Here is an interesting article about the rise of mortgage securities CDOs and Credit Default Swaps. The problem is too great to put at the feet of any one man (unless that person is Alan Greenspan) but it is still interesting. I will post some more analysis later.
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=3
Wednesday, February 25, 2009
Wednesday, February 18, 2009
Auto Bailout redux
See this article in today's NY Times. It outlines, as I have on two occasions, the need to put GM (and probably Chrysler) into bankruptcy:
http://dealbook.blogs.nytimes.com/2009/02/16/altman-a-gm-bankruptcy-to-save-taxpayer-money/
The sooner this is done, the sooner GM can get back to business of making cars instead of wasting time on fruitless negotiations.
http://dealbook.blogs.nytimes.com/2009/02/16/altman-a-gm-bankruptcy-to-save-taxpayer-money/
The sooner this is done, the sooner GM can get back to business of making cars instead of wasting time on fruitless negotiations.
Monday, February 16, 2009
Auto Bail-out: Take 2
The Auto Industry has until tomorrow to come back to Congress with the terms of its restructuring. Having the automakers develop the terms of their restructuring strikes me somewhat like asking a heroine user to develop their methadone treatment plan: they may be best educated to understand the problem but the least prepared to deal with it realistically.
The problems facing the industry are many, and for the most part were avoidable had the industry recognized and embraced the need for change earlier rather than fighting it and maintaining business as usual. The truth is that the models developed by Detroit are largely uncompetitive, the costs are too high, there is too much debt on the corporate books, there are too many models and too many parts, and there is too much investment stranded in plants supporting uncompetitive and overlapping models. The dealership model is costly and largely unnecessary.
The numbers seem to vary depending upon the source, but based on reasonably reliable sources it appears that on average an auto worker makes about $28/hour. However, the labor costs per employee including benefits for existing and retired employees are more than double that. Huh? The reason is that the unions demanded and the auto companies complied with providing a level of benefits that is unsustainable. Foreign manufacturers, who are newer to the US labor pool, are not burdened with these costs, which equal (depending upon the estimator) approximately $2000 more per car for the US models.
So the question now is, who should bear the brunt of the restructuring? The answer is simple - all constituents:
1) The automakers need to trim the number of nameplates they maintain and models they produce by roughly half, close plants accordingly, and lay-off a proportionate number of workers. This will be painful, but not doing so puts all models, plants, and workers at risk. The unions must accept this.
2) Workers will need to accept benefits more in line with other industries.
3) Retirees who are under 67 years old will see some reduction in benefits. Those over 67 will not be affected.
4) Lenders will need to accept a reduction in the principal amounts of the debt they have lent to the industry. They were irrational in providing this level of credit, prolonging the industry's lack of recognition of their problems, and need to share the pain. They should convert a significant portion of their indebtedness to equity.
5) Dealers will be shut down. There is simply no reason, with fewer makes and fewer models, to maintain the same number of dealers. In addition, the advent of the internet diminishes the need for them. Dealers should be replaced with regional showcases for new models. Existing dealers should focus on service, and perhaps selling used cars, rather than stocking new models.
6) Automaker leadership will need to be examined sternly, and for the most part, replaced.
7) The above mentioned items will only be able to be accomplished through bankruptcy. Unfortunately, many of my elected California representatives, as well as representatives from other states, equate bankruptcy with "failure" and therefore oppose it. This simply is not true, and it is disingenius to continue repeating it.
Chapter 7 would in fact be a "failure," ie a liquidation of the companies. But no one is advocating, or ever has advocated, Chapter 7, rather Chapter 11 bankruptcy is what has been proposed. Chapter 11 is a "reorganization," and does not require that the automakers shut down. This process gives the companies the power to reject untenable contracts, including leases, dealer arrangements, and employment contracts. Without this power, the automakers are subject to the whims of too many competing interests.
8) The government will need to step in - A: Congress must address the benefits of the retirees. Reducing the number of workers in the industry will actually increase the average cost per worker, so the government will need to take on some of this pension and benefit obligation. Perhaps all of it. If not, the industry will never be able to be competitive.
9) The government steps in - B: The companies will need to receive what is called Debtor in Possession financing during the bankruptcy process. However, in order to get banks to provide this capital, the government will need to guarantee it.
10) The government steps in - C: The government will need to provide buyer incentives to get models moving. These should include tax rebates for fuel efficient and electric cars. In addition, the government will need to guarantee loans for the sale of new cars - preferably fuel efficient ones.
11) Existing shareholders (including management), as a consequence of the foregoing, will be wiped out. At best they may participate in the recovery through substantially out of the money options.
None of the government activities should occur unilaterally - they should occur pursuant to a negotiated - or prepackaged - bankruptcy, ie chapter 11. The government needs to stop taking it on faith that its bailout targets will do the right thing - they have all proven they won't.
The problems facing the industry are many, and for the most part were avoidable had the industry recognized and embraced the need for change earlier rather than fighting it and maintaining business as usual. The truth is that the models developed by Detroit are largely uncompetitive, the costs are too high, there is too much debt on the corporate books, there are too many models and too many parts, and there is too much investment stranded in plants supporting uncompetitive and overlapping models. The dealership model is costly and largely unnecessary.
The numbers seem to vary depending upon the source, but based on reasonably reliable sources it appears that on average an auto worker makes about $28/hour. However, the labor costs per employee including benefits for existing and retired employees are more than double that. Huh? The reason is that the unions demanded and the auto companies complied with providing a level of benefits that is unsustainable. Foreign manufacturers, who are newer to the US labor pool, are not burdened with these costs, which equal (depending upon the estimator) approximately $2000 more per car for the US models.
So the question now is, who should bear the brunt of the restructuring? The answer is simple - all constituents:
1) The automakers need to trim the number of nameplates they maintain and models they produce by roughly half, close plants accordingly, and lay-off a proportionate number of workers. This will be painful, but not doing so puts all models, plants, and workers at risk. The unions must accept this.
2) Workers will need to accept benefits more in line with other industries.
3) Retirees who are under 67 years old will see some reduction in benefits. Those over 67 will not be affected.
4) Lenders will need to accept a reduction in the principal amounts of the debt they have lent to the industry. They were irrational in providing this level of credit, prolonging the industry's lack of recognition of their problems, and need to share the pain. They should convert a significant portion of their indebtedness to equity.
5) Dealers will be shut down. There is simply no reason, with fewer makes and fewer models, to maintain the same number of dealers. In addition, the advent of the internet diminishes the need for them. Dealers should be replaced with regional showcases for new models. Existing dealers should focus on service, and perhaps selling used cars, rather than stocking new models.
6) Automaker leadership will need to be examined sternly, and for the most part, replaced.
7) The above mentioned items will only be able to be accomplished through bankruptcy. Unfortunately, many of my elected California representatives, as well as representatives from other states, equate bankruptcy with "failure" and therefore oppose it. This simply is not true, and it is disingenius to continue repeating it.
Chapter 7 would in fact be a "failure," ie a liquidation of the companies. But no one is advocating, or ever has advocated, Chapter 7, rather Chapter 11 bankruptcy is what has been proposed. Chapter 11 is a "reorganization," and does not require that the automakers shut down. This process gives the companies the power to reject untenable contracts, including leases, dealer arrangements, and employment contracts. Without this power, the automakers are subject to the whims of too many competing interests.
8) The government will need to step in - A: Congress must address the benefits of the retirees. Reducing the number of workers in the industry will actually increase the average cost per worker, so the government will need to take on some of this pension and benefit obligation. Perhaps all of it. If not, the industry will never be able to be competitive.
9) The government steps in - B: The companies will need to receive what is called Debtor in Possession financing during the bankruptcy process. However, in order to get banks to provide this capital, the government will need to guarantee it.
10) The government steps in - C: The government will need to provide buyer incentives to get models moving. These should include tax rebates for fuel efficient and electric cars. In addition, the government will need to guarantee loans for the sale of new cars - preferably fuel efficient ones.
11) Existing shareholders (including management), as a consequence of the foregoing, will be wiped out. At best they may participate in the recovery through substantially out of the money options.
None of the government activities should occur unilaterally - they should occur pursuant to a negotiated - or prepackaged - bankruptcy, ie chapter 11. The government needs to stop taking it on faith that its bailout targets will do the right thing - they have all proven they won't.
Friday, February 13, 2009
Happy Birthday Mayor Jack Maltester
I was fortunate enough to attend a small luncheon in honor of Jack Maltester on the occasion of his 96th birthday. The luncheon was hosted by the gracious Jake Francesca at his wonderful restaurant Vila Cereja, a fixture in the San Leandro community for 40 years. Others in our party included former Oakland Raider and Pro Bowl player Raymond Chester, San Francisco radio personality and comedian Brian Copeland, long time real estate businessman Doug Federighi, and attorney Tom Armstrong of the White & Lee.
Mr. Maltester served as the honourable Mayor of San Leandro, CA for 20 years, from 1958 to 1978. He was an early supporter of the Civil Rights movement, proposing a Committee on Human Rights and Responsibilities to the City Council, first in 1963, that was rejected three times. He twice served as Chairman of the United States Conference of Mayors.
In 1971, Jack "sponsored a resolution at the annual USCM meeting in Philadelphia, entitled "Withdrawal from Vietnam and Reordering of National Priorities", calling upon then-President of the United States, Richard Nixon, "to do all within his power to bring about a complete withdrawal of all American forces from Vietnam by December 31, 1971."" (Nationmaster Encyclopedia.)
Mr. Maltester was an influential member of California's Democratic party, and a key campaigner for Jack Kennedy in his 1960 election bid, receiving a personal thank you call from President Kennedy upon his installation in office. At 96 years old, Jack may not be as spry as he once was, but he still has a sharp intellect and a rapier wit.
Happy birthday, Jack.
Mr. Maltester served as the honourable Mayor of San Leandro, CA for 20 years, from 1958 to 1978. He was an early supporter of the Civil Rights movement, proposing a Committee on Human Rights and Responsibilities to the City Council, first in 1963, that was rejected three times. He twice served as Chairman of the United States Conference of Mayors.
In 1971, Jack "sponsored a resolution at the annual USCM meeting in Philadelphia, entitled "Withdrawal from Vietnam and Reordering of National Priorities", calling upon then-President of the United States, Richard Nixon, "to do all within his power to bring about a complete withdrawal of all American forces from Vietnam by December 31, 1971."" (Nationmaster Encyclopedia.)
Mr. Maltester was an influential member of California's Democratic party, and a key campaigner for Jack Kennedy in his 1960 election bid, receiving a personal thank you call from President Kennedy upon his installation in office. At 96 years old, Jack may not be as spry as he once was, but he still has a sharp intellect and a rapier wit.
Happy birthday, Jack.
Where is the Money?
During the luncheon, Raymond Chester asked a seemingly simple question: "Where did all the money go? What happened to the money?" Understand that Ray is an intelligent and thoughtful person, having led a very successful post football career developing and operating golf courses. He recently served as Chair of the Oakland-Alameda County Coliseum Commission. But the answer to his question is difficult for many people to grasp.
Tremendous wealth has been destroyed in the last 18 months. Property values have declined precipitously, and much of the money in our economy was based on real estate values: second mortgages were used to buy cars, boats, furniture, stereo equipment, take vacations, and refinance credit cards. That source of capital into our economy has disappeared.
Dropping values have wiped out the equity in many homes, making it impossible for many homeowners in adjustable rate mortgages to refinance, causing them to default and lose their homes. Construction of new homes and remodeling of existing ones has been ground to a halt, causing construction companies and real estate developers to go bankrupt and close their doors.
Further, stocks have dropped 50%+ from their highs, and margin calls have wiped out many investors. Dividends have been cut, reducing incomes for many investors, particularly retirees.
In short, much of the cash in our economy had been supplied by leveraging rising asset values. With the dimunition of those values, the ability to lever them for either commercial or consumer lending is kaput. And with it went "the money."
The reduction of debt available both commercially and for consumers has led to a drastic reduction in the fortunes of contractors, retailers, automobile manufacturers, makers of durable goods, and all their suppliers. Unemployment is pointing towards 10% nationally and in Michigan may already be 20%. In the US - not latin America.
The only thing that is going to turn the economy around is the availability of credit for commerce, real estate, and consumers. Until that happens, Raymond, don't expect to see "the money" again any time soon.
Tremendous wealth has been destroyed in the last 18 months. Property values have declined precipitously, and much of the money in our economy was based on real estate values: second mortgages were used to buy cars, boats, furniture, stereo equipment, take vacations, and refinance credit cards. That source of capital into our economy has disappeared.
Dropping values have wiped out the equity in many homes, making it impossible for many homeowners in adjustable rate mortgages to refinance, causing them to default and lose their homes. Construction of new homes and remodeling of existing ones has been ground to a halt, causing construction companies and real estate developers to go bankrupt and close their doors.
Further, stocks have dropped 50%+ from their highs, and margin calls have wiped out many investors. Dividends have been cut, reducing incomes for many investors, particularly retirees.
In short, much of the cash in our economy had been supplied by leveraging rising asset values. With the dimunition of those values, the ability to lever them for either commercial or consumer lending is kaput. And with it went "the money."
The reduction of debt available both commercially and for consumers has led to a drastic reduction in the fortunes of contractors, retailers, automobile manufacturers, makers of durable goods, and all their suppliers. Unemployment is pointing towards 10% nationally and in Michigan may already be 20%. In the US - not latin America.
The only thing that is going to turn the economy around is the availability of credit for commerce, real estate, and consumers. Until that happens, Raymond, don't expect to see "the money" again any time soon.
Thursday, February 12, 2009
Venture Capital - A Broken Model
The stock market is low. The price of private deals is even lower. This should present great buying opportunities for Venture Capital, right?
Well, that would be true if Venture firms were actually in business today.
The Venture Capital model of recent years barely resembles the industry the one that I first learned of in the 1980s. In those days, investment funds made small investments ($1 - 3 million) in companies with modest valuations (single digit millions). The funds played a significant role in the oversight of their portfolio companies. The likely exit was through a sale - IPO activity was modest, and when IPOs occurred the deal sizes were small.
In those days, the funds themselves were modest size - $40- $50 million funds were big. The interests of the limited partners (ie the investors in the funds) and the general partner (the fund management) were aligned. They GP took a modest annual management fee (2%) and received 20% of the profits in good deals.
This changed in the middle 1990s. An IPO became the most likely exit. Some of the successes were mammoth (Netscape, Google, Yahoo) and this changed the business. The funds attracted huge pools of capital, and it was no longer efficient to make small investments or to provide much oversight. Further, the pricing changed: funds now charged 2.5% annually and as much as 30% of the profits on very successful deals.
When a manager makes 2% on $50 million ($1 million/year), from which he pays all his costs (rent, salaries, travel, deal expenses), it is clear that his interests are aligned with investors: he depends upon good deals, and lots of them, to meet his wealth objectives. When, as is the case with many funds now, a manager makes 2.5% on $1 billion annually ($25 million/year) - well lets just say that the wolf is certainly not at the door.
With a billion dollars or more to invest, managers started putting $15 million or more to work in deals, with the intention to provide follow-on investments of $10 million or more. And since venture firms rarely invest alone, that means another manager was investing similar dollars. Greater investment dollars drove up the pre-money valuations - it became commonplace for start-ups to have pre-money valuations of $25 million or more.
A "home run" might generate 20x. On a $25 million investment thats $500 million - and with 30% to the GP (up from the 20% of the old days) that's a cool $150 million. Since losers were not (and are not) netted against winners the Venture Capital firm had plenty of incentive to swing for the fences.
To justify these large investments, investors brought in high priced talent to operate these businesses and sell them to Wall Street as IPO candidates. Never mind whether they had the appropriate experience to run a small developing business. This jacked up the operating costs and the cash burn rates - essentially accelerating the rate of failure. But with a frothy market promising a quick exit via IPO at huge valuations - who cared?
Now - the IPO exit is non-existent. Funds have piles of cash, but little understanding of what to do with them. They cannot efficiently make small investments and expect to keep track of them, much less provide oversight. And even if they do, the nominal dollar returns on these smaller investments don't "move the needle" - ie are not large enough to make the VCs interested. So they sit, collecting their 2.5% annually - not a bad consolation prize - and hoping that Wall Street will revert to the way it was. Or worse - chase renewable energy deals by investing huge sums at a time with the same frothy misguided enthusiasm ( a recent solar energy deal had a pre-money valuation of $1 billion!).
What they should do is reduce the size of their funds (canceling commitments to $50 million or so), or split them into small sector funds with separate management. They should make modest investments in promising companies at modest valuations. They should plan on holding investments for longer periods, and assume that their exits will be through responsible M&A. In this way the managers actually have to work and be successful to get rich. They will bring in management appropriate for small entrepreneurial ventures. And they will provide the kind of oversight to maximize the likelihood that all of their portfolio companies can achieve some level of success.
Small, entrepreneurial companies that deserve funding will receive it.
And the interests of the Venture Capitalists will once again be aligned with that of their investors.
Well, that would be true if Venture firms were actually in business today.
The Venture Capital model of recent years barely resembles the industry the one that I first learned of in the 1980s. In those days, investment funds made small investments ($1 - 3 million) in companies with modest valuations (single digit millions). The funds played a significant role in the oversight of their portfolio companies. The likely exit was through a sale - IPO activity was modest, and when IPOs occurred the deal sizes were small.
In those days, the funds themselves were modest size - $40- $50 million funds were big. The interests of the limited partners (ie the investors in the funds) and the general partner (the fund management) were aligned. They GP took a modest annual management fee (2%) and received 20% of the profits in good deals.
This changed in the middle 1990s. An IPO became the most likely exit. Some of the successes were mammoth (Netscape, Google, Yahoo) and this changed the business. The funds attracted huge pools of capital, and it was no longer efficient to make small investments or to provide much oversight. Further, the pricing changed: funds now charged 2.5% annually and as much as 30% of the profits on very successful deals.
When a manager makes 2% on $50 million ($1 million/year), from which he pays all his costs (rent, salaries, travel, deal expenses), it is clear that his interests are aligned with investors: he depends upon good deals, and lots of them, to meet his wealth objectives. When, as is the case with many funds now, a manager makes 2.5% on $1 billion annually ($25 million/year) - well lets just say that the wolf is certainly not at the door.
With a billion dollars or more to invest, managers started putting $15 million or more to work in deals, with the intention to provide follow-on investments of $10 million or more. And since venture firms rarely invest alone, that means another manager was investing similar dollars. Greater investment dollars drove up the pre-money valuations - it became commonplace for start-ups to have pre-money valuations of $25 million or more.
A "home run" might generate 20x. On a $25 million investment thats $500 million - and with 30% to the GP (up from the 20% of the old days) that's a cool $150 million. Since losers were not (and are not) netted against winners the Venture Capital firm had plenty of incentive to swing for the fences.
To justify these large investments, investors brought in high priced talent to operate these businesses and sell them to Wall Street as IPO candidates. Never mind whether they had the appropriate experience to run a small developing business. This jacked up the operating costs and the cash burn rates - essentially accelerating the rate of failure. But with a frothy market promising a quick exit via IPO at huge valuations - who cared?
Now - the IPO exit is non-existent. Funds have piles of cash, but little understanding of what to do with them. They cannot efficiently make small investments and expect to keep track of them, much less provide oversight. And even if they do, the nominal dollar returns on these smaller investments don't "move the needle" - ie are not large enough to make the VCs interested. So they sit, collecting their 2.5% annually - not a bad consolation prize - and hoping that Wall Street will revert to the way it was. Or worse - chase renewable energy deals by investing huge sums at a time with the same frothy misguided enthusiasm ( a recent solar energy deal had a pre-money valuation of $1 billion!).
What they should do is reduce the size of their funds (canceling commitments to $50 million or so), or split them into small sector funds with separate management. They should make modest investments in promising companies at modest valuations. They should plan on holding investments for longer periods, and assume that their exits will be through responsible M&A. In this way the managers actually have to work and be successful to get rich. They will bring in management appropriate for small entrepreneurial ventures. And they will provide the kind of oversight to maximize the likelihood that all of their portfolio companies can achieve some level of success.
Small, entrepreneurial companies that deserve funding will receive it.
And the interests of the Venture Capitalists will once again be aligned with that of their investors.
Wednesday, February 11, 2009
Wall Street Comp
Sorry everyone for the hiatus. I am back on the job!
There has been a lot of discussion of Wall Street compensation over the past two weeks. Compensation that equaled 2004 levels, when the "street" had a then record year for profits, strikes many on Main Street as problematic when these firms received over $250 billion in TARP (bailout) funds because they were unable to meet the minimum required capital ratios.
Often Main Street is wrong - this time they are not. At a time when the street should be shoring up its balance sheet, and using its capital to make markets and make loans, the street paid out $18.4 billion in bonuses - or roughly 8% of its TARP funds. The firms claim that they didnt use any TARP funds to pay bonuses, but that flies in the face of a common street expression: "Money is fungible." Translation: A dollar is a dollar, and if you put money in one pocket and spend it from the other, it still has the same effect - you still are down those dollars.
The firms' answer is that if they didn't pay out these bonuses they would experience a significant defection of top talent - the dreaded "brain drain." But aren't these the same brains that got the firms into trouble in the first place?
I for one think that the "brain drain" would be a good thing. Where will they go - to other big firms? No, because they won't be able to pay up either. No, they will start new boutique investment banking firms.
Wall Street was a much better place when much of the better talent resided at these smaller, private partnerships with limited capital. In those days, firms relied on their wits instead of their balance sheets (or more rightly, their shareholders' balance sheets). In those days care of clients was paramount, not short term trading profits. And in those days, you "ate what you killed;" i.e. if you brought in business - based on your intellectual capital - you got paid well. If you didn't, well you didn't.
In recent years Wall Street has made its money by maker larger and more complex bets using the balance sheet. This is not the same thing, and quite frankly does not deserve the same level of compensation. For example, in the past, a department might get paid out 40%-60% of the profits, with the balance being paid to the partners or retained as capital. However, if you are using risk capital, it is not appropriate to get paid that way. Unfortunately, the Universal banking model has meshed the pay practices of the private partnerships with the brute force capital approach of the traditional money center banks.
In a competitive moving market, with lots of participants, the only way to make more money risking capital is to take larger & riskier bets. If you are going to get paid the same ratio for risking shareholder capital as not, then the law of large numbers kicks in and you have incentive to risk larger and larger amounts. This is in fact what happened over the last decade or so.
I really do not care what someone makes - provided he earns his living either risking little capital or his own. If he is risking shareholder capital, then compensation needs to be reigned in. The same applies to corporate CEOs. You are playing with shareholder money - you are an employee - act like it and get paid accordingly!
Andrew Ross Sorkin of the New York Times has, in a recent article, proposed that instead of decreasing Wall Street compensation, we simply pay the regulators Wall Street-like wages. That way we attract the "best and the brightest" to the regulatory side. Andy, Andy, Andy. Consider who is feeding you this nonsense - Wall Street and Private Equity houses.
Look, having the best and the brightest didn't keep Wall Street from making disastrous bets on mortgages, CDOs, and credit derivatives, and it didn't keep Rumsfeld and Wolfowitz (very smart guys) from making idiotic decisions on Iraq. Best and brightest is not the issue - the aura of being beyond reproach is the issue.
Pay bankers for performance? - sure. Pay them for risking shareholder capital ? - not so much. If bankers got paid less for risking capital than for not, believe me they would spend more time on non-capital intensive strategies.
There has been a lot of discussion of Wall Street compensation over the past two weeks. Compensation that equaled 2004 levels, when the "street" had a then record year for profits, strikes many on Main Street as problematic when these firms received over $250 billion in TARP (bailout) funds because they were unable to meet the minimum required capital ratios.
Often Main Street is wrong - this time they are not. At a time when the street should be shoring up its balance sheet, and using its capital to make markets and make loans, the street paid out $18.4 billion in bonuses - or roughly 8% of its TARP funds. The firms claim that they didnt use any TARP funds to pay bonuses, but that flies in the face of a common street expression: "Money is fungible." Translation: A dollar is a dollar, and if you put money in one pocket and spend it from the other, it still has the same effect - you still are down those dollars.
The firms' answer is that if they didn't pay out these bonuses they would experience a significant defection of top talent - the dreaded "brain drain." But aren't these the same brains that got the firms into trouble in the first place?
I for one think that the "brain drain" would be a good thing. Where will they go - to other big firms? No, because they won't be able to pay up either. No, they will start new boutique investment banking firms.
Wall Street was a much better place when much of the better talent resided at these smaller, private partnerships with limited capital. In those days, firms relied on their wits instead of their balance sheets (or more rightly, their shareholders' balance sheets). In those days care of clients was paramount, not short term trading profits. And in those days, you "ate what you killed;" i.e. if you brought in business - based on your intellectual capital - you got paid well. If you didn't, well you didn't.
In recent years Wall Street has made its money by maker larger and more complex bets using the balance sheet. This is not the same thing, and quite frankly does not deserve the same level of compensation. For example, in the past, a department might get paid out 40%-60% of the profits, with the balance being paid to the partners or retained as capital. However, if you are using risk capital, it is not appropriate to get paid that way. Unfortunately, the Universal banking model has meshed the pay practices of the private partnerships with the brute force capital approach of the traditional money center banks.
In a competitive moving market, with lots of participants, the only way to make more money risking capital is to take larger & riskier bets. If you are going to get paid the same ratio for risking shareholder capital as not, then the law of large numbers kicks in and you have incentive to risk larger and larger amounts. This is in fact what happened over the last decade or so.
I really do not care what someone makes - provided he earns his living either risking little capital or his own. If he is risking shareholder capital, then compensation needs to be reigned in. The same applies to corporate CEOs. You are playing with shareholder money - you are an employee - act like it and get paid accordingly!
Andrew Ross Sorkin of the New York Times has, in a recent article, proposed that instead of decreasing Wall Street compensation, we simply pay the regulators Wall Street-like wages. That way we attract the "best and the brightest" to the regulatory side. Andy, Andy, Andy. Consider who is feeding you this nonsense - Wall Street and Private Equity houses.
Look, having the best and the brightest didn't keep Wall Street from making disastrous bets on mortgages, CDOs, and credit derivatives, and it didn't keep Rumsfeld and Wolfowitz (very smart guys) from making idiotic decisions on Iraq. Best and brightest is not the issue - the aura of being beyond reproach is the issue.
Pay bankers for performance? - sure. Pay them for risking shareholder capital ? - not so much. If bankers got paid less for risking capital than for not, believe me they would spend more time on non-capital intensive strategies.
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