Wherein Your Droll, Semi-Victorian Bloggist Jumps the Shark

Let it never be said, O Dearly Beloved, that your Curmudgeonly Interlocutor is loathe to trot out his sesquipedalian stylings for the benefit and punishment of the broader world at large. Approach me in a suitably submissive and humble manner, bearing burnt offerings of fruit bats and breakfast cereals, and there is no telling what pearls of wisdom I might let drop from my coruscating lips.

Such were the tactics of one Charles Reinhardt, intrepid reporter from the literary hinterlands of Brooklyn, who approached me on behalf of his employer and online literary magazine Volume 1. Brooklyn. I must admit I initially considered his proposal of interviewing a semicoherent apologist for the financial industry on behalf of his distinctly hip, educated literary audience an intriguing, albeit unorthodox (and perhaps ill-conceived) project. But I am not immune to flattery. And I must own that the hook was set when I subsequently viewed his employer’s motto on the website:

If you’re smart, you will probably like us.

Well, of course then.

In any event, Mr. Reinhardt served up several appropriately non-financial softball questions for me to toy with, and toy with them I did. A sample:

How did the blog start?
The beginnings of my blog are shrouded in the mists of internet time. I dimly recall beginning to read certain online blogs like Marginal Revolution, Calculated Risk, and Going Private in the 2005-2006 timeframe and thinking–if not exactly that I could do that myself–that it might be quite nice to have my own soapbox. Part of it, I suppose, was driven by the sense I had that few people commenting or reporting online actually knew what the hell they were talking about when it came to finance. I thought I could actually add something valuable–or at least factual–to the conversation. Part of it was undeniably driven by boredom with the quotidian concerns and demands of my profession which, I am the first to admit, can be staggeringly sterile, routine, and blinkered. And part, of course, was driven by a desire to test whether I could write entertaining and informative prose, bolstered by the narcissistic conviction that I could. I started blogging in January 2007, and the world has been suffering miserably ever since.

There is much, much more. Go read it.

And if enough of you flatter my ego by reading it, I just may cancel my new project of selling artisanal cupcakes in Williamsburg on the weekends. Then again, maybe I won’t. I’m beginning to dig my new hipster cred.

Related reading:
Charles Reinhardt, The Bookish Banker: An Interview with The Epicurean Dealmaker (Volume 1. Brooklyn, January 8, 2013)


© 2013 The Epicurean Dealmaker. All rights reserved.

A Photograph, Not a Circuit Diagram

Except in the simplest cases, one cannot expect observation alone to reveal the effect of the use of an aspect of economics. One cannot assume, just because one can observe economics being used in an economic process, that the process is thereby altered significantly. It might be that the use of economics is epiphenomenal—an empty gloss on a process that would have had essentially the same outcomes without it, as Mirowski and Nik-Khah (2004) in effect suggest was the case for the celebrated use of “game theory” from economics in the auctions of the communications spectrum in the United States.

— Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets ¹

By now, many of you may have already read Frank Partnoy and Jesse Eisinger’s lengthy, outrage-y article in The Atlantic about the ongoing horror that is bank accounting, and/or one of many, many responses and reactions to it. I will not try your patience (or mine) by addressing their each and every substantive argument, but I thought it might be useful to lay out in summary form here why I think the entire premise of their screed is wrongheaded.

First, I will take the liberty of condensing and paraphrasing Messrs. Partnoy and Eisinger’s 9,500 word confection for the benefit of those among you with limited time and attention spans:

Banks are opaque and hard to understand! This is scary! Even big, sophisticated investors don’t understand the risks big banks take! Financial reporting for banks is scary and complex and mystifying! To calm ourselves, we tried to understand stodgy, prudent Wells Fargo’s financial statements. What did we find? Wells Fargo is big, opaque, complex, and scary!! Even their friendly investors relations person could not or would not answer our questions! We are scared! What should we do? We should send more bank executives to jail for scaring us! Oh, and come up with better, more understandable financial disclosure! Otherwise no-one will ever, ever, ever invest in publicly traded banks again! And then, disaster!!

Sigh.

* * *

Before I begin, I think it is fair to concede our Cassandras’ contention that large commercial, investment, and universal banks² are highly complex, risky, and opaque institutions. It is also fair to say that most of the bad or downright naughty things which have occurred in the financial sector over the past several years (although not all; viz., Bernie Madoff) have bubbled up from the bowels of large, complex, opaque banks and their brethren. But the notion that there is some sort of magical accounting regime which could simultaneously shine sunlight into the deepest reaches of multi-trillion-dollar global financial institutions, clearly convey the actual and potential risks these institutions face or create in their daily operations, and therefore usher everybody into a new era of financial transparency, trust, and mint juleps on the sun porch is simply ludicrous. It completely misunderstands what accounting is and what accounting is for.

It is a rookie mistake.

First, accounting is—as Donald MacKenzie characterizes (academic) economics in the quote above— an epiphenomenon to the actual day-to-day activities which any business conducts. It is a way to keep track of the financial outcomes of a firm’s true activity, which is conducting business. It is passive, it is backward looking, and properly used under normal circumstances it drives none of the important business decisions or activities which firm executives pursue. When accounting consequences do drive decisionmaking, as in tax avoidance strategies or manipulating earnings, it introduces distortions into the underlying business which can lead to all sorts of economic inefficiences, up to and including fraud.

Accordingly, reading a set of financial statements can tell you very little about how to run an actual business. That is why every business of even modest complexity runs its own internal management information systems which provide the people running the show with real time, targeted information which they can use to make decisions. These systems have very little, if anything, to do with generally accepted accounting principles. The daily trading book and profit and loss statement for a Wall Street trading desk will bear little resemblance to the balance sheet and income statement of its investment bank parent. Of course at year and quarter end each desk’s results do get rolled up and reconciled into its parent’s consolidated financial results, but this process by necessity compresses and distorts the actual real-time, granular information used to run a business into standard, pre-approved accounting categories. In addition, the backward looking nature of accounting for the period just ended means the more dynamic and changeable an underlying business process is—for example, sales and trading at a securities firm—the more out of date and potentially misleading the reported numbers can be to the current state of the business.

And it is not a matter of simply providing more, more detailed information more frequently. Put aside the common tension that most businesses compete with others, and detailing too much information in publicly available accounts would undermine their competitive position. (This is particularly important for market-making investment banks.) No, such a strategy would increase the complexity of a firm’s accounts, which seems exactly contrary to Messrs. Partnoy and Eisinger’s stated objectives of greater transparency and shorter financial reports. Not to mention still not get at the idiosyncratic risk and business practices of each such firm, because it is the entire point of public accounting to standardize reporting to enable comparability across firms.

And this last gets directly at a critical point which seems to have eluded our intrepid reporters: what accounting is for.

* * *

For that is what public accounting is: a public accounting of the financial results of a firm for the benefit of external stakeholders of various stripes, including lenders, creditors, business counterparties, regulators, and investors. It is meant to be an intermittent report on the health and progress of a firm to potentially interested parties, filtered, standardized, and formatted into a presentation which can allow those parties to compare the firm to its peers and competitors both within and outside its industry. It is not meant to be a real-time profile of the actual business operations of an individual firm; nor is it meant to give outsiders such operational knowledge of the firm that they completely understand and perhaps could even run the business themselves. It is a report card, not a class curriculum or even lecture notes.

And you should not think that regulators—who we might indeed prefer to have much more detailed, real-time operational knowledge of systemically important risky financial institutions—are hobbled in any way by the limitations of their regulatees’ public financial reports. Securities and bank regulators always have intimate access to the current operations and results of firms under their supervision and, arguably, should have much more. But this is true whether a firm files public reports or not.

Lastly, Messrs. Eisinger and Partnoy’s concern for the confidence of equity investors in banks is completely ass-backwards. A quick peek at the balance sheet of their subject Wells Fargo reveals that it derives only 10.4% of its outside funding from equity investors: the vast bulk is in the form of retail and other deposits, and the balance comes from other debt and preferred investors. Show me a retail depositor who decides whether to keep her money at Wells Fargo based on the footnote disclosure in its annual report and I—after I pick my lower jaw up off the floor—will show you a hot January. Likewise, equity investors were not the funders first to the lifeboats when Bear Stearns and Lehman Brothers ran aground. Stock investors were not the parties who cratered failing banks in the financial crisis.

That is because banks and investment banks do not rely on equity investors for daily funding or liquidity. They rely on trading counterparties, repo suppliers, short-term lenders, and prime brokerage hedge fund customers to roll over constantly maturing short term debt (often funded overnight) and keep their trading balances and assets at their firm. When these institutional investors lose confidence, a bank is toast. They refuse to roll over short-term funding, they yank their assets on deposit, and they may even put on a nice, juicy short against the beleaguered bank’s stock just for good measure. And you can bet your bottom dollar they are not going to wait for the quarterly 10-Q report to be filed 45 days after period end to make their decision.

* * *

Even the much maligned (by me) Securities and Exchange Commission understands the proper relationship of public accounts to equity investors. Remember that the SEC’s objective for public reporting is not to help you fully understand a business. It is to disclose all pertinent and relevant facts and risks about a business so an investor can make her own informed decision. Banks are big, opaque, risky, and complex. What do bank financial statements tell us? They tell us banks are big, opaque, risky, and complex. That sounds pretty accurate to me. The kind of disclosure our doughty duo proposes, including ludicrously simplistic “worst-case scenarios,” would not increase investors’ understanding of the real risks inherent in the mind-bogglingly complex business of global finance. In point of fact, these are only poorly or dimly understood by the very bankers undertaking them. Instead, it would promote a sort of unwarranted confidence that would be both dangerous and misleading.

Equity investors should be terrified of banks. After all, they are the last capital providers in line in famously and ineluctably evanescent institutions, firms whose very existence can wink out over a weekend if the depositors, counterparties, and institutional investors ahead of shareholders decide to take a powder. That is the nature of banks, then, now, and always. Banks are structurally short liquidity. When liquidity dries up, or becomes prohibitively expensive, banks fail, and they fail fast. It’s as simple as that.

And yet, notwithstanding all of poor Bill Ackman’s axe grinding, retail and institutional investors still seem to want to own bank stocks.³ Why is that? Well, notwithstanding the good money to be made owning them in good times, it seems the prices of bank stocks, whether measured by historical prices, P/E ratios, or price to tangible book value, have dropped to a level where investors feel fairly compensated for the risk they are assuming. You know: the risk disclosed in the banks’ public financial statements that they are big, opaque, risky, and complex.

Nowhere is it written that bank stocks should trade at a specific multiple of book value, no matter how accurate or believable book value is. Investors may be paying lower than historical multiples of book for bank stocks because they do not trust banks to have properly marked assets to market, they may not trust management not to destroy value by making stupid errors (or errors unavoidable in today’s volatile and unpredictable markets), or they simply fear more unanticipated systemic disruptions will sink even the best-managed, most conservatively-accounted-for banks (including threatened regulatory changes). Investors are paying lower prices for bank stocks because they require higher risk-adjusted expected returns.

This does not sound like a crisis of confidence to me. This sounds like sensible, prudent investing in an uncertain world.


Related reading:
Frank Partnoy and Jesse Eisinger, What’s Inside America’s Banks? (The Atlantic, January/February 2013)
Matt Levine, Turns Out Wells Fargo Doesn’t Just Keep Your Deposits In A Stagecoach Full Of Gold Ingots (Dealbreaker, January 3, 2013)
Felix Salmon, You can’t regulate with nostalgia (Reuters, January 3, 2013)


¹ Cambridge, Massachusetts: The MIT Press, 2008, p. 18.
² For the novitiates, simply, a “commercial” (or retail) bank is primarily a lending bank: they take in retail customer deposits and lend them out in the form of mortgages, commercial loans to businesses, and other retail loans. An investment bank acts as a market intermediary, buying and selling securities and derivatives on behalf of clients and itself and advising on mergers and acquisitions. A universal bank is a combination of commercial and investment bank. Most big banks you read about nowadays, including, e.g., Wells Fargo, are universal banks. Not enough for you? Want to go deeper down the rabbit hole? Start here.
³ How do I know this? Well, the trading volume and price of public banks and investment banks is not zero, that’s how. By the way, the price to tangible book value ratio for terrible, awful, scary Wells Fargo is currently 1.7x, or almost twice book value. Perhaps that’s because equity investors take great comfort from all those information-insensitive depositors ahead of them in the capital structure.

© 2013 The Epicurean Dealmaker. All rights reserved.

108 Bells

I have grown tired of the moon, tired of its look of astonish-
ment, the blue ice of its gaze, its arrivals and departures, of
the way it gathers lovers and loners under its invisible wings,
failing to distinguish between them. I have grown tired of
so much that used to entrance me, tired of watching cloud
shadows pass over sunlit grass, of seeing swans glide back and
forth across the lake, of peering into the dark, hoping to find
an image of a self as yet unborn. Let plainness enter the eye,
plainness like the table on which nothing is set, like a table that
is not yet even a table.

— Mark Strand, “Nocturne of the Poet Who Loved the Moon”

At midnight tonight, as they do on December 31st every year, Buddhist temples around Japan will ring out the old year with 108 chimes of the temple bell, in a ceremony called Joya no Kane. Each chime is supposed to symbolize the purification of one of 108 sins, defilements, errors, and worldly desires that stand in the way of a believer’s passage to Nirvana.

I am no Buddhist, but I am a firm believer in the psychological and, dare I say it, spiritual benefit of ritual. No matter what ritual you follow tonight, may you cleanse the errors and confusions from your past life and replace them with the clarity of a clean and hopeful future.

It is time to say goodbye to the last, tired moon of 2012. Say hello to the sunrise of a brand new year.


© 2012 The Epicurean Dealmaker. All rights reserved.

TED’s Greatest Hits of 2012

Yes, O Dearly Beloved, it is time. That season of the year has arrived in which Your Humble and Ever-Attentive Opinioneer attempts to survey which among his meager works has earned the attention, approbation, and/or opprobrium of the masses in Anno Domini Two Thousand and Twelve. My tools, as usual, consist simply of the page view rankings of posts authored this year as they have been recorded in Google Analytics. This data is necessarily incomplete and potentially unreliable, as it misses the actual eyeballs harvested by each respective post from the far greater numbers of people who simply visited the home page of this humble opinion emporium. But hey, it’s good enough for government work.

My feelings do not enter into this ranking, as I defer, as is my wont, to my Beloved Audience’s merest whim. Three hundred and sixty-four point two five days of the year, I convey my own opinions here. Today is your day.

Listed in order of popularity, as determined by you, here are this year’s greatest hits. Enjoy.

THE CANON, 2012 Edition

1) The Rules (November) — An excessively popular semi-tongue-in-cheek list of the rules for proper behavior in corporate finance and M&A. I will let you clever readers figure out which bits are tongue-in-cheek and which are only semi. No peeking.

2) Can’t Buy Me Love (April) — In which I explain why the great unwashed should not envy the reportedly stratospheric pay of investment bankers, nor should the eager young flock to my industry in search of endless wealth. I realize that few of the latter will listen, but perhaps I will save one or two as they come barreling through the rye.

3) Goodwill Hunting (November) — A prominent financial journalist uses the incident of Hewlett Packard’s writedown of its investment in Autonomy to embarrass himself publicly with the depth and breadth of his ignorance concerning firm valuation and the rules of public accounting. I, being of sound mind and generous heart, take mild exception and attempt to convey what are quaintly known in journalism as “the facts” to any and all individuals who might actually like to know them. Illustrated with one of Your Dedicated Bloggist’s favorite Frank Cotham cartoons.

4) The Root of Some Evil (January) — A respected academic named after a Harry Potter character attempts to tie senior financial executive pay to performance and, ultimately, link excess pay to the onset of the financial crisis. After engaging in deep breathing exercises and ingesting copious quantities of legal mood stabilization substances to reduce his skyrocketing blood pressure, your Tireless Servant and Guide to All Things Financial patiently explains why said academic is full of stinky goose shit. In summary, like most academics observing my industry from the outside, this scribbler would have been far better served actually learning how my industry works, rather than trotting out tired old shibboleths from the leafy groves of lazydeme.

5) The Rape of Persephone (January) — A rather lengthy disquisition on the practice of private equity investment, spurred by the extensive media attention triggered by the Presidential candidacy of a certain ex-Bain Capital poohbah, long since forgotten. I counter various pundits’ facile misrepresentations and misunderstandings of the financial sponsor business, and roast a few canards to boot. Short summary: private equity is not Evil Personified. It’s okay; I understand your shock.

6) All’s Fair (January) — Ex-investment banker William Cohan launches a scurrilous political attack against ex-private equity boss Mitt Romney. I respond by detailing the process of buying and selling companies and the nature of the negotiations involved. As you might suspect, the M&A arena is characterized by sharp elbows and sharp practices, pragmatically employed in the service of larger goals. Just like politics. Unsurprisingly, Mr. Cohan does not come off well.

7) Three’s a Crowd (March) — Wherein I use the very public J’accuse by Goldman Sachs apostate Greg Smith and a fellow traveler to delve into the structural and cultural workings of the investment banking industry. I describe the core conflict of interest or tension at the heart of my business and explain its origin as the ineluctable outgrowth of our attempts to serve the conflicting interests of different sets of clients. I also explain how the introduction of public shareholders permanently upset this tenuous balance for the worse. Yes, you heard me correctly: it’s the shareholders’ goddamn fault.

8) A Good Offense (April) — Was the famous beaching of J.P. Morgan’s “London Whale” an example of hedging gone awry or rank speculation undone? I examine the rotting carcass from several points of view and draw a few measured conclusions. Gratuitous World War II tank destroyer analogy included gratis.

9) Chesterton’s Fence (March) — Wherein I resurrect a hoary old chestnut from professional curmudgeon and Dead White Male G.K. Chesterton to remind us that professed reformers are wise to examine the history and reasoning behind objectionable human institutions before they decide to tear them down. While this was perhaps interpreted by most readers (and intended by Mr. Chesterton) as a defense against change, the rule offers a clearly defensible roadmap to reform: if upon examination we determine an institution was established for bad reasons, or reasons which no longer apply, then we are entirely justified in removing it or replacing it with something better. When the stakes are high, tradition should not survive simply because it is tradition. Neither should change happen simply for a change. Corollary: Do not look for simple answers at this site. I do not supply them.

10) Too Much Is Never Enough (October) — And, finally, a piece in which I explain the dirty little secret of the private equity industry: that, when they have incentives to overinvest or invest poorly—say, for example, when they risk losing money, prestige, and potential future earnings if they don’t invest the excess cash currently burning a hole in their industry’s pocket—these purported paragons of fiduciary probity can be just as self-serving as any venal schmoe. This conundrum neatly illustrates two general points worth remembering: 1) economic rationality or not, almost every human endeavor is riddled with conflicts of interest, and 2)

the primary mission of any institution, once it becomes large enough, is the perpetuation and survival of the institution itself.

The private equity industry, as an aside, has become very, very large.

* * *

Well, here’s hoping 2013 will be a marked improvement over 2012, in every dimension. This year has been a total bust.

Cheerio, children.<sup>1


1</sup> Sorry, no clever footnotes this year. I’m fresh out. But hey, you get what you pay for, you know.

© 2012 The Epicurean Dealmaker. All rights reserved.

Santa Baby

Santa Cutie,
and fill my stocking with a duplex and checks;
Sign your ‘X’ on the line,
Santa Cutie,
and hurry down the chimney tonight.

Come and trim my Christmas tree
with some decorations bought at Tiffany;
I really do believe in you;
Let’s see if you believe in me...

— Eartha Kitt, “Santa Baby”

Here’s wishing Santa brings you everything you want this year.

For me, I’d just like a little more peace and joy.

Hurry down the chimney, Santa.

Happy Holidays.


© 2012 The Epicurean Dealmaker. All rights reserved.