10 billion mergers and billion dollar IPOs are as rare as hens' teeth. Bankers spend years cultivating relationships with companies and other potential clients for a chance at such fee jackpots. When they eventually arrive, they have to feed a lot of people for a lot of work over many years, so it is no surprise banks have to pay a lot to the hunters who brought down the beast.

Adding to the pressure to divert revenues to employees is the fact that—notwithstanding the complex, time-consuming nature of investment banking transactions—the various investment banks competing for a piece of the pie are almost indistinguishable. Investment banks compete desperately to differentiate themselves in their clients' eyes, including such patently ridiculous efforts as squabbling over league table rankings. Because their capabilities are essentially identical, banks spend a great deal of time and energy burnishing and competing on the basis of their reputations.

The truth is that scrappy little Jefferies is probably just as capable of underwriting your IPO or advising on your acquisition as gold-plated Goldman Sachs. Investment banks are a dime a dozen. Companies that sell commodities tend to pay their salespeople a lot of money, for the simple reason they must rely on the sale for their business, not on the unique advantages of their product or service (unlike, for example, Microsoft). Not for nothing are successful repeat sellers in my trade called "rainmakers." Without them, otherwise lookalike investment banks would never harvest anything.^{4, 5}

Okay, you say, bankers get paid a lot because banks get paid a lot. Why do banks get paid a lot for admittedly complex but essentially commodified services? That's a good question. I have tried to answer this question a couple of times before, explaining why customers continue to pay what they complain are ridiculously high fees for cookie-cutter services provided by one or more investment banks in an industry which most investment bankers—Your Dedicated Correspondent included—claim has had too much competition forever. You can offer a lot of ideas, but at base they all boil down to supply and demand.

Demand is strong and inelastic, supply is plentiful and elastic, but price competition remains low. Go figure. (Gee, maybe we bankers really do earn our money.)

Damn that Adam Smith.

* * *

The second important characteristic of investment banker compensation—what we get paid with—is more critical to our goal of understanding the sources of the recent crisis in the financial system.

First, let me advise you that I will speak in generalities, and mostly about big publicly owned firms.⁶ Junior bankers, newbies, and other worker bees on the professional side of the firm tend to make a lot for their age and level of responsibility, but it is rare to see total compensation for an investment banker breach the $1 million barrier before they reach the level of Managing Director. This is the fancy title for senior bankers with revenue responsibility, translated by management to mean "Now that You've Arrived, You Damn Well Better Produce or We're Gonna Can Your Sorry Ass." That being said, there are a lot of people in the industry who make this amount of money and much, much more.⁷

Once a banker's pay reaches some level, which has typically gotten lower every year I have been in the business, he starts getting substantial portions of his pay in the form of deferred compensation. Usually this is restricted stock, which vests over some multi-year schedule (sometimes all at once, in a "cliff" vesting) and which the banker forfeits if he leaves his employer for a competitor. Sometimes, and the higher up you get, you get stuffed with restricted stock options, "stock appreciation rights," "phantom stock units," and all other kinds of dubious shit designed to both i) prevent you from jumping ship easily and ii) provide your employer with cost-free short-term financing.

Due to this, the typical Managing Director who has been with his firm for a number of years has an ever-increasing proportion of his net worth tied up out of reach in his employer's stock. Given that, and given SEC- and firm-mandated policies and biases against active securities trading for your own account (not to mention the complete lack of time to do so), most investment bankers' financial position looks horrifically undiversified. (A friend of mine used to joke that his personal beta—sensitivity to price changes in the overall equity market—was somewhere between 6.0–9.0: 2.0–3.0 for his employer's unvested stock, 2.0–3.0 to reflect his job and income's dependence on this same employer, and 2.0–3.0 for his exposure to Manhattan real estate, which lives and dies by Wall Street. This same friend now raises chickens in New Hampshire.) It was not uncommon for a mid-level MD at a big bank—no superstar—to have $10 to $20 million or more tied up in unvested stock before the crash.

Senior executives and senior producing investment bankers, of course, have more. Given that these are the same people who make the decisions, run the firm, and make the trades and transactions that generate revenue for the firm, it is ludicrous to suggest that they are insensitive to their employer's health and stock price. Sure, they do get paid some amount in cash every year, and they are usually able to convert some restricted stock into cash when it vests, but most of them spend most of that money on living expenses. The big nut of deferred compensation they have tied up in their firm becomes their retirement account, and believe you me they watch it like a hawk.

More to the point, it is extremely rare that an investment banker is faced with an opportunity to print a ticket huge enough to render inconsequential the future health of his firm and unvested compensation. Even if it does happen, you can bet that senior management will do all in their power to prevent the banker from collecting a gigantic windfall, arguing, among other things, that the rarity of the event is proof enough that the banker wasn't solely responsible for it. And if a banker does collect outsized compensation one year on the basis of huge revenue production, you can also bet the firm will stuff him with so much illiquid paper he could open his own recycling plant.

There are a lot of knocks you can legitimately put on Wall Street, but claiming investment bankers take crazy risks just so they can walk out the door December 31st with pockets full of cash, free and clear of future effects on their employer, is not one of them. Unlike the public shareholders in their firms, who are mostly highly diversified and therefore have far lower relative exposure to the health and survival of any one bank, investment bank employees can't yank their accumulated years of compensation out of their employer when the shit hits the fan. They are stuck, and they have a hell of a lot bigger personal stake in the future health and survival of their firm than any public shareholder.


Next: Part III: Seed of Destruction ...


¹ Perhaps that, plus the fact that everyone on the planet cares about money—whether they admit it or not—is the reason commentators who wouldn't recognize an investment banker wearing a neon placard reading "Hello, I'm an Investment Banker" if they tripped over him at the corner of Wall Street and Broad tend to focus on money to the exclusion of all else.
² For the purposes of my discussion, I will focus mostly on what are known in the trade as "professionals," i.e., those individuals armed mostly with college and/or MBA degrees who do the line work of an investment bank, like M&A, underwriting, and sales and trading. I will not discuss the huge numbers of highly effective and highly paid support staff without whom no investment bank could even open its doors. Suffice it to say that while few of these latter ever become millionaires, they do tend to earn extremely attractive wages in relation to people doing similar or identical work in other industries. You need shed no tear for Goldman Sachs' receptionists.
³ You mean to tell me your work as a [fill in the blank here] is "worth" more to society than that of a firefighter? An elementary school teacher? A combat infantryman in Afghanistan? A priest? Good luck with that.
⁴ I do not want to oversell this important concept. There is a constant tension within investment banks as to whether a banker's success is due primarily to his own skills and efforts or to the cachet and capabilities of the platform he works for. This argument reliably rears its head near the end of every fiscal year, when bankers and top management go to war to carve up the bonus pool. I do not need to tell you which side argues which position.
⁵ This analysis also helps explain why some investment banks are willing to pay a lot of money—offering multi-year guarantees, buying out a banker's unvested stock in his prior employer—to poach big producers from other banks. Note as well that big, successful banks which pride themselves on the strength of their platform and reputation, and which spend a lot of time and energy promoting the firm and not their bankers, tend to find poaching and multi-year pay guarantees annoying. Gee, I wonder why.
⁶ Small, privately held investment banks and boutiques often pay higher percentages in cash, or substitute partnership units or stakes for public stock. None of these firms caused the systemic breakdown, however, so we need not pay attention to them.
⁷ See my pal Andrew Cuomo's exposé on the number of people earning over a million bucks at TARP banks, for example. In fact, you might argue this has been one of the perennial attractions of investment banking. Unlike most industries, where the graph of pay against responsibility looks relatively flat and low until it goes asymptotic at the executive suite, the belly is much shallower and pay is much higher in the middle of the curve for investment banking. In most industries, only the CEO or the owner can get rich. In investment banking, lots of people can get rich. (Or used to be able to.)

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.

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.