Daily Dose of Optimism

NYT Dealbook: Bankers set for a boom, Commodities set for a bust

The New York Times DealBook recently saw fit to post, without noting any irony whatsoever, the following two posts within six minutes of each other. If you like data points on sentiment for commodities vs. other opportunities, this is a great example:

Here's the first, at 8:04am:

London’s Bankers, in Short Supply, Get Fat Pay Packages (May 12, 8:04 am)

Financial workers in the City of London are “holding most of the aces” in the recruitment market as banks desperately search to fill vacancies created by the surge in corporate activity, a new report claims.

Recruitment firm Morgan McKinley said pay packages are becoming more attractive and staff are moving jobs more frequently to meet demand. According to the report, the number of new positions on offer in April was 20.4% higher than last year. (Link)

Here's the second, at 8:10am:

Commodity Traders Should Plan for the Bust of Their Hiring Boom (May 12, 8:10 am)

Being a commodity trader is the hottest job in town. After years in the doghouse, these experts in the arcane arts of contango and backwardation are suddenly worth millions.

In this booming market, anyone who can say “crack spread” without laughing is getting hired, says Breakingviews. But while banks want to pay up now while prices are still high, they’ll be just as fast to fire. Wise traders should ask for multi-year contracts. (Link)

Interesting how one article pretends to understand the future - clearly, commodities are set for a fall - and one is simply telling what we already knew - that bankers are valuable.

I realize that the NYT DealBook'ers simply report what is being written around the web, but they also made the editorial decision to post these right on top of each other without comment.

Ed's wild guess: there are 10x more investment bankers reading newspapers than there are commodity professionals. As such, interpretating hot demand for bankers as "normal" and hot demand for commodities traders as a "bubble" is a journalistic strategy for success: flatter your target audience.

Usually, the things people talk about as a great place to be are peaking, and the things people are fearful (or ignorant of) are still in a bull market. Commodities are getting a lot of play as a phenomenon that is close to "done," and the argument typically given for why commodities are ready to fall is that "this rise can't go on much longer."

On the flip side - in line with the demand for investment banker-types and investment banking services - is how private equity funds continue to raise record levels of capital, and are doing ever larger deals that are dependent on a low cost of funds...in an environment of rising rates.

Simply borrow money to buy a company with almost "no money down," borrow some more money to pay yourself a hefty "dividend," and then sell the equity of the company to the lumpeninvestoriat of mutual funds, "hot" deal chasers, and retail.

From the worldview of Dealbook (and others), private equity is an activity that can (and should) continue indefinitely. But 3 years of high gas prices...can only be the work of anti-American communists. - Ed

Project DDO: Confidential, Important Work Being Done Here

I would just like to point out how the convention of referring to deals as “Projects" in investment banking (and I suppose, in the corporate world generally) is actually pretty silly, and poor information security management to boot. For that matter, I imagine putting "confidential" on a document is similarly poor security protocol.

Naming something “Project X" is a signal that something is happening (unless, of course, it's just analysts photocopying and binding intern resumes - ”Project Intern”)

What I think might work better from an information security standpoint is to drop “Project” and "Confidential" altogether.

For project naming: call the project by a word that can be used in the context of a conversation without sticking out. “Are you working on Greenfield?” As opposed to “Project Greenfield.” Obviously, any sort of distinctive codeword attracts attention, but by not preceeding with the word "project", the distinction is lessened.

The practice of writing "confidential" or "strictly..." is a similar flag. Thinking about the executive offices I have seen and how full of paper they are - to flag documents as "Project", "Confidential" or "Strictly..." seem to only save a would-be information thief time from having to rifle through everything else in the office.

Now, it is quite possible that this is well recognized within investment banking, and the naming conventions persist because they persuade end clients - corporations - that the work being done for them is unique and special.

In this case, I wouldn't expect to see the names go away anytime soon. - Ed

How to Make Money off Financial Advice

Useful to keep in mind:

The best way to benefit from financial advice [is] to give it.

From the Lex column in the FT. The same article from the FT also makes this point, which I think is probably accurate:

One response [by investment banks to the reality of increased competition and higher compliance costs] is to put more of the bank's own money at risk, be it through loans, trading activities or private equity style investments. The snag is that such steps not only make conflict of interests harder to manage, but are also bound to dilute returns on capital of investment banks eventually. For their investors at least, things are unlikely to get much better. 

Link: Lex/FT via Yahoo

PWC/KPMG: 90% of Corporate Spreadsheets Have Material Errors in Them

I shared this with some colleagues a while back, and the most insightful comment back was that the benefits provided by widespread use of spreadsheets probably outweighs the errors. I'd say I have to agree with that. But for investors, I'm sure the question pops up - does this figure include sell-side models? - Ed

"According to PWC and KPMG, more than 90% of corporate spreadsheets have material errors in them. With each error costing between $10K and 100K per month, one expert estimates corporate America loses in excess of $10B annually through the misuse and abuse of spreadsheets." From the article: "The key point about spreadsheets is that you need to know which ones are critical to your business, which ones are merely important and which ones you do not have to bother too much about. Once you know that, you can start to apply appropriate policies depending on the criticality of the spreadsheet involved."  Link (via Slashdot)

Prop Accident?

Two weeks ago, I discussed the risks to prop trading:

Is it likelier that GS and MWD will implode from too much risk taking, leaving the investment banking market wide open to the jumbo commercial-investment banks, or...

that GS and MWD will be fine; the giants will be broken up due to slow-to-no growth and bureaucratic bumbling, leaving GS and MWD comforably perched atop the pyramid?

Then I saw this a week ago (10/5/05):

Morgan Stanley has named three traders to temporarily replace Sutesh Sharma, head of global proprietary trading, who is taking a leave of absence after six months in the job.

In an internal memo Jerker Johansson, head of institutional equities at Morgan Stanley, said: "Sutesh Sharma has informed us of his desire to take a temporary leave of absence through March 2006 in order to spend more time on personal matters."

Until he returns, Andy Pipa will be responsible for North America and Mike Frydman and Lars Lemonius will be co-heads of the European and Asian regions.

Sharma was named head of global proprietary trading in April when Robert Karofsky, the former head of Morgan Stanley's US cash equities business, quit with a team of seven traders to join rival Deutsche Bank.

Obviously, this sudden departure might mean nothing, particularly because it is only for six months. Then again, I also wouldn't be surprised if later on, the change were made permanent. 

Now, let's be fair - I'm speculating wildly here. This is because the first thing that came to mind when I read the excerpt above was:

On a conference call with investors (Aug 14, 2001), Enron President and CEO Jeffrey Skilling announced his immediate resignation, citing personal reasons. To fill the void, and while the firm searched for a permanent replacement, Enron announced that Ken Lay - the company's chairman - would assume Skilling's responsibilities.

I think my reaction is proof that investors (especially paranoids like me) are, post-bubble implosion,  still quick to assume the worst, and that we're sensitive to signs of "bad stuff". Hopefully for MWD, this announcement was nothing, but if it was, the language used is unfortunate.

MWD 3Q earnings were announced on September 12 (the company has a November fiscal year end). If any bad news were related to this departure, we would not know the impact officially until 4Q earnings are announced in mid-December.

Any reader who is familiar with this news and knows it is not an issue, feel free to drop me an email.  - Ed

Interesting Stat on Lehman Brothers (LEH)

Business Week did a piece on Lehman Brothers over this past weekend, and pointed out 70% of its pretax profits come from issuing and trading bonds.

BW: Is Lehman really ready [to be considered a peer of the elite investment banks]? Despite its recent moves to grow and diversify, the bank still has some notable voids in its business mix and global presence that it must fill to play in the top ranks.

The biggest weakness: Lehman still gets 58% of its revenue -- and, analysts say, 70% of pretax profits -- from issuing and trading bonds. That's down from 63% of revenues in the prior quarter, but it still leaves Lehman as the Wall Street firm most dependent on fixed-income business.  Link

As a youngster, I am not all that familiar with the history of how Lehman became the firm it is today. Talk about an achilles heel! - Ed

Goldman Sachs and Risk

A case study on why you read blogs. Here's the DDO on September 28:

Is it likelier that GS and MWD will implode from too much risk taking, leaving the investment banking market wide open to the jumbo commercial-investment banks, or...

that GS and MWD will be fine; the giants will be broken up due to slow-to-no growth and bureaucratic bumbling, leaving GS and MWD comforably perched atop the pyramid?

Here's the Financial Times on October 2nd:

When things are going well at Goldman Sachs (NYSE:GS), its president, Lloyd Blankfein, likes to remind everyone he hasn't felt this good since July 1998 the month before the bond market meltdown.

A spirit of paranoia does seem to haunt the investment bank: one risk model takes the worst nightmare of each asset class and assumes they all happen at once. Such extreme stress-testing might help reassure those investors who worry about Goldman's perceived riskiness. [...]

[In addition to the increase in VAR and capital committed to to trading,] another issue is whether [Goldman Sachs investors are] being adequately remunerated for the risk it takes on. How Goldman prices risk across its trading book is never going to be clear to outsiders. But the bank must be doing a fair job, because its overall returns on equity have been so good. They hit 25 per cent in the third quarter and have tended to be at the top end of the brokers' historic average, at least in strong markets. Link

I've read Goldman Sachs and Bear Stearns conference call transcripts many times for insight into the operations of financial services businesses. These transcripts are studies in disclosure.

Where Goldman CFO Viniar is a model of party-line repetition, Bear Stearns is plain spoken and forthcoming. A recent Bear investor day transcript yielded a good 80 pages of in-depth management commentary on virtually all aspects of their business, and quarterly earnings calls are no exception.

No answer on the "true" state of Goldman's risk management will likely be available to outsiders until something knocks Goldman off its comfortable perch as the smartest and best-run i-bank/trading house out there.

This is not to say that something WILL knock them off, but I don't think they'll change unless something beyond their control forces some humility into the process of being a public company. - Ed

Andy Kessler - Key Events in the Forced Evolution of Sell-Side Trading

Trying to get clear and concise Wall Street history isn't easy. When I come across something that explains in a plain-english, give-me-the-dirt style, I tend to hoard that information. Today, I'm sharing the wealth, with an excerpt from Wall Street Meat, by Andy Kessler.

I reviewed the book a while back, and came to this conclusion:

I would say, yes, [Wall Street Meat] is readable and entertaining [10 hrs to read], and if you are a Wall Street freak with time to burn then read it; however, read The Number, by Alex Berenson if you have less time and want a more useful perspective of the same time period. Link

I still stand by this assessment. However, this is not to say that Kessler was a wash. One of the passages I really appreciated was this overview of how the sell-side response to the crash of 1987 led to the creation of electronic trading networks that over time are crushing the profitability of the traditional sell-side trading business.

Kessler's main point is that this loss of profitability on the trading side contributed to the corruption of research, as banking fees were now the primary profits available to compensate analysts. My reason for posting, however, is simply as an interesting explanation of how the current market structure regime came about.

Note that I have created this passage by sandwiching two separate segments that are in the book about 120 pages apart. Enjoy!

By lunchtime, it was clear that October 19, 1987, was going to be historic. [The market] was just down, down, down.  By 2pm, most of the research department was lining the perimeter of the trading floor, just gawking. No one was having fun. The phones kept ringing. After a while, traders just stopped answering them. Over-the-counter traders would occasionally look up and yell, "What the fuck are you staring at? This ain't a circus. Go away."

No one did. At the close, the market had dropped 508 points, or 22.6%, on top of the 100 or so point drop the previous Friday.

The crash was more a wakeup call than the start of a depression, as many had feared. It wasn't a repeat of the 1930s. Wall Street did restructure. Layoffs started, but I can't recall any analysts being let go. Instead, more were hired.

Companies kept reporting earnings and the stock market opened for trading five days a week. Salesmen needed something to call investors about. Institutions needed advice from analysts, or so I was told. Research seemed immune.

Underneath the surface, however, changes in how Wall Sreet was paying for analysts would change the game in subtle ways. Some of it had to do with those over-the-counter traders not answering their phones. Wall Street got sued for not answering the phones and the SEC insisted the Street put in a system know as Small Order Execution System, SOES. This automated execution of small orders would lead to day traders and would eventually lead to automated trading systems known as ECNs.

These ECN trading systems would represent over half of over the counter trades by 2001, with commissions a hundredth of what they had been in 1987. It changed the way Wall Street gets paid. Commissions were toast. Banking fees would replace commissions, and eventually kill research in the process. (pages 71-72)

[With the establishment of the SOES system, or Small Order Execution System, trades under 1,000 shares would be executed automatically at the current market price.]

Two smart programmers, Jeff Citron and Josh Levine wrote an MS/DOS program on their PC that could game the SOES system, electronically sending in rapid-fire trades to pick off over-the-counter traders. These guys were not so affectionately known as the SOES bandits, and roadblocks, including limits like only one trade very five minutes per trader and only so many per day, were put in to slow them down.

This led to the creation of day traders -- whole rooms filled with SOES bandits to get around the per trader rules. When a trader had a big block of shares to buy or sell, it was impossible not to run into these bandits and lose your shirt on these trades. So, traders would often signal to others on the street to get the hell out of their way, they had a big trade to cross, and other traders would pull their bids and make room for the other guys to maneuver around the SOES bandits.

In 1996, the day trader loophole led to a massive domino dropping in the middle of every trading floor, a class action lawsuit called the "NASDAQ Market Makers Antitrust Litigation" led by William Lerach. It alleged collusion amongst Wall Street traders. In 1998, Lerach proved his case. Of course he did, since they had to collude to get around the day traders. Wall Street settled for $1 billion. The SEC also put in a regulation, Rule 11Ac1-4, the limit order display rule, authorizing electronic communication networks or ECNs. These were computer systems that could match trades without human intervention.

It was not just the loss of market share to these anonymous matching systems that would alter Wall Street. The Lerach suit and its $1 billion settlement killed liquidity, which is what makes markets work efficiently. If you want to sell shares, but there are no buyers around just then, someone like Goldman Sachs might step up and buy your shares for their own account, and then sell them over the next day or two. Goldman Sachs would use its own capital to facilitate your trade. Wall Street Legend tells of a sign on the football field-sized trading floor at Goldman Sachs that read, "If you can't find the other side of a trade, you are it." That is liquidity. It kept stocks from bouncing wildly. Their payoff was the spread between what they paid for it, the bid, and what they sell it for, the ask..

Lerach sued because the spread was too large. Paying $1 billion got Wall Street's attention and sure enough, liquidity disappeared. If Wall Street could not get paid enough to do your trade, then they were not going to put their own capital at risk. I saw that change in 1998, when brokerage firms no longer bought my shares outright, but would instead "work" the order for days, even on bigger names that traded a lot. It was as if Goldman Sachs had put a new sign reading, "If you are the other side of the trade, you are fired."

Without liquidity for over-the-counter trades, you could breathe on a stock and make it move. A big buy order was almost guaranteed to make a stock go up two, three, even five points. Likewise, a decent sell order could half a stock. Perhaps that is why Amazon jumped 46 points on the same as Henry Blodget $400 price target call.

Instinet, now owned by Reuter's, had been around for decades, but quickly turned itself into an ECN trading system. The same guys who started the whole day trading phenomenon, Citron and Levine, tweaked their code and created their own matching system to compete with Instinet. They called their ECN, The Island. ECN trading systems would do half of over-the-counter trading volume by 2001.

Those traders should have answered their phones in October 1987. (page 197-8)

For readers unfamiliar with how electronic trading is transforming the sell-side business model, just imagine a robot competing for an auto worker's union job in a factory. Reduces costs for consumers, but dislocates the "establishment". 

In this situation, the rise of automated trading was enabled by the behavior of the same workers, who in effect created a "picket line" on their trading desks on Black Tuesday in 1987. Because they sought to protect their books in the short term, they created much larger problems for themselves in the long term. - Ed

Michael Lewis on Investment Banking Fees

I wanted to follow up with my post regarding the comparison of Dana Vachon to Michael Lewis.

I concluded that D-NASTY says nothing interesting about the world of finance today, and in fact proves that much of finance has ceased to become interesting even to the people who practice it. Link I only hope that his book does a better job addressing this problem than his blog has.

However, all is not amiss as far as finding people saying interesting things about finance.

In fact, the next Michael Lewis just might be...Michael Lewis.

I wanted to share this column from April 2002, which shows that Lewis definitely understands how Wall Street works in a way that you don't often hear in the press.

And, as far as books about Wall Street go, consider this: Lewis hasn't stopped writing books that are fascinating to people working on Wall Street.

His latest book, Moneyball (about using statistics effectively in baseball), actually speaks more to what investing is all about than do most books explicitly on the subject of investing.

Proof of Moneyball's popularity is that it has become common for firms to describe their investment philosophy in terms of which metrics they use that are generally underpriced. Firms want to show how they've found the "on-base percentage" equivalent for investing.

For example, there was this article on Putnam from Barron's this past weekend - which I think is embarrassing for them. This is not to say that the tools Beane used aren't great for investing, simply that it would be wiser for Putnam to simply put these systems into place, and let the results be the reward. Press like this is advertising the fact that they are susceptible to trendy thinking, and standing around in baseball jerseys for photo shoots doesn't help.

I guess the final point to make is this: for his books, Lewis understands that great characters drive the narrative.  Lew Ranieri (among others) drove Liars Poker, Jim Clark drove The New, New Thing, and Billy Beane drives Moneyball.

Vachon's interesting characters are celebrities he doesn't know, and based on his interests, he would probably be better off working as an intern at Page Six (and that's not to dismiss Page Six at all) than at an investment bank. - Ed

How Investment Banking Fees Corrupt Wall Street - April 18, 2002

A report this week that Goldman Sachs Group Inc. declined General Electric Co.'s request for a $1 billion line of credit was the most-read article on Bloomberg. Small wonder.

The world's largest corporation, warned by Moody's Investors Service that its credit rating might slip if it didn't line up more backing for its short-term borrowings, had asked the world's toniest investment bank to lend it money and was turned down. Amazingly, this was treated by many not as a warning signal about GE but as a problem for Goldman Sachs.

The general view, implicitly accepted by the 11 banks and Wall Street firms that bowed to GE's credit demands, was that any firm that didn't give GE what it wanted would be excluded when it came time for GE to dole out its huge banking fees. As the former head of corporate bond research at Deutsche Bank AG put it, "If you say no to GE, you get banished to the underworld."

This is a perversion of the way capital markets are supposed to work. In essence, GE, along with many other big US companies, has been demanding that Wall Street firms extend lines of credit they otherwise would not, in exchange for future banking fees.

Kickbacks

The logic of the Wall Street response -- we have to do X, even though it doesn't make financial sense, or we will miss out on a payday down the road -- rings a bell. It's the same argument that these same firms made to themselves when they compromised their stock market research. In doing so, they exhibit their usual willingness to transform the allocation of capital into a system based on kickbacks.

Protecting the Fees

Wall Street firms don't care if they need to forbid their analysts from owning stock in the companies they analyze. They don't care if they are required to pay a lawyer to be present when their analysts and their corporate financiers meet. They don't care if they need to append a few more lines of fine print to the end of brokerage reports, declaring their investment banking interests. They certainly don't care if they need to add even more disclaimers to prospectuses that no one reads.

What they do care about is preserving their fees. And yet no one has breathed a word about these.

Investment banking fees are a curiosity for anyone intimate with the inner workings of a securities firm. Investment banking is not rocket science and investment bankers are nearly as plentiful and fungible as dollar bills. Yet while the typical fee on a bank loan has been driven down to .01 percent of the total, the typical fee for arranging a securities transaction remains stuck as high as 7 percent.

Full-Service Shops

Why? Why don't big companies such as, say, General Electric, play Wall Street firms off one another and drive down the fees? At first glance, this would appear to be a good example of market failure.

But then you see what the investment banks do for the big companies to get the fees -- lie to the investment public on their behalf, extend them credit when they shouldn't get it -- and it all makes a bit more sense.

The big fees are a tool used by big companies to manipulate the investment banks. They are not "earned" so much as "doled out." And because they are vastly in excess of what the work is worth in a competitive market, they cease to function as fees for honest service and begin to look more like bribes.

Whether a business model based on a system of bribes and kickbacks makes sense for Wall Street firms in the long run I do not know. But in the short run, the firms seem to feel that the fees are worth sacrificing their reputations and balance sheets. Even Goldman Sachs in turning down GE was not repudiating the system. Goldman officials were just upset they weren't getting a big enough cut of the take.

You want to clean up Wall Street? You want to minimize the number of future newspaper stories that expose systematic corruption in high finance? There's an easy solution:

Regulate banking fees.

Jim Cramer on Institutional Equities

Jim Cramer put up some interesting commentary on the institutional equities business at major sell-side firms that I wanted to highlight. He correctly notes that people are focused on the yield curve's potential impact, while overlooking the fact that equity trading is looking pretty weak right now:

"Everyone is focusing on how the yield curve's lack of slope has hurt the brokers' earnings. I believe, though, that not enough attention has been paid to the absolutely relentless and brutal decline in the commissions that brokers receive. The institutional business is under siege like no other time in the last 30 years. In fact, I believe you have to go back to May Day, that historic occasion in 1975 when commissions were no longer fixed, to find a more tumultuous time in the business.

These direct-access folks are charging a penny a share. The buy side, led by Fidelity, doesn't want bundled research and trading.

[Editorial aside: there is a line of thinking that says this move is not about transparency for investors, but about major mutual fund complexes trying to eliminate what they see as a free subsidy to pint-sized competitors. By paying brokers huge sums of money and then allowing the brokers to give the same research the majors pay through the nose for to any Tom, Dick, or Harry who wants it, the majors allow little guys to nibble at their heels by using the same research product they do, which they wouldn't be able to afford on their own. Interesting!]

It's all becoming rather clear that the equity brokerage business, even with syndication, has become a total commodity even for the Goldmans and the Lehmans, which spend millions and millions of dollars on research.

So, even though I believe that the estimates and lack of enthusiasm should make these stocks less likely to roll over, the long-term secular trend for a major part of all of their businesses -- equities -- is so dire, I can't summon enthusiasm for them. As with so many other parts of this market, I don't want to go long or short them."

Link