The Epicurean Dealmaker

Charitable Giving

2009-11-24T21:23:00.034-05:00

"Guess what? I have flaws. What are they? Oh I dunno, I sing in the shower? Sometimes I spend too much time volunteering. Occasionally I'll hit somebody with my car. So sue me—no, don't sue me. That is opposite the point I'm trying to make."

"Do I need to be liked? Absolutely not. I like to be liked. I enjoy being liked. I have to be liked. But it's not like this, compulsive, need, to be liked. Like my need to be praised."

— Michael Scott, The Office

In an otherwise less than sympathetic piece on the public relations travails of the Vampire Squid everybody loves to hate, Financial Times journalist Chrystia Freeland credits the investment bank's recently announced 10,000 Small Businesses initiative as "cleverly conceived" and "designed for maximum effect." I have to disagree.

Like many of you, I am sure, I was impressed when I heard Goldman was going to donate $500 million to a myriad of small businesses, which are widely perceived to be the primary engines of job creation in our economy. Oh goody, I thought: half a billion bucks mainlined into the veins of those businesses best able to kick start the economy back into rude health. What a coup.

Then I read the blasted thing. It is not pretty. Sixty percent of the committed funds will be distributed for "lending and philanthropic support," but this will be directed through "Community Development Financial Institutions." Call me a skeptic, but this does not sound like high powered money coursing directly into the working capital accounts of productive enterprises which can use it. Instead, it sounds like a $300 million slush fund for the functional equivalent of community NGOs. The remaining forty percent—200 million clams—will go toward "education."

Oh great, Lloyd, that's just what every small businessman needs: an education. After all, everybody knows what the owner of a chain of dry cleaners or a machine tool factory really needs is "scholarships," greater "educational capacity," and mentoring by some half-assed social worker out of an abandoned storefront. Why stop there, though? Why not endow a hundred spots at Harvard Business School in perpetuity so Hmong immigrants can learn to apply CAPM and discounted cash flow analysis to their corner delicatessens? ¹

Either that, or you could pull your head out of your ass and actually lend some money to these guys instead. Heck, set up a small business lender with half a billion in capital, lever it up ten to one, and loan five billion dollars out to struggling small businesses. You might actually spur some real economic growth, rather than employing an army of aspiring bureaucrats to fill out scholarship applications in triplicate. Plus, you might finally earn some respect from a country which suspects you and your peers are constitutionally incapable of taking a crap without consulting the Harvard Business Review or the McKinsey Handbook of Corporate Obfuscation for instructions. ²

This idea scales attractively, too: Put in a billion of equity, and loan out ten billion, and people might even stop whispering disparaging remarks about the size of your junk in the corridors of Capitol Hill. Now there's a return on capital.

* * *

On the other hand, given that you run an investment bank, if you want to raise some serious money for charity, you could always open a Swear Jar. Just make sure it's big enough.

¹ Well, okay, that was a cheap shot. You and I both know doing any such thing would destroy the exclusivity and aura of an HBS education, which would be a societal catastrophe too terrible to contemplate. (Not to mention wasting two years out of the lives of otherwise productive elements of the economy.) Just kidding, bro.
² I mean really, who comes up with this shit? I know you couldn't give a damn about tiny ass businesses which will never grow large enough to become paying customers of your firm, but you are theoretically announcing this program for public effect, no? Why not make it clear, simple, and understandable, instead of a convoluted, bureaucratic mess apparently derived from some EU functionary's wet dream? Bank? Lending? Ring a bell?

© 2009 The Epicurean Dealmaker. All rights reserved.

Compassion Fatigue

2009-11-17T12:40:00.064-05:00

"No matter how many times you save the world, it always manages to get back in jeopardy again. Sometimes I just want it to stay saved, you know? For a little bit? I feel like the maid: 'I just cleaned up this mess! Can we keep it clean for ... for ten minutes?!'"

— The Incredibles

I don't know about you, Dear and Long-Suffering Readers, but I am beginning to worry about Yves Smith.

The indefatigable blogger and soon-to-be-published author is really showing the strain of commenting from the front lines of the global financial crisis, as she has done, admirably, from the very beginning. Today, she lit into Neil Barofsky's SIGTARP post mortem on the New York Fed's disbursement of billions of taxpayer dollars to cancel credit default swaps written by the pathetic boobs at AIG. AIG sold those swaps, you may remember, under the cheerfully naive assumption that, as long as you hold a AAA credit rating and employ a bunch of overpaid financial engineers in a fancy office on Curzon Street, you can write as many naked puts on as much toxic crap as you like with no consequences. Much as I would be delighted to learn otherwise, I believe we may safely consider that presumption to be dead, buried, decayed, mixed into topsoil, and completely absorbed into the Earth's mantle via tectonic subduction by now.

In the meantime, however, the rest of us continue to live with the consequences of AIG's tomfoolery, and Ms Smith remains understandably upset about this state of affairs. So much so, in fact, I think she rather unfairly pans Mr. Baroksky's report as unacceptably timid and mealy-mouthed. I read her to say she would rather have the report blast the Fed's mishandling of the AIG crisis in no uncertain terms, not sugarcoat its misdeeds in the bland and unoffensive coating of bureaucratese.

But this is unfair. From my perspective—known to most of you as distinctly unappreciative of the Fed's spineless and inept handling of this imbroglio—I think Barofsky and pals did a rather bang-up job of blowing holes in both the government's actions and their pathetic ex post rationalizations therefor. You just have to read between the dry, measured lines a little.

* * *

As witness, I offer for your reading pleasure select excerpts from the Conclusions and Lessons Learned section of the report, with a few helpful explanatory titles and glosses of my own design.

Page 28: "Plan B? What Plan B?"

— or —

The New York Fed Conclusively Demonstrates It Cannot Plan Its Way Out of a Paper Bag, Even with a Map and a Blowtorch

When first confronted with the liquidity crisis at AIG, the Federal Reserve Board and FRBNY, who were then contending with the demise of Lehman Brothers, turned to the private sector to arrange and provide funding to stave off AIG’s collapse. Confident that a private sector solution would be forthcoming, FRBNY did not develop a contingency plan; when private financing fell through, FRBNY was left with little time to decide whether to rescue AIG and, if so, on what terms. ... Not preparing an alternative to private financing, however, left FRBNY with little opportunity to fashion appropriate terms for the support, and believing it had no time to do otherwise, it essentially adopted the term sheet that had been the subject of the aborted private financing discussions (an effective interest rate in excess of 11 percent and an approximate 80 percent ownership interest in AIG), albeit in return for $85 billion in FRBNY financing rather than the $75 billion that had been contemplated for the private deal. In other words, the decision to acquire a controlling interest in one of the world’s most complex and most troubled corporations was done with almost no independent consideration of the terms of the transaction or the impact that those terms might have on the future of AIG.

This bang-up example of tactical thinking and mental flexibility, of course, led directly to a threatened downgrade of AIG by the ever-helpful credit rating agencies, which in turn made it absolutely necessary for AIG to get out from under those nasty, collateral-sucking CDSs. This allowed the Fed staffers a stellar opportunity to affirm their collective membership in the phylum Platyhelminthes (spineless flatworms) by halfheartedly negotiating for haircuts on the CDOs underlying AIG's swaps with its recalcitrant counterparties.

Apparently, the sum and substance of these negotiations was remarkably similar to that which my bloggish antagonist Economics of Contempt rather presciently proposed just recently:

AIG: "Would you be willing to accept, say, 70 cents on the dollar?"
Goldman: "No."

THE END

I kid you not.

Seven of AIG's largest counterparties—including, for the two which were French, that beacon of unfettered capitalism and bastion against tortious interference in contract law, the Government of Fucking France—told the Fed to go pound sand. The eighth, UBS, showed a deplorable lack of principle by venturing to offer a 2% haircut to its position, as long as everyone else did. Nevertheless, the Fed decided that friends don't let friends make insultingly small unilateral concessions where the US taxpayers' dime is concerned, so they just told them to forget it.

Mr. Barofsky picks up the narrative from here:

Page 29: "Integrity Is Our Watchword"

— or —

For Some Unexplained Reason, Perhaps Having to Do with Sunspots or the Phase of the Moon, the Institution Which Presided Over the Botched Fire Sale of Bear Stearns and the Clusterfuck Incineration of Lehman Brothers Magically and Unexpectedly Decides to ~~Grow a Pair of Testicles~~ Adopt a Set of Principles

In pursuing these negotiations, FRBNY made several policy decisions that severely limited its ability to obtain concessions from the counterparties: it determined that it would not treat the counterparties differently, and, in particular, would not treat domestic banks differently from foreign banks — a decision with particular import in light of the reaction of the French bank regulator which refused to allow two French bank counterparties to make concessions; it refused to use its considerable leverage as the regulator of several of these institutions to compel haircuts because FRBNY was acting on behalf of AIG (as opposed to in its role as a regulator); it was uncomfortable interfering with the sanctity of the counterparties’ contractual rights with AIG, which entitled them to full par value; it felt ethically restrained from threatening an AIG bankruptcy because it had no actual plans to carry out such a threat; and it was concerned about the reaction of the credit rating agencies should imposed haircuts be viewed as FRBNY backing away from fully supporting AIG. Although these were certainly valid concerns, these policy decisions came with a cost — they led directly to a negotiating strategy with the counterparties that even then-FRBNY President Geithner acknowledged had little likelihood of success.

The first, of course, is my personal favorite, for there is absolutely no tactic more effective at gutting whatever leverage and flexibility you might have in a negotiation—other than shoving a fragmentation grenade up your ass and pulling the pin—than refusing to treat different counterparties differently. I remember hearing hints of this preposterous limitation in earlier accounts of the AIG fiasco, but the Fed always seemed to imply it was a legal restriction inherent in its charter. Now, perhaps, we learn differently:

FRBNY’s decision to treat all counterparties equally (which FRBNY officials described as a “core value” of their organization), for example, gave each of the major counterparties (including the French banks) effective veto power over the possibility of a concession from any other party. This approach left FRBNY with few options, even after one of the counterparties indicated a willingness to negotiate concessions. It also arguably did not account for significant differences among the counterparties, including that some of them had received very substantial benefits from FRBNY and other Government agencies through various other bailout programs (including billions of dollars of taxpayer funds through TARP), a benefit not available to some of the other counterparties (including the French banks). It further did not account for the benefits the counterparties received from FRBNY’s initial bailout of AIG, without which they would have likely suffered far reduced payments as well as the indirect consequences of a potential systemic collapse.

Oh, yeah, that was a real winner.

Also in the winner column was the Fed's newly discovered squeamishness about playing hardball. Where the fuck did that come from? Mr. Barofsky needs no gloss on this topic (pp. 29–30):

Similarly, the refusal of FRBNY and the Federal Reserve to use their considerable leverage as the primary regulators for several of the counterparties, including the emphasis that their participation in the negotiations was purely “voluntary,” made the possibility of obtaining concessions from those counterparties extremely remote. While there can be no doubt that a regulators’ inherent leverage over a regulated entity must be used appropriately, and could in certain circumstances be abused, in other instances in this financial crisis regulators (including the Federal Reserve) have used overtly coercive language to convince financial institutions to take or forego certain actions. As SIGTARP reported in its audit of the initial Capital Purchase Program investments, for example, Treasury and the Federal Reserve were fully prepared to use their leverage as regulators to compel the nine largest financial institutions (including some of AIG’s counterparties) to accept $125 billion of TARP funding and to pressure Bank of America to conclude its merger with Merrill Lynch. Similarly, it has been widely reported that the Government, while arguably acting on behalf of General Motors and Chrysler, took an active role in negotiating substantial concessions from the creditors of those companies.

Gee, that sounds familiar.

* * *

Of course, then there is the whole "backdoor bailout" question, which arguably lies at the core of the persistent conspiracy theories percolating through our troubled polity.

Page 30: "No, No, No. I Didn't Give You That Dollar, I Gave You This Dollar"

— or —

The Fed Attempts to Gauge Exactly How Stupid 310 Million Americans Really Are by Denying the Fungibility of US Currency

Questions have been raised as to whether the Federal Reserve intentionally structured the AIG counterparty payments to benefit AIG’s counterparties — in other words that the AIG assistance was in effect a “backdoor bailout” of AIG’s counterparties. Then-FRBNY President Geithner and FRBNY’s general counsel deny that this was a relevant consideration for the AIG transactions. Irrespective of their stated intent, however, there is no question that the effect of FRBNY’s decisions — indeed, the very design of the federal assistance to AIG — was that tens of billions of dollars of Government money was funneled inexorably and directly to AIG’s counterparties. Although the primary intent of the initial $85 billion loan to AIG may well have been to prevent the adverse systemic consequences of an AIG failure on the financial system and the economy as a whole, in carrying out that intent, it was fully contemplated that such funding would be used by AIG to make tens of billions of dollars of collateral payments to the AIG counterparties. The intent in creating Maiden Lane III may similarly have been the improvement of AIG’s liquidity position to avoid further rating agency downgrades, but the direct effect was further payments of nearly $30 billion to AIG counterparties, albeit in return for assets of the same market value. Stated another way, by providing AIG with the capital to make these payments, Federal Reserve officials provided AIG’s counterparties with tens of billions of dollars they likely would have not otherwise received had AIG gone into bankruptcy.

And, lastly, the SIGTARP report blasts the Fed's continued ridiculous insistence on complete confidentiality for its actions, even in retrospect. Given the revelations we have been privileged with, I can only assume the Fed's diffidence has far more to do with covering up its massive, multidimensional incompetence in dealing with AIG than with any other purpose.

Page 31: "Transparency? We Don't Need No Fucking Transparency!"

— or —

Sunlight Is the Best Disinfectant, But Only for Those Other Guys

Second, the now familiar argument from Government officials about the dire consequences of basic transparency, as advocated by the Federal Reserve in connection with Maiden Lane III, once again simply does not withstand scrutiny. Federal Reserve officials initially refused to disclose the identities of the counterparties or the details of the payments, warning that disclosure of the names would undermine AIG’s stability, the privacy and business interests of the counterparties, and the stability of the markets. After public and Congressional pressure, AIG disclosed the identities. Notwithstanding the Federal Reserve’s warnings, the sky did not fall; there is no indication that AIG’s disclosure undermined the stability of AIG or the market or damaged legitimate interests of the counterparties. The lesson that should be learned — one that has been made apparent time after time in the Government’s response to the financial crisis — is that the default position, whenever Government funds are deployed in a crisis to support markets or institutions, should be that the public is entitled to know what is being done with Government funds. While SIGTARP acknowledges that there might be circumstances in which the public’s right to know what its Government is doing should be circumscribed, those instances should be very few and very far between.

* * *

In fact, reading through this report, I find very little evidence that Barofsky et al. were even remotely swayed by the transparent nonsense the Fed used to justify its idiocy. Sure, they included it in their report, as they were no doubt required to do, but their conclusions seem remarkably impervious to the Fed's perspective.

And, weasel words aside, I read the SIGTARP report and find complete confirmation of two important points. First, the New York Fed, led by our current Secretary of the Treasury, botched the rescue of AIG so completely and so pathetically that it does border, as Yves says, on criminal incompetence. Second, the Fed had enough negotiating leverage in the entire affair to have substantially lessened the amount of taxpayer funds it ending up paying to AIG's counterparties, to the tune of billions and billions of dollars. A competent and motivated negotiator could have extracted billions of dollars in concessions with little else. But the Fed squandered that leverage, and it explicitly renounced several situational and structural advantages it possessed that contributed to that leverage, in the service of ... what, exactly? Certainly not in the service of its fiduciary duty to the American people, which cannot and should not be limited simply to the ad hoc preservation of a bunch of systemically important financial institutions.

Sadly, the horse has left the barn, the barn has burned down, and the farmer's wife has run off with the village idiot. I fear there is little upside in further speculation on what might have been. Suffice it to say, however, that I think Michael Moore should add a coda to his recent movie, Capitalism: A Love Story. In my vision, the chubby provocateur will pull his rented armored truck up to the steps of the Federal Reserve Bank and start chanting into his bullhorn:

"I am here to make a citizen's arrest of the Board of Governors of the Federal Reserve. We want our money back!"

I would pay $12.50 to see that.

© 2009 The Epicurean Dealmaker. All rights reserved.

Notes from a Presidential Address I Would Like to Hear

2009-11-12T13:40:00.006-05:00

As delivered from the bully pulpit long ago, in another time and place, which looks a lot like this time and place:

Probably the greatest harm done by vast wealth is the harm that we of moderate means do ourselves when we let the vices of envy and hatred enter deep into our own natures. But there is another harm; and it is evident that we should try to do away with that. The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is duty bound to control them wherever the need of such control is shown.

— Speech at Providence, Rhode Island (August 1902)

Every man holds his property subject to the general right of the community to regulate its use to whatever degree the public welfare may require it.

— The New Nationalism (August 1910)

Our aim is not to do away with corporations; on the contrary, these big aggregations are an inevitable development of modern industrialism, and the effort to destroy them would be futile unless accomplished in ways that would work the utmost mischief to the entire body politic. We can do nothing of good in the way of regulating and supervising these corporations until we fix clearly in our minds that we are not attacking the corporations, but endeavoring to do away with any evil in them. We are not hostile to them; we are merely determined that they shall be so handled as to subserve the public good. We draw the line against misconduct, not against wealth.

— State of the Union address (December 1902)

* * *

There is more:

We stand equally against government by a plutocracy and government by a mob. There is something to be said for government by a great aristocracy which has furnished leaders to the nation in peace and war for generations; even a democrat like myself must admit this. But there is absolutely nothing to be said for government by a plutocracy, for government by men very powerful in certain lines and gifted with "the money touch," but with ideals which in their essence are merely those of so many glorified pawnbrokers.

— Letter to Sir Edward Grey (September 1913)

Political parties exist to secure responsible government and to execute the will of the people. From these great tasks both of the old parties have turned aside. Instead of instruments to promote the general welfare they have become the tools of corrupt interests, which use them impartially to serve their selfish purposes. Behind the ostensible government sits enthroned an invisible government owing no allegiance and acknowledging no responsibility to the people. To destroy this invisible government, to dissolve the unholy alliance between corrupt business and corrupt politics, is the first task of the statesmanship of the day.

— "The Progressive Covenant With The People" speech (August 1912)

* * *

Where oh where is the Bull Moose for our time and place?

© 2009 The Epicurean Dealmaker. All rights reserved.

Veterans' Day

2009-11-11T15:20:00.003-05:00

November 11, 2009:

What passing-bells for these who die as cattle?
—Only the monstrous anger of the guns.
Only the stuttering rifles' rapid rattle
Can patter out their hasty orisons.
No mockeries now for them; no prayers nor bells,
Nor any voice of mourning save the choirs,—
The shrill, demented choirs of wailing shells;
And bugles calling for them from sad shires.

What candles may be held to speed them all?
Not in the hands of boys, but in their eyes
Shall shine the holy glimmers of goodbyes.
The pallor of girls' brows shall be their pall;
Their flowers the tenderness of patient minds,
And each slow dusk a drawing-down of blinds.

— Wilfred Owen, Anthem for Doomed Youth

Let us not forget those who have truly paid the price for our folly and our hate.

Nostra culpa, nostra culpa, nostra maxima culpa.

Photo credit: Great War Primary Document Archive: Photos of the Great War.

© 2009 The Epicurean Dealmaker. All rights reserved.

Character Study

2009-11-02T22:41:00.014-05:00

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

— The Dark Knight

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

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

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

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

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

Finally, do not forget the psychopaths.

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

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

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

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

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

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

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

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

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

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

© 2009 The Epicurean Dealmaker. All rights reserved.

Shock and Awe

2009-10-30T00:11:00.004-04:00

What the hell did I ever do to piss Steve Randy Waldman off?

I tell you honestly, Dear Readers, my afternoon conversation with this genial and intelligent gentleman started unremarkably enough, with a little playful banter in the Twitterverse on this and that. (I called myself a squirrel; he revealed himself to be a slime mold.) But then, something went horribly wrong. After trying to out me with an hurtful photograph of me wearing a hat I haven't owned in years (and an extra 20 pounds I have subsequently shed), he upped his attack on Your Peaceable and Equable Correspondent by trying to pick a fight between yours truly and the fearsome Economics of Contempt.

Now, I have to tell you I consider this very bad form. For one thing, my physical constitution and pugilistic skills are far better suited to being the spotty faced provocateur shouting "Fight! Fight!" from the perimeter of an altercation than being one of the principals. For another, I make it a practice never to get into a fight with a lawyer, unless I can attack him unexpectedly from behind with a lead pipe, preferably in the dark. Furthermore, my unwelcome opponent in this imposed brouhaha was none other than a structured finance lawyer, which every six year old knows is the most dangerous specimen of that deadly species. Heck, I work with structured finance lawyers all the time, which is why I count my fingers every time I shake one's hand and go through six liters a month of hand sanitizer.

So, suffice it to say I clicked through Mr. Waldman's incendiary link to EoC's post with a maximum of trepidation, calculating in advance just how many Russian hookers I might have to ply my opponent with to elicit mercy. But when I arrived, I breathed a virtual sigh of relief, for I discerned my opposite was far less formidable than I feared.

* * *
For one thing, Mr. Contempt's main purpose seems to have been to tie hedge fund principal and commentator Janet Tavakoli to a post and whip her decisively with a wet noodle. This he accomplished admirably, and I have nothing to add to the central thrust of his argument; namely, that Ms Tavakoli overstated her case and overplayed her hand. I also have nothing to add to his speculation on the exact size and nature of Goldman Sach's exposure to AIG in the troubled days of last Fall because, frankly, who the fuck cares?

However, I did note that Mr. C and I do in fact have a basic disagreement about the relative negotiating power at that time of Goldman Sachs and the other AIG counterparties, on the one hand, and the Federal government as owner of AIG, on the other. This, I think, is the core of his argument:

[T]here's no way Goldman would ever have agreed to a "bankruptcy-like settlement" — why would they? As someone who has actually been involved in these kinds of negotiations, let me explain how the AIG/Goldman negotiations would have played out:

AIG: Would you be willing to accept, say, 70 cents on the dollar?
Goldman: No.

THE END

Seriously, what could AIG have threatened Goldman with? If they didn't accept a haircut, AIG would file for bankruptcy? Fine, Goldman would've just seized the $7.5 billion in cash collateral, and collected the remaining $2.5 billion from its counterparties on the now-triggered CDS on AIG (on which more below), covering Goldman's full bilateral exposure to AIG. That's what it means to be "hedged."

(This is also why the Fed paid Goldman and the other counterparties 100 cents on the dollar to terminate their CDS contracts with AIG, which this Bloomberg article portrays as some sort of gift to the banks. But the Bloomberg article also relies on the Immaculate Negotiation argument — how, exactly, was the Fed supposed to get the counterparties to agree to take a haircut? The Fed had just demonstrated to the entire world that it wasn't willing to let AIG file for Chapter 11. How do you suppose those negotiations would have gone? The Fed couldn't say, "You can either take a haircut to 70 cents or AIG will file for bankruptcy and you'll only get 50 cents," because everyone knew the Fed wasn't willing to put AIG in bankruptcy.)

He then finesses Tavakoli's argument that Goldman wasn't adequately hedged in such circumstances because AIG's collapse would have engendered widespread systemic disruption and called into question not only the capability of any counterparty to satisfy its obligations under a hedge but also the health and solvency of every participant in the financial system. He does this by saying: 1) Oh yes they could, because the hedges were adequately collateralized, and 2) the potential for total systemic meltdown wasn't the scenario Goldman's CFO was talking about when he said they were adequately hedged. While neatly parrying Ms Tavakoli's principal charge that Goldman lied about its exposure, you must see that this argument almost entirely begs the question.

Mr. C also disagrees that Goldman—and, presumably by extension, the other counterparties to AIG's CDSs—faced any reputational pressure in these negotiations. He writes:

Finally, Tavakoli argues that Goldman's exposure to AIG included "reputation risk." Yes, I'm sure that if AIG had failed, Goldman's reputation for having prudently managed its counterparty risk would've been devastating.

While comprising an admirable example of sarcastic snark, this remark completely mischaracterizes the circumstances surrounding AIG's near death experience last year. All one need do is read a few pages in Andrew Ross Sorkin's hour-by-hour account of the collapse of Lehman Brothers and its aftermath to realize that "reputation risk" encompassed far more than each individual firm's performance of its fiduciary duties alone. More to the point, the CEOs and Boards of the principals involved were very well aware that business—or fiduciary duty, or contract law, or corporate governance—as usual was completely and utterly out the window:

On the surface, Goldman looked like one of AIG's biggest counterparties, but earlier that morning, Goldman's Gary Cohn had boasted internally that the firm had hedged so much of its exposure to AIG that it might actually make $50 million if the company collapsed. The firm's decision to buy insurance in the form of credit default swaps against AIG beginning in late 2007 was starting to seem like a smart investment. The firm had conducted what it internally called a "WOW analysis"—a worst-of-the-worst case scenario—and it was quickly coming true. Even though Goldman had hedged its direct exposure to AIG, [Lloyd] Blankfein appreciated the larger problem: The collateral damage to its other counterparties and the rest of the market could expose the firm to untold billions in crippling losses.¹ [emphasis mine]

So, let us not be legalistic, or simplistic, or disingenuous here. Under normal circumstances, I would completely agree with my professional better and, indeed, would and have paid him and his kind mucho dinero to advise me on the way structured finance does and should work when all is right with the world. But virtually nothing was right with the world in the fourth quarter of 2008. Cats laid down with dogs, Paris Hilton matriculated at Oxford, and the thundering hoofbeats of the Four Horsemen could be heard in broad daylight throughout the canyons of Wall Street. The system was on the knife's edge of chaos, and everyone with half a brain—including Goldman Sachs and all of AIG's other counterparties—was very well aware of that.

* * *
So, in the spirit of Mr. Contempt's entertaining post, I would like to propose an alternate transcript for what I think might have occurred during those dark days had I or one of my professional counterparts been in charge of negotiations with Goldman Sachs et al. Normally, I would not reveal a potential negotiating strategy such as this in public without an enormous and frankly obscene fee already marinating nicely in my personal bank vault, but I am feeling inexplicably charitable. Also, it is clear from the underwhelming response to my previous offer of assistance that the Federal government has the backbone and intestinal fortitude of an earthworm, so I'm not worried I am giving away potentially lucrative advice to a client who might actually hire me.

Anyway, let's proceed:

TED, as representative of the Federal government and AIG: Welcome, gentlemen. Please take a seat, and let's begin.

Senior representatives of Goldman Sachs, SocGen, BAML, et al., as counterparties to AIG: Thank you.

TED: Now, you all realize we are here to resolve the payments which the government of the United States of America, as majority and controlling owner of AIG, proposes to make to each of you to cancel the credit default swaps from AIG you each hold. Before we begin, I would like to make a few opening remarks.

Counterparties: Uh, okay.

TED: First, let me remind you that we are here—and the federal government is here—because our country and indeed the entire world stands upon a knife's edge. We took control and injected tens of billions of dollars of taxpayer money into AIG because we did not want to see this company collapse in an uncontrolled fashion. We believed then, and still believe, that such a collapse would threaten the entire global financial system and indeed the entire global economy. I do not need to explain to you gentlemen the effect such a collapse would have upon each of you, your firms, your employees, and your capital providers. I do not need to explain to you the effect such a collapse would have upon our society, our political system, and indeed the very social order upon which we depend to live our daily lives. We in the government do not have a crystal ball in this regard, but I have been authorized from the very highest level to convey to you that we are scared shitless. You should be too.

Counterparties: [Uncomfortable silence; shifting in seats; coughs]

TED: I have also been authorized to inform you that we are fully aware of the legal rights and fiduciary duties which constrain each of you to do what you think is best for your firms and your stakeholders. Under normal circumstances, we would be entirely supportive of these obligations. However, these are not normal times. Furthermore, and because these are not normal times, I would like to inform you that the government of the United States of America will take an extremely dim view of any individual or institution which chooses to pursue simply its own interest and its own duties without regard for the consequences to the broad economy, this country, and indeed the entire world. This government has a fiduciary duty too, gentlemen, and I am afraid that it trumps yours.

Counterparties: [Angry murmurs, outbursts, shock and outrage, etc.]

TED: Gentlemen, gentlemen, please. Let me continue. I am not finished.

Now, this discussion is a voluntary one. None of you have been compelled to attend this meeting, nor indeed can be compelled to give your acquiescence to what we intend to propose. Some of you here represent companies which are headquartered in foreign countries, and which derive their corporate authority and obligations from the laws of other lands. Be aware that the United States government has already discussed the settlements we will propose here today with ranking representatives of your countries' governments, and we have received their approval and acquiescence.

We previously requested that all of you arrange whatever entities you may need to authorize the corporate and board level approvals your bylaws may require to be standing by, so there is no further delay in resolving these critical issues. The decision point is now, gentlemen. It is today. It is in this very room. The government of the United States of America will brook no further delay.

Counterparties: [Wilting, sweating, uncomfortable silences]

TED: And before we get to brass tacks, gentlemen, allow me to make a personal observation. I have known and admired many of you for many years, and I personally respect the power and dignity of each of your individual institutions.

But I am not your friend today. I am not your fucking friend. As far as you are concerned, you should view me as the Angel of Fucking Death. Because the time has come for each of you to do what is right for the greater good. It is time to think about survival, gentlemen—your own and that of your institutions—both now and in the future. For let me assure you that the decisions you make in this room today will be remembered. They will be remembered, gentlemen, as long as there is a United States of America. And if, God willing, we all come through this terrible crisis to a safer and more stable world, those people who helped us get there will be remembered. And, perhaps more importantly, those people and institutions in this room which did not help us, which put their own narrow personal and corporate interests before the interests of this nation and its people, will be remembered as well.

And let me tell you something, gentlemen, banker to banker: you do not want to be on that list. That list will be a world of pain. That list will be Death. That list will be populated with people and institutions which will have the full weight, power, and authority of the government of the United States of America brought down on them in the most thorough, comprehensive, and legal way you could possibly imagine. That list will be the proctology exam from Hell, and it will never end.

So, having set the stage, you should each find before you a term sheet with a proposed haircut for the AIG CDSs your institution currently holds. In each case, this is the government's best and final offer. I would like each of you to retire from this room with your team, talk it over amongst yourselves and with your Board, and bring the signed term sheets indicating your firm's acceptance of these terms back to me in this room. You have one hour.

Any questions? No?

Then I thank you for your attention. You may leave.

* * *
Would this approach have recovered all 40% of the original discount AIG tried to obtain? Probably not. Tough talk or no, the assembled banks would balk at completely unreasonable demands by the government. And if they balked, they would have time to mobilize their vast lobbying apparatus to try to counteract the government's bid through Congress. Delay would be deadly. You could not allow the counterparties to regroup, or even collect their thoughts.

You've gotta drop a daisy cutter on their ass, and roll the tanks in immediately thereafter. Shock and awe, baby.

But you know why this could work? Because all those bank CEOs and CFOs would look across the table at me and realize: this guy is a mercenary, heartless, psychopathic bastard just like me. And he is getting paid to run a Roto Rooter up my ass. Let's get it over with, and then I can plan my revenge on this bastard later on.

I'm an equal opportunity asshole, baby. I'll screw anyone over. Investment banks can deal with that.

¹ Andrew Ross Sorkin, Too Big to Fail. New York: The Viking Press, 2009, p. 383.

© 2009 The Epicurean Dealmaker. All rights reserved.

Never Send a Boy to Do a Man's Job

2009-10-27T23:37:00.007-04:00

Interesting article over at Bloomberg.com this morning. Did you see it?

Oct. 27 (Bloomberg) — In the months leading up to the September 2008 collapse of giant insurer American International Group Inc., Elias Habayeb and his colleagues worked nights and weekends negotiating with banks that had bought $62 billion of credit-default swaps from AIG, according to a person who has worked with Habayeb.

Habayeb, 37, was chief financial officer for the AIG division that oversaw AIG Financial Products, the unit that had sold the swaps to the banks. One of his goals was to persuade the banks to accept discounts of as much as 40 cents on the dollar, according to people familiar with the matter.

Among AIG’s bank counterparties were New York-based Goldman Sachs Group Inc. and Merrill Lynch & Co., Paris-based Societe Generale SA and Frankfurt-based Deutsche Bank AG.

By Sept. 16, 2008, AIG, once the world’s largest insurer, was running out of cash, and the U.S. government stepped in with a rescue plan. The Federal Reserve Bank of New York, the regional Fed office with special responsibility for Wall Street, opened an $85 billion credit line for New York-based AIG. That bought it 77.9 percent of AIG and effective control of the insurer.

...

Beginning late in the week of Nov. 3, the New York Fed, led by President Timothy Geithner, took over negotiations with the banks from AIG, together with the Treasury Department and Chairman Ben S. Bernanke’s Federal Reserve. Geithner’s team circulated a draft term sheet outlining how the New York Fed wanted to deal with the swaps—insurance-like contracts that backed soured collateralized-debt obligations.

...

Part of a sentence in the document was crossed out. It contained a blank space that was intended to show the amount of the haircut the banks would take, according to people who saw the term sheet. After less than a week of private negotiations with the banks, the New York Fed instructed AIG to pay them par, or 100 cents on the dollar. The content of its deliberations has never been made public.

Uh, okay.

* * *
I must admit, Dear and Long-suffering Readers, that my first reaction to this news was of a kind with several of the sources quoted in the article: white-hot, scalding rage.

I mean, what the fuck?! Tim Geithner and pals left up to thirteen billion dollars of taxpayer money just sitting on the table? Why?

[B]ecause some counterparties insisted on being paid in full and the New York Fed did not want to negotiate separate deals, says a person close to the transaction.

Oh, that's a good reason. No, really, I mean it.

Dumb fucking cocksuckers.

* * *
Now, to be fair, I am not willing to swallow the Bloomberg article hook, line, and sinker. For one thing, none of the numbers I have been able to glean either from it or from other sources add up. I suspect the high-speed, real-time negotiations over cancelation of the credit default swaps, purchase of the "super-senior" CDOs underlying AIG's CDSs, and coincident payment by AIG of increasingly frequent, strident, and large collateral calls by its counterparties during the frantic days of mid-September a year ago make it damn difficult for anyone to reconstruct exactly what happened and who paid how much to whom and when, much less a bunch of underpaid, slightly innumerate financial reporters.

And you definitely need to read between the lines. Just because Elias Habayeb intended to persuade Goldman Sachs, SocGen, Merrill Lynch, Deutsche Bank, and several other representatives of The Great Deceiver Here on Earth to accept 40% haircuts doesn't mean he had a snowball's chance in hell of doing so. In fact, the GAO's September 2009 report on the AIG fiasco unequivocally states his efforts failed prior to the government takeover (p. 17):

AIG’s negotiations with counterparties and creditors to reduce the outstanding obligations through contract renegotiation had proven unsuccessful.

But this selfsame GAO report clearly outlines the issue with the Fed's subsequent precipitate actions (p. 18):

Critics of the government’s assistance have noted that by providing assistance to AIG for the purpose of providing or returning cash collateral to counterparties, the government was indirectly assisting the counterparties, and they questioned the efficiency of this approach. Some noted that banks that had bought CDS contracts from other failed insurers were paid 13 cents on the dollar in deals mediated by New York’s insurance regulator, whereas AIG’s counterparties were paid market value. They said that new capital to AIG in effect served as direct infusions to the counterparties, including foreign financial institutions. Conversely, Federal Reserve officials believed that if AIG had failed to pay the collateral amounts due, it would have been in default of its agreements, which could have resulted in AIG’s counterparties forcing it into bankruptcy. Moreover, they believed that the unfolding crisis warranted swift action to prevent total collapse of the financial system given its fragile state at that time.

It is clear that some banks were in deep doo-doo as AIG spiraled ever more quickly toward its predestinate sticky end (p. 22):

Finally, the Federal Reserve and Treasury stated in separate reports and testimonies in the fall of 2008 and early 2009 that the failure of AIGFP could have led to billions of dollars of losses at bank counterparties that bought CDS contracts from AIG.²⁹ Because many banks used these contracts as credit protection, following losses to CDS contract holders, if any, AIG’s failure could have led to mounting losses through sudden, unhedged, uncollateralized exposure as market conditions worsened and underlying assets continued to decline in value. Banks and other counterparties could have faced declining capital bases because of these unrealized losses. Moreover, counterparties with unfulfilled derivative contracts could have faced difficulties in offsetting balance sheet exposures through replacement derivatives, and they would have had to confront the possibility of entering into new contracts at a time when market participants had become increasingly risk averse and unwilling to execute new transactions.

Of course, not all of AIG's counterparties would have faced wrack and ruin had it defaulted on its obligations. Most notably, Goldman Sachs crowed loud and long at the time that it was fully hedged against AIG's untimely demise, and that it couldn't give a rat's ass whether Bob Willumstad's company took the pipe or not. This has led more than one market observer to speculate that the $11 or $12 or $13 billion in cash which the Federal Reserve presented to Goldman on a silver platter represented a particularly fetching and unexpected gift from the pockets of the American taxpayer direct to the bank accounts of Goldman's employees. It certainly encourages me to believe that whatever difference between a realistic haircut Goldman could have expected to endure on AIG's CDSs and the no-haircut they did receive represents a particularly large and tasty helping of frosting on an already delicious and unexpectedly rich cake.

Taking, for argument's sake, the 40% figure bandied about, that would be about five billion dollars worth of buttercream for Lloyd and his buddies. Or, as a point of reference, a figure approximately equal to the entire compensation and benefit expense Goldman recorded in its most recent fiscal quarter. Sweet, huh?

* * *
So, what's my point?

Just this: Tim Geithner and the Federal Reserve got royally played. And you and I, my friends, paid dearly for the privilege.

Sure, the Fed was worried that AIG's uncontrolled collapse could lead to a complete and utter meltdown of the global financial system. Even now, with the worst of the crisis behind us and plenty of time to reflect, it is hard to criticize this worry as hysterical. It is also true that things were moving way too quickly to sit down and think them through logically, so we should not superimpose unreasonable expectations of measured, rational thought on the Fed's negotiators. It is also even remotely possible that some of AIG's counterparties were so inept and unprepared for the insurance company's troubles that they truly might have blown up themselves if it went down. (Although AIG's train wreck was so long coming and so well telegraphed that any bank so blind to the obvious and unprepared for the inevitable probably should have been shut down purely on principle.)

But Christ, people, think about it.

What moronic financial entity—fully hedged or not—would really risk global financial catastrophe by throwing AIG into bankruptcy, even if it had the contractual and legal right to do so? Because it insisted on receiving 100% of the proceeds due to it by contract? Even though parties to financial contracts renegotiate existing terms under normal market conditions all the time? What good, for example, would those extra five billion clams—not collected, by the way, until the bankruptcy judge wound the company down, if ever—have done Goldman Sachs if it, Morgan Stanley, and every other major investment and commercial bank were in liquidation too?

Furthermore, what foreign or domestic bank CEO in his right mind has the balls to threaten the government of the United States of America with financial meltdown if it doesn't cough up another couple billion dollars out of the public purse? Are you fucking kidding me?

AIG's counterparties had no leverage whatsoever. None.

Of course, Geithner and Bernanke were over a barrel, too, because they didn't want to do anything stupid to trigger Armageddon either. Among other things, I believe it is in their brief to prevent just such annoyances. I do not claim they should have been able to get all 40% of the target discount from the banks. But nothing? Not even from the guys who claimed not to care?

Give me a break.

* * *
Now, I am sure I will catch flak from the usual suspects—ignorant twenty-somethings who have never renegotiated a contract in their lives and disingenuous ideologues who have and should know better—for suggesting it, but I think the Fed has a good case for clawing back some of AIG's payments. I think a couple of quiet words with the CEOs and Boards of Goldman Sachs, SocGen, BofA, and Deutsche Bank could go a long way toward encouraging a "voluntary" return of some of these monies to the public purse. Consider it, if you will, a generous donation from the assembled titans of finance for the benefit of the regulators who pulled their testicles out of the fire a mere thirteen months ago. A grateful gift, so to speak, from the money men to the people and officials who make their very existence possible.

Of course, history and common sense tell us that a mere bureaucrat will lack the credibility to deliver such a ~~threat~~ message to the Masters of the Universe. Even now, as Secretary of the Treasury, Mr. Geithner is more likely to inspire giggles of disbelief from Lloyd Blankfein et al. than deferential respect.

No, what you need is a professional psychopath, a highly trained and expert negotiator, who will tuck his Hermes tie into his shirt and slap the offending CEOs silly before emptying their firms' bank accounts. Someone who can run roughshod over the rights and expectations of self-interested plutocrats in the name of Life, Liberty, and the Pursuit of Happiness, or at least a balanced budget. Someone who can make assembled onlookers squeal in horror as he tramples precedent, custom, and noblesse oblige into the mud alongside all the other tired, self-righteous pablum capitalists and free marketeers have been reciting like Holy Writ for nigh on thirty years.

Someone who isn't afraid to negotiate hard. Someone who isn't afraid to scream, and yell, and threaten all sorts of horrible consequences, real and imagined, for anyone who doesn't accede to his demands.

And, since Steve Rattner is no longer in the picture, I guess it'll just have to be me.

Lloyd, you are so fucked.

© 2009 The Epicurean Dealmaker. All rights reserved.

Primus inter Pares

2009-10-16T15:31:00.006-04:00

No! I am not Prince Hamlet, nor was meant to be;
Am an attendant lord, one that will do
To swell a progress, start a scene or two,
Advise the prince; no doubt, an easy tool,
Deferential, glad to be of use,
Politic, cautious, and meticulous;
Full of high sentence, but a bit obtuse;
At times, indeed, almost ridiculous—
Almost, at times, the Fool.

— T.S. Eliot, The Love Song of J. Alfred Prufrock

Bruce, you sneaky bastard.

By now, most of you in the hermetic little world of finance have discovered that Bruce Wasserstein passed away Wednesday. He snuck out of the theatre early, making some excuse or other about taking a phone call or smoking a cigarette or something, and never returned. He left so quickly and quietly it feels like he skipped out on a debt. He was 61.

It is a measure of how much the world has changed from the days when the so-called "Father of M&A" bestrode the financial markets like a colossus that the ripples from his passing have already begun to dissipate. He has already disappeared from the front page of The Deal.com, the online version of the M&A newspaper of record which he conceived over a decade ago and supported until his death, hurried off by the bustle of current deals and events. From my admittedly narrow vantage point atop a skyscraper deep in the heart of the least American part of America, I cannot tell whether his passage even registered with the country at large. "Bruce who?," most people probably asked, "Wasn't he the boy who got trapped in the balloon?" Sic transit gloria.

In some respects, I think Bruce would have wanted it this way. Dealmaking is a guerrilla war that never ends, fought in both sunlight and shade, in clamor and in silence. When your captain is killed, you pause to recite a hurried prayer, then you step over his cooling body and move on. There are no battlefield monuments in this war. Nor should there be.

On the other hand, there was part of Bruce—a big part—that loved the limelight and craved being the center of attention. In this way, he was completely unlike T.S. Eliot's attendant lord. During his heyday in the 1980s, Bruce intentionally broke the mold of the modest, retiring consigliere to become a prime mover himself. He abjured the merger advisor's traditional place behind the throne of the CEO or the private equity mogul to become a kingmaker, a catalyst, and a decision maker in his own right. He grabbed the spotlight away from companies and firms actually doing the deals and shone it upon himself. In the process, he shone a light into the heretofore obscure and recondite universe of M&A bankers, and he helped raise awareness of them and their trade far beyond the claustrophobic little world of central and lower Manhattan and the boardrooms of major corporations. Bruce became the story.

And some people never forgave him for that.

* * *

Like most complicated men, Bruce Wasserstein leaves a complicated legacy.

He was brilliant and precocious, sure. He was also loud, arrogant, and overbearing, but he could sweet talk a pit bull off a juicy bone. He was principled and opportunistic. He could be simultaneously disheveled and as smooth as glass.

As the mainstream media has done the rounds of his peers, clients, and competitors, many have come to call him an innovator in the field of M&A. I think this misses the mark. Sure, Bruce was smart as hell, and thought up some pretty tricky maneuvers in his day, alongside a pretty long list of other people. But it's not like he made the kind of enduring contribution that, say, über-attorney Marty Lipton did when he invented the poison pill. There is no M&A Heimlich Maneuver with Bruce's name on it. It would be foolish to look for one.

Being smart and effective in M&A requires being able to apply techniques, approaches, insight, and analysis to an ever-shifting set of contingencies and personalities in the context of a potential deal. At base, it is a tactical art, and Bruce was a master tactician. Virtually no deal is exactly like another, just as no client, deal rival, or competitor is like another. You need to be able to sense shifting strengths, weaknesses, threats, and opportunities and craft an approach to deal with them in real time. It is an art that requires quick, perceptive, deep, and supple thinking. Like chess, it encourages you to think several moves ahead. Unlike chess, legal moves are practically unlimited, and each of your pieces has a sometimes distressingly unique personality and often requires tremendous persuasion just to get off its ass and move already.

Unlike many M&A bankers, however, who are good in the trenches of individual battles, Bruce proved himself capable of waging a war as well. Like the best generals, he could think not only tactically but strategically. This, for me, is most clearly demonstrated by his masterful campaign to wrest control of the storied investment bank Lazard from the iron grip of Michel David-Weill. By the time David-Weill hired Wasserstein to help bolster his firm's sagging fortunes, Bruce had already made a large fortune pawning off his old boutique to Dresdner Bank. It is not clear to me he was looking for much more than a comfortable perch to while away the twilight of his career and enjoy his newly monetized wealth. However, soon after he arrived, Bruce must have sensed an opportunity to gain control of the factionalized firm from its imperious owner, and he set about doing so. Long story short, he totally remade the firm by hiring tons of expensive new bankers, which had the simultaneously happy effect of stacking the ranks with Wasserstein loyalists and draining so much cash from Lazard's coffers that David-Weill and the other absentee owners ultimately had to agree to take the firm public. In the midst of these maneuverings, Bruce executed a neat judo flip and defenestrated the fearsome David-Weill from the firm which had been his lifelong legacy. It was a masterpiece of strategic dealmaking and boardroom Realpolitik.

But Bruce could often be his own worst enemy. He famously detested the moniker "Bid 'em up Bruce" which rival dealmakers painted him with early in his career, but the label stuck, and for good reason. Furthermore, his determined cultivation of the limelight and naked pursuit of his own self interest severely colored most corporate and private equity dealmakers' perceptions of him. Shortly after he achieved notoriety on Wall Street—and, later, in the broader corporate and dealmaking world—people began to view Bruce as a form of plutonium. In other words, a really powerful substance that was extremely effective in limited—often hostile—circumstances, but one which could poison the unwary user if not handled with extreme care.

Many CEOs and Boards of Directors held their noses when hiring Bruce, and kept their hands on their wallets at all times when he was in the room. A common complaint of dealmakers at the time was that there were always at least five competing motives at play when a client discussed a potential deal with Bruce: the client's own, Bruce's own obvious self-interest, and three other motives percolating in Bruce's head which might or might not become apparent over time. The only thing most clients were certain of was that Bruce's motives were only coincidentally aligned with their own. Often, companies which had already retained advisors would hire Bruce's firm as well, just to prevent him from working for real or potential competitors on the deal. They would then pointedly fail to invite him to meetings. Bruce probably took umbrage at this kind of behavior, and I am sure some of it was unfair, but you can be sure he cashed the fee checks anyway. I certainly would have.

* * *

I do not have a strong handle on Bruce Wasserstein as a person. He was neither mentor nor friend to me, and we crossed paths only a few times over the course of my career, and not meaningfully.

But I did admire how he aged over time. He seemed to lose some of his rough edges and arrogance with age and success, and he developed a personal gravitas that was both pleasing and impressive in recent years. Some of the most heartfelt tributes to him I have seen have come from the field of journalism, which he had a lifelong passion for, and which he supported with money and influence for decades. It appears he could stay in the background, in a supporting role, where his media properties were involved. This does him great credit.

His peers and rivals have lined up to offer praise and remembrance as well. I suppose I am too cynical, but my investment banker's radar has picked up far too much preemptive posturing and self-aggrandizement in most of these supposed encomia. Even in death, Bruce's competitors feel the need to measure themselves against him. Which, I suppose, is a fair measure of his stature.

At an industry conference in Cambridge today, David de Rothschild said

he was “extremely sad to see someone of that caliber go” and that “no normal banker should feel any different to see such a competitor go.”

Methinks this smacks of too much protest. Every senior investment banker—and hundreds of senior executives outside the industry all over the world—is perfectly justified in having mixed feelings about Bruce Wasserstein's passing. On the one hand, a brilliant and tremendously influential industry figure—one who arguably did more than anyone else to transform the M&A industry—has passed away, and the industry is the poorer for it. On the other hand, Bruce was a fearsome and clever competitor and adversary to many of us, and I am sure a substantial number of people around the world breathed a somewhat guilty sigh of relief at the news of his passing.

After all, I do not recall any of the leaders of Europe suffering particular regret at the news of Napoleon Bonaparte's death, either.

* * *

For the dead, we owe only honesty and respect. For the living, we owe our sympathy.

In closing, let me acknowledge that Bruce was also a human being, with family, friends, and others who cared for him. I extend my personal sympathies to each and every one of them for their loss.

Exalted and sanctified is God's great name
in the world which He has created according to His will
and may He establish His kingdom
may His salvation blossom and His anointed near
in your lifetime and your days
and in the lifetimes of all the House of Israel
speedily and soon; and say, Amen.

Wherein I Go Mosquito Hunting with a Howitzer

2009-10-12T23:30:00.005-04:00

I guess James Kwak ate a bad oyster or two at the Yale Law School cafeteria this evening. He rants:

Further Proof That Nothing Has Changed

Overheard on the streets of New Haven, just ten minutes ago:

Two young women, almost certainly Yale undergraduates, are walking down York Street, discussing their efforts to get jobs as bankers.

Student #1: “Why does everyone want to go into banking?” [Note: When an Ivy League undergrad says "banking," he or she invariably means "investment banking," meaning underwriting or trading.]

Student #2: “We should advertise – ‘Being a lawyer is so much better than banking.’”

Student #1 (after a pause): “Seriously, everyone wants to go into banking.”

End scene.

Also further proof that no one does campus recruiting better than a Wall Street investment bank. Or do undergrads these days want to work in industries that are best known for torpedoing the entire economy through a combination of greed and incompetence (and abusing their customers along the way)?

At least, after the last twelve months, no one can claim that he didn’t know what kind of business he was getting into.

By James Kwak

I mean, seriously, Jim, what the fuck?

* * *

Let me respond to Mr. Kwak's apparently throwaway anecdote with a few of what I hope will be corrective observations.

First, unlike Mr. Kwak, I do not pretend to know what Yale undergrads mean by "banking" or "investment banking." But as a practitioner with almost twenty years in the business, I can most reliably assure him there is more to investment banking than securities underwriting and trading. Depending on which kind of investment bank we are talking about, its business can comfortably encompass not only these, but also mergers and acquisition advisory, restructuring advisory, corporate lending, leveraged finance, derivatives, structured finance, proprietary trading, and even private equity investment. These are all very different businesses, with different career paths, different duties and responsibilities, and different cognitive and personality requirements for individuals who might choose to enter them.

An individual who might make an excellent corporate financier is almost certainly incapable of being an outstanding trader, and vice versa. I should bloody well hope that any Wall Street recruiter worth his or her salt has identified the different career paths available at his or her firm for the benefit of the wide-eyed young undergraduates and clarified their different requirements. If not, they should damn well be fired.

Perhaps it would bolster Mr. Kwak's understanding if I were to draw an analogy with his current career path. Saying that investment banking consists solely of underwriting and trading is almost exactly analogous to saying the practice of law consists of no more than intellectual property management and environmental litigation. (Which, for those of you not well versed in the intricacies of the legal industry, is fucking preposterous.)

I don't know how current Ivy Leaguers think, Mr. Kwak (and I suspect you don't either), but if you're going to presume to talk about my industry in a public forum, I suggest you get it right.

* * *

Second, Wall Street investment banks do do campus recruiting better than anyone else, or at least they used to. Part of this can no doubt be attributed to the fact that successful investment bankers like me are devilishly charming, stunningly handsome, scathingly brilliant, and in every other respect fucking paragons of the best and brightest an Ivy League education has to offer. Of course, even those nattering nabobs of negativism like Mr. Kwak who would deny the preceding have to admit upon examination of the facts that Wall Street's recruiting efforts on university campuses have been massively successful for the simple reason that—for a certain type of Ivy League individual—these jobs are fucking awesome.

How so, you ask? Well, let me count (a few of) the ways.

For one thing, they are exciting.

Unlike, say, 99.6% of all other jobs available to a wet-behind-the-ears idiot in proud possession of little more than an expensive college degree, becoming an investment banker fresh out of college is a huge rush. Depending on what role they perform, new entrants just weeks into the job can participate in billion dollar underwritings, multi-billion dollar mergers, complicated cross-border restructurings, or devilishly complex trading programs, all the while possessing a level of experience formally known in the industry as "jack shit."

In what other industry, I ask you, can a 22-year-old who just stopped wetting the bed three weeks ago participate in a deal which runs for weeks on the cover of The Wall Street Journal or the Financial Times? To be sure, he is probably doing little more than making copies, getting coffee, and trying not to look as stupid and lost as he feels, but at least he is in the room. Contrast this, if you will, with a fresh McKinsey recruit tasked with interviewing shop floor supervisors to develop a human resources inventory for a ball bearing manufacturer in East Bumfuck, Illinois. Or a pre-law student who spends 80 hours a week in a windowless basement cross-checking sale-leaseback contracts for a patent dispute in Moldavia. On average, young investment bankers spend less time traveling that management consultants and more time sleeping than corporate attorneys. Plus, they get to tell their friends and family that they carried Bruce Wasserstein's bags. What could be better?

For another, investment banking jobs are challenging.

Excluding certain training programs for elite military units, there are few career choices available to a young person as emotionally and intellectually challenging as investment banking. The pressure is intense, the expectations of your bosses and clients completely insane, and you swim in a Sargasso Sea full of assholes who would as soon rip your head off as look at you. It is an environment, if you can survive it, that fosters an intense esprit de corps among your peers and immense personal pride in your own accomplishments. As such, it can be considered emotional crack cocaine to those hyperaggressive, intensely driven, super-competitive young psychopaths whose mommies and daddies have pushed them down the Deerfield–Harvard–Goldman Sachs path to Übermensch-dom from infancy.

Long gone are the days when investment banking was a quiet backwater for the idiot sons of wealthy WASPs. For decades now, socially ambitious families have been steering brilliant little Bobby and Sally toward positions at Goldman Sachs and Morgan Stanley as the pinnacle of social achievement. Bobby and Sally have drunk this goal in with their mother's milk. Surely you don't think a little recession or crisis is going to change that right away, do you?

And, finally, there is the money.

Surely I don't have to explain about the money.

* * *

Third, I really do take exception to Mr. Kwak's pusillanimous little swipe at my industry for "torpedoing the entire economy." Admittedly, several large investment and commercial banks utterly failed to cover themselves in glory during the recent crisis. I have said so myself, repeatedly, in these pages. However, notwithstanding Mr. Kwak's insinuation, investment bankers were far from alone in contributing to the epic clusterfuck we have just lived through. We had plenty of help from shortsighted and incompetent regulators, meretricious and ignorant politicians, and greedy and disingenuous investors, not to mention millions of ordinary Americans who apparently believed it was their God-given right to own a million dollar house and three plasma televisions, no matter how little money they made.

In fact, I think you might have to look long and hard to find someone who was not culpable in some way for what happened. I, for one, would not automatically exclude the other professional enablers of corporate and institutional idiocy in our economy: the management consultants and the lawyers. It is a well-known fact that Mr. Kwak's own alma mater, McKinsey, has been the strategic consulting firm of choice for almost every major Wall Street investment bank for decades. Bang-up job, Jim.

* * *

Anyway, I grow tired of shellacking Mr. Kwak's flimsy, ill-considered post with the Howitzer of Truth, so I will try to close on a more productive note.

For those youngsters still considering a career in investment banking, I would offer the following. On the positive side, the excitement, challenge, and relatively plentiful monetary rewards of a career in my business should remain. The fundamental nature of the business, and the need for our services in the economy, will not change. On the negative side—and diminishing somewhat the preceding attractions, at least for a time—the industry will shrink, and this will make it harder both to get and to keep a job. Some subspecialities on the trading side might disappear completely.

But if you are smart, aggressive, driven, and competitive, I can think of few industries better suited to your personality than mine.¹ (And, unlike elite military units, people rarely shoot at investment bankers. At least not yet.) You may not receive the kind of social admiration and approbation of your career that you and your parents were looking forward to, but the personal rewards of doing well in one of the toughest professions out there will remain.

And, in any event, you will always be able to sneer with impunity at the lawyers.

UPDATE: To his credit, James Kwak has removed the egregious crack to which I took offense, calling it "gratuitous," and replaced it with a more anodyne remark. I will let my comments stand, however, since his original swipe was of a kind with many of the ludicrous comments attending his post. It is also sadly symptomatic of a persistent knee-jerk tendency in the media and the populace at large to scapegoat investment banking for all our current troubles, whereas by my most recent calculations we can legitimately be blamed for only 16.27% of the crisis.

POSTSCRIPT: Some correspondents have taken exception to my apparent boosterism of entry-level career opportunities in investment banking. Should any of you be of like mind, might I gently suggest you reread my remarks with a more critical eye? You might detect a faint whiff of a commodity somewhat rare in these over-strident times: irony. Just a thought.

¹ Especially if you're a girl.

© 2009 The Epicurean Dealmaker. All rights reserved.

Cold Pastoral

2009-10-09T16:30:00.000-04:00

Heard melodies are sweet, but those unheard
Are sweeter; therefore, ye soft pipes, play on;
Not to the sensual ear, but, more endeared,
Pipe to the spirit ditties of no tone:
Fair youth, beneath the trees, thou canst not leave
Thy song, nor ever can those trees be bare;
Bold Lover, never, never canst thou kiss,
Though winning near the goal —yet, do not grieve;
She cannot fade, though thou hast not thy bliss,
For ever wilt thou love, and she be fair!

...

O Attic shape! Fair attitude! with brede
Of marble men and maidens overwrought,
With forest branches and the trodden weed;
Thou, silent form, dost tease us out of thought
As doth eternity: Cold pastoral!
When old age shall this generation waste,
Thou shalt remain, in midst of other woe
Than ours, a friend to man, to whom thou sayst,
"'Beauty is truth, truth beauty,' —that is all
Ye know on earth, and all ye need to know."

— John Keats, Ode on a Grecian Urn

Enjoy your weekend.

© 2009 The Epicurean Dealmaker. All rights reserved.

Res Ipsa Loquitur

2009-10-05T20:24:00.002-04:00

Subsequent to my recent half-hearted cudgeling of the Shaggy Horse of Shareholder Governance as an important contributor to the excessive pursuit of risky returns by publicly-owned financial institutions, my argument received overwhelming reinforcement today in the pages of the The New York Times Dealbook from the person of scarily smart and excessively erudite Delaware corporate jurist Leo E. Strine, Jr.

Not only did Herr Professor Doktor Strine take the heretofore only slightly bruised nag out back and decisively beat it to death, he skinned it, deboned it, rendered its fat for glue, and gilded its hooves into four rather fetching ashtrays for the Court of Chancery's waiting room. In short, in your Humble Correspondent's considered opinion, he nailed it.

In a nutshell, the Esteemed Vice Chancellor most assuredly does not agree with those who believe that all public shareholders were innocent dupes taken along for a ride by evil, greedy, grasping investment bankers and their bosses in the recent run-up to the crisis:

Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage.

He continues:

During the last 30 years, it is indisputable that: (1) regulatory standards have been greatly relaxed, giving the financial industry free rein to leverage itself to the hilt and to engage in a wide range of speculative and increasingly opaque, complex activities, often without rigorous safeguards; (2) the power of stockholders to influence the composition of corporate boards and the direction of corporate strategy has been markedly enhanced; (3) institutional investors who hold stocks, on average, for a very brief period of time and are highly focused on short-term movements in stock prices have become far more influential and prevalent; and (4) “pay for performance” compensation systems were implemented to align the interests of managers with stockholders by giving managers incentives to pump up corporate profits in a manner that will increase the corporation’s profits and stock price immediately, rather [than] durably.

This is consistent with my view, that public shareholders of investment banks, as a group, did not act to brake the risk taking of their employees at all, but rather encouraged and rewarded it, or—what is perhaps more pertinent—punished any executive who did not embrace such activity wholeheartedly.

* * *

What I find most interesting about Mr. Strine's remarks is the salient distinction he draws among the motivations and behavior of different kinds of public shareholder. To the best of my admittedly limited knowledge, this is the first instance I am aware of where anyone has focused on this issue to this extent. He draws from it some useful policy prescriptions:

Therefore, if the correct policy balance is to be struck regarding regulation of the financial industry and other industries that pose large systemic and societal externality risks, policy makers cannot continue to avoid the obvious alignment problem that now vexes our corporate governance system.

Most Americans invest with a rational time horizon consistent with sound corporate planning. They invest with the hope of putting a child through college or providing for themselves in retirement. But individual Americans don’t wield control over who sits on the boards of public companies. The financial intermediaries who invest their capital do. These intermediaries have powerful incentives — in important instances, not of their own making — to push corporate boards to engage in risky activities that may be adverse to the interest of long-term investors and society. That is, there is now a separation of “ownership from ownership” that creates conflicts of its own that are analogous to those of the paradigmatic, but increasingly outdated, Berle-Means model for separation of ownership from control.

Unless these incentives and conflicts are addressed, it should be expected that corporate boards will continue to face strong pressures to manage their enterprises in a manner that emphasizes the short term over the long term, and that involves greater risk than is socially optimal. As a result, more stringent than optimal prudential regulation will have to be in place to bar the financial sector from taking risks that endanger society as a whole, rather than simply the capital of their investors and the employment of their employees.

Of course, this analysis and argument applies more broadly than just to publicly owned financial institutions. However, given the extreme sensitivity said financial institutions have proved to have toward excessive risk taking, and the genuinely calamitous negative externalities they have inflicted on society at large as a result, I think the Honorable judge's recommendations have particular force in their case.

In any event, I believe Mr. Strine's analysis should conclusively disabuse participants in the current debate over financial regulatory reform of two related notions. The first is the red herring that somehow stronger corporate governance by public shareholders over investment bank Boards and executives would have prevented the kind of reckless risk taking that brought these firms—and the global economy at large—to the brink. The second is the canard that all public shareholders are alike, and they all share the same interests and motivations.

Realizing that the second of these is false, and that Fidelity Investments and SAC Capital do not have the same investment timeframe and objectives as Aunt Millie or even the Ohio Teachers Pension Fund, would have a highly salutary effect on the beliefs and behavior of truly long-term shareholders.

If nothing else, getting Aunt Millie to realize she is the only one in the shark tank without a safety cage should do her a world of good.

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part IV

2009-09-29T20:57:00.006-04:00

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

— The Princess Bride

* *

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

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

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

* *
— Part IV: Darkness Calls —

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

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

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

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

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

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

* * *

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

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

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

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

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

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

* * *

So, what can we conclude from all this?

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

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

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

* * *

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

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

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

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

— THE END —

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

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

© 2009 The Epicurean Dealmaker. All rights reserved.

Nature Red in Tooth and Claw: Part III

2009-09-28T17:45:00.011-04:00

I've been to Paris
And it ain't that pretty at all
I've been to Ro-ome ...
Guess what?

I'd like to go back to Paris someday
And visit the Louvre Museum
Get a good running start and hurl myself at the wall

Going to hurl myself against the wall
'Cause I'd rather feel bad than feel nothing at all
And it ain't that pretty at all
Ain't that pretty at all

— Warren Zevon, Ain't That Pretty at All

* *

EDITOR'S NOTE: This is the third installment of a multi-post treatise on investment banking compensation currently in progress. Previous entries include:

Part I: Investment Banking, A Love Story, about the evolution of the industry; and
Part II: The Right Hand of Doom, about the drivers and structure of banker pay

This post focuses on risk factors and risk management in the industry.

* *
— Part III: Seed of Destruction —

We have discussed in general terms both the history and evolution of the investment banking industry over the last few decades and the sources and nature of investment banker compensation. Before we can draw some conclusions about how they interacted in the recent financial crisis, however, we must first take a little detour to understand where an investment bank's risk comes from and how investment bankers typically manage that risk.

Historically, pure investment banks were always relatively thinly capitalized entities. This made sense, considering the nature of their business and the risks they undertook. Remember: of the three basic business lines pure investment banks pursue—M&A advisory, securities underwriting, and sales and trading¹—only underwriting and sales and trading carry any material risk to capital. M&A advisory is pure agency business, where the only risk you run is that you put a lot of time and effort into a transaction which does not lead to a fee. The bank puts no capital at risk whatsoever.

In traditional underwriting, on the other hand, there are risks, but they are largely short-term market and liquidity risks. The bank spends a lot of time and energy pre-selling (and usually over-selling) a securities offering to potential investors, so when they buy the securities from the issuer and immediately turn around and sell them to the public, they are assured of a smooth offering. The risk is lowest for what are known as "best efforts" offerings, wherein the bank tells the issuer they will do the best they can to sell the paper, but no promises. The bank does not commit to a particular size or price for the offering, but simply offers to drum up investor demand for a slice off the top. Investment banks love to do these deals; clients not so much.

The alternative is a "bought deal," where the investment bank essentially promises to purchase an entire offering from the issuer at an agreed size and price. In such a deal, it is up to the investment bank to cut a check to the issuer (minus its fee, of course) and then turn around and offload the paper to third party investors. Clients love these deals because they transfer virtually all of the market and execution risk onto the shoulders of the underwriter. Of course, in such circumstances the bank will do as much pre-marketing and pre-selling as it can, and the morning of the sale to investors is usually a frenzied, all-hands-on-deck sort of fire sale. Since it really is putting a substantial chunk of capital at risk, an investment bank tries to price its purchase from the issuer at a level that will comfortably clear the market afterwards. Sadly, bought deals are often found in highly competitive situations, where more than one investment bank is competing for the business, so the winning bank is usually the one which has the most aggressive posture toward market risk (or is the most foolhardy).

Consider as well the fact that it does not take much of an adverse price move to wipe out the investment bank's economics on the deal. If you offer a typical high yield bond at par, and the market moves against you or you have misjudged demand, it only takes a clearing price 2% or 3% below par to wipe out your entire underwriting spread. Given that investment banks normally don't want to end up owning a lot of their client's paper, you can see how nerve wracking it can be to put a couple hundred million of capital at risk to collect a $6 million fee. Talk about picking up pennies in front of a steamroller.

Bought deals were relatively rare a couple decades ago, but they have become increasingly more common over the course of my career. Being able to offer bought deals to large, lucrative, demanding clients like private equity firms funding LBOs has become a competitive requirement for the larger investment and universal banks. Other things being equal, the more bought deals a bank does, the more capital it needs and the more sales and trading capacity it has to have to shovel them out the door, fast. Bought deals are expensive, in terms of capital, people, and risk. They may not be happy about it, but banks painted themselves into this corner. Bought deals increased as a percentage of all underwriting because banks acquired enough capital to do them, weaker banks literally "bought" their way into deals with the practice, and clients flocked to the new product in droves. On Wall Street, the competitive arms race never ends.

* * *

There is also a relatively small risk that an underwriting—either best efforts or bought deal—can go so wrong it needs to be rescinded. Normally this happens because the issuer blows up, fraud is discovered, or the like. In such instances, the bank typically makes the purchasers of the issue whole by buying the securities back from them at the offer price and then tries to collect the money from the issuer. This does happens on occasion, but investment banks try to minimize this risk by performing good due diligence on the issuer before the fact.

More interestingly, there is a longstanding tradition on Wall Street that a bank which underwrites a securities offering has an ongoing obligation to make a market in (i.e., buy and sell) those securities. Usually this is a good thing, as the bank can continue to make money crossing trades in the securities after they have been sold the first time. Unfortunately, it also means the underwriter is the de facto buyer of last resort for such paper. You can see how this can become a nontrivial source of pain for an investment bank when the market is in free fall and Fidelity or Putnam phones you for a bid on $100 million of toxic CDOs you sold them three months ago. It's even worse when everybody calls you up at once, because then you become the market.

Generally, bankers think long and hard before they try to welsh on this obligation. Traders and investors on Wall Street pride themselves on very long memories, and more than one investment bank has lost millions of dollars of repeat business from a buy-side account because they flouted this rule. Unlike M&A and other corporate finance activities—where you have to sign a 30-page contract, confidentiality agreement, and indemnification provision just to go to the bathroom—much of the sales and trading activity that takes place around the world continues to do so on the moral and virtual equivalent of a handshake. Even if most of the CDOs and other toxic securities Wall Street underwrote during the boom did not have explicit investor put options embedded in them—as those sold by Citigroup were reported to have—the implicit put was always there. It was no surprise that most of this shit ended right back on the balance sheets of the banks which underwrote it in the first place.

* * *

Market making—also known as nonproprietary or "customer" trading, in distinction to proprietary trading for the bank's own account—also carries material risk. The real purpose of market making is to provide liquidity for an investment bank's customers: be a buyer when they want to sell and a seller when they want to buy. In exchange for this service, the bank collects a fee which consists of the spread between price paid and price received on the securities it crosses. Unless the security in question trades very frequently in high volumes (i.e., is highly liquid), the bank will likely need to hold a material amount of it in inventory, in its trading book. This inventory must be supported by capital, and it poses nontrivial market and liquidity risk to the bank.

The more a bank treats a particular trading book like a pure market making facility, the fewer securities it will typically hold in inventory. That way, if the market price plunges, its mark-to-market loss will be smaller and more manageable, and it will be easier to sell the (small) losing position to another buyer. The real risk in this situation is a market stoppage, or complete evaporation of liquidity. If trading in a security completely stops, not only is the bank stuck with any securities it has in inventory, but the true market price either becomes unknown or severely discounted from the last trade. Big mark-to-market losses result, and capital takes a nasty hit. Fewer pennies, bigger steamroller.

Finally, as I mentioned previously, market making can shade almost imperceptibly into proprietary trading and speculation. The more it does so, of course, the more an investment bank's risk profile increases in relation to both market (or price) risk and liquidity risk. While investment banks have always prided themselves on their market sense, derived from their privileged position astride the global financial markets, it is a different kettle of fish entirely to surf the ebb and flow of the market to capture nickels and dimes than to build and hold concentrated investment positions over extended periods of time. The sorry history of most of the internal hedge funds set up within investment banks over the past few years is proof of this.

* * *

Now, what does this tell us about how investment banks have typically gone about managing risk?

Well, for one thing, you need to understand that investment bankers have traditionally viewed their business as a flow business. That is, for most of its history, investment banking has focused on facilitating the investment and capital allocation transactions of others. They are not in the business of accumulating assets, inventing products, building businesses, or indeed building anything. They are pure agents, and their objective is to get paid to help other people do things with capital and markets.

Also, as capital markets intermediaries par excellence, investment bankers believe in their very bones that every market they participate in—M&A, equities, bonds, commodities, derivatives, etc.—is deeply and irrevocably cyclical. Each of these markets goes through repeated cycles of boom, bust, and inactivity.² Hopefully, an investment bank has adequate capabilities and market position in a selection of markets, so it can enjoy the boom in one or more sectors while it struggles through a bust in others. But for individual investment bankers, who nowadays tend to be highly specialized and therefore difficult to reassign to other duties, that means you have to be ready to rumble when the time is ripe. Most investment bankers can expect only so many boom cycles in their chosen specialty during their career, so they tend to go whole hog when they happen.

Not for nothing is the informal motto of my industry "Make hay while the sun shines."

The entire industry compensation system is designed to manage this cyclicality, too. Bankers are paid fixed salaries which are a small fraction of their expected average pay, with the balance made up of variable incentive compensation, otherwise known as the "bonus." This does several things. For one, it reduces fixed labor cost to a bare minimum, in case results for the year—measured firmwide, by division, by group, or by banker—don't pan out. For another, it encourages bankers to work as hard as possible to make lots of revenues, since there is no theoretical upper limit to a senior investment banker's compensation. Given that healthcare banking may only boom once every five years, for example, the firm wants to make sure the banker who has already booked $75 million in revenues keeps trying to get another $25 or $50 million more. Finally, the fact that a huge portion of a banker's wealth is tied up in stock of his employer gives him an important incentive to keep trying for revenues even in a down year.

Having a seat at the table the next time a boom comes around gives a banker a very valuable option. Bankers work hard to hold onto a position at their firm in bad times, and they work like the Devil to harvest revenues when the sun is shining. Given the intensity of competition and the stakes at hand, investment bankers rarely tend to think in terms of a "career." Instead, they focus deal to deal, and on booking the next trade. This is true in every division of the modern investment bank. When the revenue salmon are running, you don't stop to count how many you have caught, worry whether you will get ill from eating too many, or wonder when they will stop. You just keep fishing.

Investment bankers don't do the future well.

* * *

For some businesses, like M&A and best efforts underwriting, this is where the story ends. Bring in a good deal, and you get paid. Lose it, or mess it up, and you may get dinged, or even fired, but it will not seriously threaten the firm.

It's different in sales and trading, where bankers commit real firm capital. Mistakes can have huge effects, and a single trader's mistake can wipe out half the bonus pool for his division or cause a net loss for the firm. There, traditionally, traders managed themselves. That is, a grizzled old veteran who cut his teeth trading XYZ bonds was the guy who monitored the trading book and risk positions of the junior trader tasked with that job today. In the old days, when most investment banks were partnerships owned by their employees, this made for very effective risk control. No crusty old bastard who has given 30 years and three marriages to his employer is going to let some wet-behind-the-ears tyro blow his retirement account. Even now, with atomized public ownership diluting investment bankers' stakes in their own firm, you can make an argument this is a decent system. Who better to understand the risks than a guy who sits on top of the market and has the best view of short-term opportunities and threats?

But monitoring markets in real time this way has serious limitations as a form of risk management. It was sufficient for traditional market making and early proprietary trading, when positions held were small, turnover was fast, and trading books were relatively uncomplicated. You didn't put on or maintain a position you couldn't close out in a couple hours or days, and the head trader personally understood all the securities in his underlings' books backwards and forwards. Nowadays, that is not the case, so risk management has become professionalized and separated from the sales and trading function. This helps preserve objectivity, but at the price of introducing a more serious problem.

For it should be clear to you by now that the most important people in an investment bank are the people making the money. The revenue producers have always held the power and authority; staff are an afterthought. Due to the cyclical nature of their markets, their incentive compensation structure, and the aggressiveness and drive of the people they attract, investment banks have always worried about revenues first, second, and third. Efficiency, resource management, and risk control were always far down the list.

And while this may have worked when span of control was short and revenue producing bankers' incentives were completely aligned with active risk control (because it was their capital they were risking), it clearly has not worked in today's environment. Forget about whether risk managers even understood the risks their firms were taking over the last several years. For all I know, they may well have.

What I do know is that when investment banks got big enough and bureaucratic enough that risk management and revenue generation could be separated, the wheels began to come off the bus. When senior executives—almost all of whom, by the way, came from revenue producing backgrounds, not risk management—no longer had direct responsibility for risk control, the importance of risk control diminished at their firms. Sure, lip service continued to be paid, but that's all it was for most of them. Risk managers were co-opted, captured, or ignored by the very revenue producing divisions they were supposed to monitor and control. As a capper, the nature of risk assumed by many investment banks changed too, to long-tailed, multi-period risk from structurally illiquid securities—exactly the opposite of the type of securities investment banks had a long history of understanding and managing well.

It all had to end in tears, and it did.

Next and last: Part IV: Darkness Calls ...

¹ A clarifying word about terminology. As a rule, investment bankers are promiscuous, sloppy, and lazy in the terms they use to describe their own business. Sadly, I am no exception. In part, there is a good reason for this, since our business is defined by how it straddles different customer universes and different market-related activities. "M&A Advisory" and "Corporate Finance" typically describe the divisions that work with corporate clients to do deals and issue securities. Sometimes this division is called "Investment Banking" by (self-described) purists, but many people also use that term to describe everything an investment bank does. "Capital Markets" is the formal term of art for the division which services the needs of institutional investors, but it is often called "sales and trading," too. Sales and trading is where you find institutional salesmen, market makers, proprietary traders, securities structurers, and the like. Complicating the picture, Corporate Finance and Capital Markets cooperate to underwrite new securities for issuers, with Corporate Finance usually sourcing the deal and Capital Markets executing it. I could go on, but I notice your eyes are beginning to droop. Alles klar?
² By which I mean cycles of activity, not price level. Investment bankers don't make money when markets go up, at least not directly. We make money when people do deals, issue paper, and trade securities. While there is some correlation between these activities and upward market moves, they are not tightly linked. In fact, on the trading side of the business, investment banks tend to make the most money when markets are flopping around like a dead fish; that is, when volatility is high.

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.

And Now for Something Completely Different

2009-09-26T09:20:00.001-04:00

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

2009-09-25T17:39:00.018-04:00

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

2009-09-24T14:46:00.015-04:00

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

2009-09-22T14:51:00.009-04:00

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

2009-09-21T12:38:00.009-04:00

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

2009-09-11T21:59:00.000-04:00

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

2009-09-09T22:00:00.005-04:00

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.

* * *

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.

Killing People Is a Bad Habit

2009-08-28T16:54:00.003-04:00

Chamberlain's wife: "You glisten too brightly."
Sanjuro: "Glisten?"
Chamberlain's wife: "Yes, like a drawn sword."
Sanjuro: "A drawn sword?"
Chamberlain's wife: [Nods] "You're like a sword without a sheath. You cut well. But the best sword is kept in its sheath."

— Tsubaki Sanjuro

In the highly stylized Kabuki world that is investment banking, there are few documents more abstruse and impenetrable to common understanding than the engagement letter.

This is the contractual document, prepared by the investment banker and his or her legal department and ultimately co-signed by the client, which encompasses the terms under which the banker will work for the client on one or more particular transactions. As such, and as one might reasonably expect, the business terms of such an engagement are relatively straightforward:

Exactly what would you like us to do for you?
How long will we work on this for you?
How many shiny simoleons will you pay us for working on it?; and
What do we do if things go wrong?

In addition to the usual inclusion of a promise that the bankers won't sell your company's data down the river at the first opportunity—the hallowed confidentiality provision—there really isn't much need for a hell of a lot more in the letter. Find a deal, do it, get paid, and play nice along the way. Simple, right?

* * *

Sadly, we no longer live in prelapsarian times. Ever since the first in-house compliance lawyer slithered down the tree in the Garden of Eden carrying an apple and an Indemnification Provision in its mouth, investment banks' engagement letters have suffered the same legalistic blight that has afflicted every other area of business documentation. Now they are almost comically bloated and opaque fugues of defined terms, parenthetical meanderings, comprehensive itemizations of minor variations on picayune themes, and "provided, howevers":

This letter, when executed by the parties thereto, will constitute an agreement (the “Agreement”) between Company XYZ (the “Company”) and The Devil's Rejects, LLC (“Advisor”), pursuant to which the Company agrees to retain Advisor and Advisor agrees to be retained by the Company under the terms and conditions set forth below.

Responsibility is neatly encapsulated and evaded:

Neither Advisor nor any of its affiliates (nor any of their respective control persons, directors, officers, employees, or agents) shall be liable to the Company or to any other person claiming through the Company for any claim, loss, damage, liability, cost, or expense suffered by the Company or any such other person arising out of or related to Advisor’s engagement hereunder except for a claim, loss, or expense that arises primarily out of or is based primarily upon any action or failure to act by Advisor, other than an action or failure to act undertaken at the request or with the consent of the Company, that is found in a final judicial determination (or a settlement tantamount thereto) to constitute bad faith, willful misconduct, or gross negligence on the part of Advisor.

A close reader of such a contract might begin to wonder just which services exactly the investment bank is supposed to provide under its engagement:

The Company will furnish to Advisor such information as Advisor reasonably requests in connection with the performance of its services hereunder (all such information so furnished is referred to herein as the “Information”). The Company understands and agrees that Advisor, in performing its services hereunder, will use and rely upon the Information as well as publicly available information regarding the Company, the Target Company, and any other potential acquisition candidates and that Advisor does not assume responsibility for independent verification of any information, whether publicly available or otherwise furnished to it, concerning the Company, the Target Company, or any potential acquisition candidates, including, without limitation, any financial information, forecasts, or projections considered by Advisor in connection with the rendering of its services. Accordingly, Advisor shall be entitled to assume and rely upon the accuracy and completeness of all such information and is not required to conduct a physical inspection of any of the assets or liabilities of the Company, the Target Company, or any other entity. With respect to any financial forecasts and projections made available to Advisor by the Company and used by Advisor in its analysis, Advisor shall be entitled to assume that such forecasts and projections have been reasonably prepared upon bases reflecting the best currently available estimates and judgments of the management of the Company.

And that, by the way, is not the worst I have seen, not by a long shot.

Of course, engagement letters are written this way because they are authored and negotiated by lawyers. Lawyers whose job it is to maximize their own client's options, deniability, and wiggle room under the contract at the expense of their counterparty's. The businessmen and bankers who strike the original deal usually have a far more optimistic (some would say naive) view of the relationship, and high hopes the investment bank can help the company strike an attractive, well-priced deal in a reasonable amount of time. It is only when things go bad and the shit hits the fan that the parties begin to point fingers at each other, and the entire mess devolves into a particularly nasty cat fight. Lawyers draft and negotiate engagement letters with just this sort of scenario in mind. I suppose one shouldn't complain: that's what we pay them for.

* * *

As far as an investment bank goes, the truly important thing in an M&A deal is to get paid. Huge quantities of verbiage are shoehorned into engagement letters to delineate details on exactly when this will happen and how many greenbacks need to change hands. It is so important that many banks demand the client pay a fee upon completion of a deal substantially like the one contemplated in the agreement letter even if the bank's engagement has been terminated. This is called a fee "tail," and investment bankers will bargain hard for a tail of up to two years after termination of the original engagement. You can see their point of view: they want to get paid if their former client completes a deal like the one they advised them on within a set period of time. That way, the client is not tempted to get close to agreement, fire the banker, close the deal, and then refuse to pay just because the contract is dead.

You just can imagine how tickled this makes most clients (and their lawyers) feel when they see that little gem. The fee tail and the indemnification provisions—wherein the bank asks the client to protect it from any and all third party claims over the deal come Hell, high water, or four scary looking guys on horseback—are usually the most hotly negotiated terms in an engagement letter. Those are the areas where most disputes, if they do come, will come.

But here's the rub.

Lawyers for investment banks try to draft airtight, ironclad engagement contracts so, if worse comes to worse and the client breaches the agreement, they can sue them for specific performance and/or damages. But I ask you: what kind of fool of a service provider regularly sues its clients? A damn fool, that's who.

The ability to sue your client over breaches in an engagement contract is a nuclear option, at best. For one thing, you better have a pretty airtight legal case, or you are going to look like seventeen kinds of idiot when the judge throws your suit out of court. For another, clients talk, and you can rest assured the fact you are suing Bobby Joe for a little ol' M&A fee on some pissant acquisition is going to get around the Dallas Petroleum Club damn quick. You better hope everyone there thinks Bobby Joe is a lying prick and a complete dickwad, or you can bet your M&A workload in the energy sector is going to suffer a nasty spill going forward.

The only time it makes sense to sue a client over an engagement letter is when the client's behavior is clearly fraudulent, the client is disappearing or doesn't matter in some way, or the money involved is just too big to let go. For that reason, I have seen very few instances over my career where investment banks have taken their clients to court to enforce an engagement contract. (I actually testified on my employer's behalf in one such case years ago, but that client was a complete dickwad, so it made sense. We won.) Usually, the better part of valor—and the better business decision—is to tear up the engagement letter and chalk it up to experience. Most of the time that is the only effective way for an investment bank to buy its way back into the good graces of a frustrated and unhappy client anyway.

* * *

None of these motivating conditions apply in the case of ~~recovering alcoholic~~ struggling insurance company AIG or its majority owner, the Federal Reserve Board, however. Hence, I have to respectfully disagree with Michael Corkery at The Wall Street Journal. In an article today describing how AIG's new CEO is slowing down or postponing the raft of asset sales his predecessors initiated in an attempt to repay taxpayers and how this threatens a huge fee backlog for Wall Street, Mr. Corkery seems to take comfort that some of those fees are protected under contract:

To be sure, the banks may have pocketed many of these fees already or have contracts that AIG and the Federal Reserve, which is heading the restructuring effort, have to keep.

Fortunately, I do not work for any of the firms Mr. Corkery lists. If I did, I would find the existence of any such signed engagement letters very cold comfort indeed.

The prospect of suing the Government of the United States of America to collect a contracted fee on a nonexistent deal strikes me as one of the least intelligent decisions any major Wall Street investment bank could possibly consider nowadays.

And, given recent history, that is truly saying something.

© 2009 The Epicurean Dealmaker. All rights reserved.

Fooled by Fabulousness

2009-08-11T17:45:00.003-04:00

Herewith do I present you, Dear Readers, 17 minutes, more or less, of Alain de Botton nattering on about meritocracy, justice, luck, envy, snobbery, and other foibles from the "human anthill," via that unnamed media organization which still refuses to pay lucrative royalties to Yours Truly for the use of his patented, copyrighted, and thoroughly well-known global sobriquet.

Perfect material for wasting time on a slow summer Tuesday and/or stimulating unused centers of reasoning within your brain, depending on your personal capabilities, receptivity, and preferences. I find de Botton's critique of the cult of meritocracy from the importance of happenstance in individuals' lives to be one of the more insightful nuggets within his talk. In this manner, his perspective is not unlike what I find to be one of the few useful strains of argument still emanating from that vast edifice of megalomanical pontification which used to go by the name of Nassim Taleb.

Notwithstanding any other bits of educational or morally enlightening value, I think one of the more entertaining parts was the fake headlines de Botton got the cheesy UK tabloid Sunday Sport to compose based on famous tragedies from the Western tradition. My favorite: the editors' catchy summation of Sophocles' Oedipus Rex as "Sex With Mum Was Blinding."

(Hat tip: A Fistful of Euros, via Dealbreaker. Yes, really: Dealbreaker. It must be a slow month for ridicule in the financial sector.)

© 2009 The Epicurean Dealmaker. All rights reserved.

The Limits of Sympathy

2009-08-07T16:44:00.039-04:00

The utility of biography, Dr. Johnson argued, rests on the fact that we can enter by sympathy into situations in which others have found themselves. Parallel circumstances to which we can conform our minds shape every life. Even the great are not removed from the factors common to all: "We are all prompted by the same motives, all deceived by the same fallacies, all animated by hope, obstructed by danger, entangled by desire, and seduced by pleasure." I must confess that twenty years devoted to the biography of Newton have not in my case confirmed Dr. Johnson's dictum. The more I have studied him, the more Newton has receded from me. It has been my privilege at various times to know a number of brilliant men, men whom I acknowledge without hesitation to be my intellectual superiors. I have never, however, met one against whom I was unwilling to measure myself, so that it seemed reasonable to say that I was half as able as the person in question, or a third or a fourth, but in every case a finite fraction. The end result of my study of Newton has served to convince me that with him there is no measure. He has become for me wholly other, one of the tiny handful of supreme geniuses who have shaped the categories of the human intellect, a man not finally reducible to the criteria by which we comprehend our fellow beings, those parallel circumstances of Dr. Johnson.

— Richard S. Westfall, Never at Rest: A Biography of Isaac Newton ¹

Lest you be overawed by the towering, alien intellect of Mr. Westfall's great subject, O Intelligent and Humble Reader, do not forget that it was this same Isaac Newton who is known to have invested a large sum in stock of the South Sea Company near the peak of its bubble in 1720² and who was reported by his niece to have lost £20,000 (or £3 million in today's money) upon its ultimate collapse.

Or, as the great man himself is reputed to have said:

I can calculate the motions of the heavenly bodies, but not the madness of people.

* * *

With all due deference and respect to my learned colleagues in the study and practice of quantitative finance, I will side with Sir Isaac and state that we still have a great deal of work to do before we can confidently predict the madness of our markets.

But then, I'm just an old fogey who finished math at linear algebra and differential equations. What do I know?

¹ Richard S. Westfall, Never at Rest: A Biography of Isaac Newton. Cambridge: Cambridge University Press, 1983, p. x.
² Ibid., pp. 861–862.

© 2009 The Epicurean Dealmaker. All rights reserved.

Andrew Cuomo Is a Cheap Pander, and Other Observations

2009-07-31T17:45:00.002-04:00

Carol Connelly: "Hey, we all have these terrible stories to get over, and you—"
Melvin Udall: "It's not true. Some of us have great stories, pretty stories that take place at lakes, with boats and friends and noodle salad. Just no-one in this car. But a lot of people, that's their story: Good times, noodle salad. What makes it so hard is not that you had it bad, but that you're that pissed that so many others had it good."

— As Good As It Gets

Envy, Dear Readers, is an ugly thing.

It may be a powerful, ancient motivator for people to improve their station and situation in life—as real estate brokers, car salesmen, and cosmetics companies from time immemorial can attest—but it is corrosive, base, and potentially destructive as well. It can transform a person who otherwise feels content with his life into a shrill, grasping, dissatisfied shrew, just because he notices that someone else has something he does not. It can lead to all sorts of chronic social ills, like celebrity magazines, reality shows, and regularly recurring profiles of Donald Trump on national television.

It is usually blind and farcically selective, as well. We envy our neighbor's new Ferrari without realizing he bought it with life savings after learning he has six months to live. We envy the thin, wealthy, and fabulously connected Upper East Side socialite without knowing her hedge fund manager husband is an abusive, philandering stranger and her children hate and despise her. We envy the famous, the rich, the beautiful, and the better or more [insert your preferred adjective here] than us without understanding either the price they pay for such gifts or the gaping holes in their lives where we possess advantages they can only dream about. We envy advantages for which we do not understand the price, and we envy possessions and qualities which we would not be willing to sacrifice what is necessary to achieve them even if we knew what it was.

Envy is the weak and lazy sister to its hardworking sibling, ambition. It is a futile, foolish, and low emotion. And it is a favorite target for populist demagogues and pandering politicians alike.

Which brings me to the Attorney General of the State of New York, the Honorable Andrew M. Cuomo.

* * *

Writing as The Deal Professor at The New York Times today, Steven M. Davidoff takes gentle umbrage at Mr. Cuomo's laughably obtuse report on the 2008 bonus compensation of the nine largest banks receiving TARP bailout funds:

I thought that this was the hard-hitting government study we needed into investment bank compensation and its relationship, if any, to the financial crisis. But I was ultimately quite disappointed.

Instead of an in-depth report on the compensation practices at Wall Street firms, both past and future, the only thing we got was compensation porn.

And uninteresting porn at that.

Echoing Professor Davidoff, I have to admit that I was similarly unimpressed. Although I realize most lawyers have difficulty writing numbers larger than "$500 per hour" on paper, I was staggered to see that over three quarters of the 21-page report were devoted to double spaced itemizations of random bonus trivia and cursory historical financials for each of the nine banks. This is the type of work a suitably trained investment banking Analyst—or, for that matter, a slightly brain-damaged monkey—could have knocked out in one evening after downing a couple of Red Bulls and some Adderall.

For this we waited nine fucking months?!

Anyway, the Professor correctly criticizes the Attorney General for failing to investigate or address key elements of his self-proclaimed brief, namely the relation of 2008 bonuses to compensation in prior years, the methodology the TARP recipients put in place to determine 2008 bonuses after they received government support, and the banks' justification for any bonuses they did pay last year. Other than collecting numbers from each bank in arbitrarily defined buckets—why, for example, look at the aggregate bonuses for the top 14 executives, exactly?—and doing a rudimentary and meaningless comparison of total compensation at each of the banks in relation to their historical net income, of all numbers, it doesn't look like the crack troops at the AG's office did much of anything with their vaunted access and limitless powers of subpoena.

But this is ridiculous. These are all empirical questions, questions which could have been investigated and addressed with each of the banks in turn without so much as breaking a sweat. It's not like the AG didn't have enough time, or his steely-eyed investigators couldn't get access to the trembling CFOs and Human Resource heads who were busy pissing their pants in fear of having Mr. Cuomo and his minions up their asses with a flashlight for the next ten years. Where are the answers to these simple questions? Did you just not do the work, Mr. Cuomo, or did you just decide to omit these results from your report, in fear they might portray a more nuanced and less politically marketable picture of Wall Street greed and excess?

* * *

I, for one, would have been very interested to learn exactly what percentage of these bankers' pay was granted in the form of non-cash compensation, like shares and options. It would have been even more illuminating to learn how much of the non-cash pay took the form of deferred compensation, pay which was locked up in the stock or options of the employing bank and which could not be claimed for years after its grant. Pay which, in my experience, a banker usually forfeits if he leaves the bank voluntarily before it vests, and pay which exposes a substantial portion of the banker's net worth to the risk and fluctuation of his employer's stock price. Risk the banker shares equally with public shareholders, with the niggling little exception that shareholders can sell their stock at any time, and the banker cannot. Of course, it would have been more illuminating to see this data broken down by level of pay, too, since it is usually the senior bankers making the big bucks who get stuffed with toilet paper, not the lowly-paid worker bees.

But I guess I see why you didn't publish that data for all the banks. It would have diluted the message to disclose for everyone what Goldman Sachs insisted you report for them: that 953 Goldman employees earned bonuses of $1 million or more, but no-one at the company took home more than $885,000 in cash. Sorta undercuts the image of fat cats dining freely on the shareholders' and taxpayers' dime, doesn't it? Joe Sixpack might not get so worked up about a banker's $10 million bonus when he learns that over $9 million of it is tied up in his firm's stock for up to five years, huh?

And while Professor Davidoff also expressed disappointment that you did not address bigger issues surrounding investment bank compensation, like the tension between individual performance and the performance of his or her firm or the potential mechanisms for clawing back previous pay, learning just how much bankers' and executives' pay is tied to the share price performance of these TARP banks—how many billions of dollars of employees' wealth is at risk along with that of shareholders and taxpayers—might just have answered both of those questions. Heaven forbid that we find investment bankers have been "playing the casino" with their own money, in addition to ours. Kinda muddles the populist message of outrage, dontcha think?

* * *

Anyway, I cannot get too outraged about this, I guess. After all, you are only a politician, and as such still reside somewhat lower on the scale of public approval and trust than investment bankers and other pond scum. In addition, your role as Attorney General makes you the chief prosecutor for the State of New York, and hence an advocate for the pursuit, discovery, and punishment of all criminals, real or perceived. It is not in your remit to be balanced and fair, or to use your powers of subpoena and investigation to discover the truth about anything. It is your job to build a case, and throw the bums in jail if you can. It is up to defense lawyers to offer up an opposing interpretation, and for judges and juries to arrive at a more nuanced and balanced vision of the truth.

And you are following a long tradition in New York, from Rudy Giuliani to Eliot Spitzer and beyond, of pursuing your version of justice—and a promising and lucrative political career, as well—in the kangaroo court of uninformed public opinion. Why befuddle the poor people with unsightly and confusing facts, when you can wrap yourself in the cloak of sanctimony and popular outrage to pelt a few fat cats in the stocks of public opinion? It's worked before, and you seem to be doing an excellent job.

So, while we are on the subject of accountability and pay for performance, Mr. Cuomo, I guess I would be interested to learn just exactly how much of my New York State income taxes was used to produce this disingenuous excuse of a marketing pamphlet for your upcoming gubernatorial campaign.

The fine and upstanding people of the State of New York deserve to know.

© 2009 The Epicurean Dealmaker. All rights reserved.

The Fish Stinks from the Head

2009-07-30T10:42:00.004-04:00

Benedick: "And, I pray thee now, tell me, for which of my bad parts didst thou first fall in love with me?"
Beatrice: "For them all together; which maintained so politic a state of evil that they will not admit any good part to intermingle with them."

— William Shakespeare, Much Ado about Nothing

Heidi Moore ¹ published an interesting counterpoint to all the recent Goldman Sachs-bashing at Slate's The Big Money yesterday, entitled "Will Everyone Please Shut Up About Goldman Sachs?" Notwithstanding its title, the article seems to be less a defense of the orcish vampire squid threat to humanity everybody loves to hate and more of an encomium to its unique culture.

Ms Moore points out the fact that, for all its reputation as "a devastating hive mind that can control any institution it touches, including the U.S. government," and as an gathering of the smartest minds, human and machine, on the planet, Goldman Sachs employees have proved singularly inept outside of the hive. I have made a similar argument—characteristically with fewer examples but many, many more words—in the past.

I have also described in these pages my experience of Goldman bankers over the course of my career and their almost uniform, as Ms Moore terms it, "lack of magic or voodoo." For such a successful firm, Goldman Sachs seems to have a remarkable dearth of superstars, whether in my exalted realm of corporate finance and M&A or the sordid cesspits of sales and trading. Almost no-one there dazzles you with their sheer genius, overwhelming salesmanship, or scintillating personality. Nevertheless, the firm has a preternatural ability to persuade past, current, and future clients that it is the best of the best on Wall Street, no matter how badly it may have fucked up any one client's particular transaction in the past. This is a truly admirable capability, and one which I and many other Goldman competitors continue to try and replicate, so far with less than complete success.

* * *

Taking her cue from the "current and former Goldman bankers and officials" she interviewed ² for the article, Ms Moore lays credit for the firm's success firmly at the feet of its vaunted culture. Goldman encourages their bankers to express their opinions and disagree freely over important decisions, she says, but discourages dissent and second-guessing once decisions have been agreed. She notes that bankers are rotated freely among positions and functions, as part of developing general management experience. She cites the legendary Goldman focus on dense and high frequency internal communication via voice mail, and she posits that the firm's system of "360-degree reviews," wherein "everyone is evaluated not only by their managers but also their underlings and peers," not only encourages homogenization but also discourages some of the more disagreeable political shenanigans found at many other banks.

The interesting thing about this litany—which is widely known across the Street—is that few of these practices are unique to Goldman Sachs. In fact, I can confidently assert that the only really unusual practices at the firm are the near psychotic intensity devoted to communication by voice mail and the rotation of bankers through different areas and positions. While many banks are indeed noted for surface consensus belied by subversion, undermining, and open backstabbing, managerial decision making by open disagreement is not that unusual.

The fearsome old troglodytes at Salomon Brothers, for instance, prided themselves on a culture which encouraged open and voluble disagreement among bankers in pursuit of robust and thoroughly examined decisions. A correspondent remembers Solly bankers proudly explaining at an NYU recruiting function years ago that the firm did not tolerate backstabbing. Instead, if someone disagreed with you they promised to "break down the door and come at you [directly] with an axe." Friends and colleagues from the house of Liars Poker confirm this tale: bankers would beat the crap out of each other over important decisions, and then go grab a beer or ten together afterwards. The system worked remarkably well.

Likewise, 360-degree reviews are now common across Wall Street. They have been almost universally adopted because they make sense, for all the reasons Ms Moore relates. However, I have worked at two big banks which used 360-degree review systems, and I can tell you from personal experience that they did not make a damn bit of difference. At both shops, bankers went through the motions of reviewing bosses, subordinates, and peers, but everyone knew that top management paid no attention to them. Banker pay and promotions were determined the old-fashioned way, through political patronage, budgetary infighting, and whoever screamed the loudest and most convincingly over deal revenues. No-one had any incentive to give honest reviews or constructive criticism, because anything negative could be seized upon by one's enemies or schemers among senior management as reason to reduce a bonus or even fire someone. Accordingly, all reviews became subject to massive grade inflation, and the category comprising bankers who were supposed to be rated in the top 10% of their peers magically grew to include 40 to 50% of everyone at the firm. It was a joke.

Now, maybe Goldman Sachs has figured this out, and these systems actually work for them. But if so, it is not due to the processes and procedures they have in place. It is the firm's culture, and senior executives' complete commitment to that culture, which makes these mechanisms successful. 360-Degree review systems, 24-hour response voice mail, and rotation of bankers through different departments only work when senior managers refuse to make exceptions to the rules. There are a nauseating number of investment banks which profess an undying commitment to teamwork and a dedicated focus on cultivating client relationships rather than chasing transactions. But these banks fall short time and time again because they do not enforce these principles. If Mr. Big Swinging Dick Managing Director who brings in a billion dollar IPO or a ten billion dollar merger throws a hissy fit and threatens to stomp out the door if he has to share credit, or a successful M&A banker refuses to manage a group in Capital Markets, or a Group Head inflates the review scores of all his subordinates to boost their pay and his power, senior management can either hold firm and preserve the culture, or they can cave. If they hold firm, everyone else at the bank hears about it, and they learn that the rules and the culture will be enforced. If they cave, everyone knows that too, and it's off to the bad old races of "what's in it for me." Sadly, most investment bank executive teams cave.

* * *

Now, for all the folderol in the press about how "brilliant" this or that banker or group of bankers is, I have always maintained that individual talent and originality are highly overrated in investment banking. With few exceptions—which always have extremely limited shelf lives, as competitors reverse engineer innovations within weeks or days—there is almost nothing new under the sun in my business. Notwithstanding what they like to tell you, investment bankers don't really sell "ideas." They sell connection, and access, and they are successful to the very extent they can maintain themselves in the flow of market information. Investment banks derive their market power and importance by maintaining dense and robust information networks across the numerous markets they participate in. This makes them better traders, better investors, and better advisors.

In the overall scheme of things, a successful bank should prefer to have strong networks, rather than strong bankers. Take a banker with excellent network connections out of his or her supporting environment, and he or she becomes dramatically less effective. Allow individual bankers to weaken the network by hoarding clients, refusing to communicate, or actively undermining their rivals within the firm, and you weaken the bank materially. Encourage the hiring and creation of "superstars," and you shift power away from the bank into the hands of individual mercenaries. All of these things make an investment bank less valuable to its clients, as well.

So, a bank which can subsume individuals into a cohesive mass, which can preserve and encourage the development of internal and external networks, and which can build a stable platform has a long-term advantage. Maintain a stable platform, and you remain in the flow of information and deals over the long term. Remain in the flow, and you build a credible and trustworthy brand. Do it long enough, and you just might become Goldman Sachs.

Of course, Goldman Sachs is not unique in the history of investment banking for having developed a distinctive and stable culture. A long litany of culturally distinct and successful organizations graces the rolls, including such standouts from my early days in the industry as JP Morgan, Drexel Burham Lambert, First Boston, DLJ, Salomon Brothers, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers. The distinguishing feature of almost all of these firms, however, is that they diluted, destroyed, or squandered their distinctive cultures through a series of ill-advised mergers or acquisitions, in the benighted industry-wide pursuit of growth.

Culture grows organically, and slowly, over time. Introduce a foreign culture into an existing institution—particularly one built entirely on the back of assets who walk out the front door every evening—and you almost always destroy what you have. The glue which binds colleagues and potential rivals into a cohesive whole dissolves, and the mantra becomes every man for himself. You can rebuild a culture, or build a new one, but it takes a long time and an almost superhuman dedication from the very top of the organization. JP Morgan is a good example of a firm with a formerly distinct and powerful culture which lost its way through acquisitions and which has now rebuilt itself to a near facsimile of its former self, largely on the back of Jamie Dimon's personality. It is still absorbing the Bear Stearns virus, but early indications are that the House of Morgan will survive the infection.

* * *

All of which helps explain why Goldman Sachs enjoys such prominence in the industry and the broader financial markets today. If nothing else, they have succeeded by being too smart—or too timid, or too insular—to buy anybody else in the last two decades. They have thrived by remaining the same—while admittedly swelling like a tick on a dog—while everybody else engaged in an orgy of corporate combination and lost or weakened their distinctive identities, franchises, and platforms.

Goldman's integrity and cohesiveness certainly make it admirable in my eyes. But that does not necessarily mean it is not evil. A powerful culture creates a powerful divide in the minds of its members between what is inside and what is outside. Goldman employees' dedication to the firm does not necessarily extend to its clients, its regulators, or the society it operates in. One can legitimately question whether Goldman behaves like the traditional stereotype of the mainland Chinese: if you are on the inside, and connected, you will be treated with respect and honesty; but if you fall outside the inner circle, you are fair game to be cheated and taken advantage of.

In the realm of fiction, the Borg are admirably focused, cohesive, and successful, too. That doesn't mean they are the heroes of the story.

"We are the Borg. Lower your shields and surrender your ships. We will add your biological and technological distinctiveness to our own. Your culture will adapt to service us. Resistance is futile."

Remember, Dear Reader, that old saw: Just because you're paranoid doesn't mean that Goldman Sachs isn't out to get you.

¹ Yes, that Heidi Moore.
² I have no idea what Ms Moore's experiences were in said interviews, but I suspect that her description of these immensely wealthy and powerful individuals as drab, colorless nebbishes may prove the exception to the rule of women interviewing powerful men I elaborated earlier. I have to suspect that interviewing your off-the-rack Goldman banker generates about as much sexual tension as watching oatmeal congeal.

© 2009 The Epicurean Dealmaker. All rights reserved.