Comments on Rick Bookstaber: Why Do Bankers Make So Much Money?

Our perspective is that "information asymmetr...

2010-04-28T14:44:57.212-04:00

Our perspective is that "information asymmetries" traditional and (maybe) manageable in merchant banking/institutional transaction where caveat emptor is accepted.

We would propose however, that as the nations wealth, and especially that of the massive Boomer retirees, comes to dominate the capital markets, globally, we are entering an era of "insti-individual" markets.

Not having a strong, institutional counter-party and predominantly "retail" customers, shifts informational asymmetries quickly to breeching fiduciary duties, bad faith and fraud.

You can NOT apply traditional merchant banking business models/practices to people's life saving - or their home equity. The social fabric is threatened.

Couple of historical fables:
- I read the early, growing Greek cities and democracies were severely challenged when they expanded in Asia Minor. An acute problem, which they solved by banning traders from the agora, was the ME traders lied doing business. The traders took "info asymmetry" as standard business practice! Something the Greeks hadn't experienced before!
- It is said that Hitler came to power mainly because of the social disruption caused by the German governments inability to pay the WWI veteran's pension benefits. Hence hyper-inflation.

Human nature hasn't changed much and NEVER mess with retiree's pensions - economic security = Teabaggers.

First I think it was Jesse James who was asked why...

2010-04-27T21:22:09.067-04:00

First I think it was Jesse James who was asked why he robbed banks, said "that is where the money is".
The folks that want money go to where the money is. Bakers get fat, bankers get rich.
The biggest problems with it is they were able to shift risk off of themselves and onto the ME! the god damned PISSED OFF TAXPAYER!
AIG SHOULD HAVE FAILED. Solomon and Citigroup should have gone bankrupt! Let them feel the full force of the risks that they took.
The boards and officers of the companies be personally sued by the stock holders they ripped off. Then they would have earned the big paychecks when they win. Now they just pay a premium to the big 2 political parties and get off with a bailout when a problem arises. They give themselves raises because they knew enough to pay off both sides in the election. This has nothing to do with Capitalist markets and everything to do with payoffs and bribery. How many people in the Bush and Obama admins worked for companies that got bailout? TOO MANY!
How many will get cozy jobs afterwards? TOO MANY! I don't mind them reaping the rewards if they are going to pay the price for losing.
FREEDOM to win or lose.

Might I suggest that anyone seriously interested i...

2010-04-26T20:07:13.451-04:00

Might I suggest that anyone seriously interested in exactly what banks do and how credit distorts the market read the paper:

The Capitalistic Renaissance
http://www.productequityvalue.info/index.php?option=com_content&task=view&id=66&Itemid=2

The Supreme Court is going to hear a variant of th...

2009-11-03T22:14:32.879-05:00

The Supreme Court is going to hear a variant of this issue in Harris v. Jones.

"They will throw a spotlight on fund fees and on the debate over whether market competition--if it truly exists in the fund industry--is enough to regulate retail fund fees. They will also draw attention to fund boards and their effectiveness in policing fees."

See: http://news.morningstar.com/articlenet/article.aspx?id=314047

In answer to the last comment: I am happy to have...

2009-11-02T19:50:20.014-05:00

In answer to the last comment:

I am happy to have you link to my post or quote from it. Also, you can send me the link at rb@bookstaber.com, since I will be curious to see it in a Russian outlet.

Rick

Hello from Russia! Can I quote a post "No tem...

2009-11-02T19:20:08.924-05:00

Hello from Russia!
Can I quote a post "No teme" in your blog with the link to you?

I think what Rick is trying to say is give me 2%/2...

2009-10-30T13:48:25.240-04:00

I think what Rick is trying to say is give me 2%/20% of the lifetime earnings of every baby I deliver - it's the same as RJR buying the annuity that was Nabisco. I don't think it is just the deal - it's the cashflow and I would like a piece of the cashflow of every patient I see whose life I save.

Unfortunately, I don't have the market power to price my labor that way, i.e. is it market power that allows bankers to price their labor so high? It is a commission business that has over time grown to the disadvantage of our 401(k)'s at a minimum.

Rick, On the topic of percent of deal vs. hourly ...

2009-10-29T00:43:59.384-04:00

Rick,

On the topic of percent of deal vs. hourly billing, I agree with you to some extent. I would say though, that the reality of corporate finance-related fees is somewhere in-between a flat percentage and hourly billing. The reason I say that is that firms typically use a downward sliding scale for fees (i.e. 2% of EV for deals under 25MM, 1.5% for 25-50MM... 0.2% of 10B plus etc.). So you would see fees go from 0.5M for a $25M EV deal to about 5M for a $1B deal. Banks run a fairly tight ship compared to other large corporations and so understandably, a more complex deal warrants a higher fee - and I guess you could also factoring more reputational risk on higher profile deals. Another aspect to consider is that a lot of times the deals will fall apart and that these % fees are mostly completion based. Divided out divided out to an hourly basis among all the guys who worked on it, it might turn out to be minimal.

On the equity side, it's usually a flat % of the offering but I think that's fair because that reflects the balance sheet risk (since there isn't much of a difference in terms of time spent putting together say a 10M offering vs. a 100M offering). Versus laywers, I think it's fair as well. Yes there's more paper work, but they don't do too much value-added work for most deals. A lot of the stuff will be menial tasks that almost could almost be automated (title searched etc.).

As for the surgeon analogy. I totally get what it's trying to say, but I would have to say it's incorrect. M&A advisor's don't charge based on wealth (i.e. how big the company is) - they charge based on the deal size, which is analogous to how complex the job is - whether that is a single bypass surgery or a qudruple bypass. While I don't know for sure, I would expect that the more complex surgery to be much more expensive since it requires a lot more resources.

Alan

For those of you in the Bay area, swissnex San Fra...

2009-10-28T19:14:23.270-04:00

For those of you in the Bay area, swissnex San Francisco is holding an event in which Peter Bossaerts, professor of finance at the California Institute of Technology, explains what economists mean by the term "competitive markets," what the markets are theoretically supposed to do, and where they fail. He’ll also evaluate whether or not eBay, the New York Stock Exchange, the real estate market, the Over-the-Counter credit derivative markets, and other institutions are really instances of "competitive markets." Bring your laptop to participate in hands-on demos of market behavior.

More info:
http://www.swissnexsanfrancisco.org/activities/events/competitivemarkets

Yes, I am thinking more about trading, but some of...

2009-10-26T20:22:32.229-04:00

Yes, I am thinking more about trading, but some of this related to IBD, too.

IBD somehow managed to argue for a percent of the deal rather than an hourly fee, which makes the lawyers who work side by side with them understandably disgruntled. I think it could have easily been set up to be an hourly pay scale.

That no one is willing to drop their fees or go hourly suggests either barriers to entry (which I mentioned in the post) or limits to competition by price.

One argument I have heard is that just as someone will go to the best heart surgeon he can find when his life is at stake, so a CEO will go to the best investment banker when his role and business is on the line. But I have two thoughts on this. One is akin to what I was writing regarding saints and witches. How can you say one is so much better than another. The second is the heart surgeons don't charge based on a fraction of the patients wealth.

Rick, On your part about talent driving banker co...

2009-10-26T20:09:03.213-04:00

Rick,

On your part about talent driving banker compensation, I think that analysis pertains more to trading than IBD. Why do MD's in IBD get million dollar bonuses? Because they have the human capital (i.e. networks) to source deals. In M&A advisory there's hardly any risk to the firm and for capital issuances the bank's balance sheet is leverage, but that's hardly risky compared to prop trading.

Speaking strictly to the IBD side, I would say that it is competitive - you've seen legions of rainmakers leave TARP banks for boutiques because of the TARP restrictions and the uncertainty the government has created. In that business, it's much more the relationship with the banker rather than the brand of the bank that pulls these deals.

Rick, I would disagree with you on one major poin...

2009-10-26T12:07:57.059-04:00

Rick,

I would disagree with you on one major point. I think the reason traders and bankers are overpaid is that one can be so precise about the dollar value of their efforts. It's not at all clear to measure exactly what the value of one IBM programmer's work is, but at the end of the year you know exactly how much P/L to credit a trader with.

This makes the market more efficient in that a trader can "prove" his value.

Of course, people underestimate the effect of luck on trading results, as well as the possibility that the trader may be taking huge "tail risk" and the value of the seat at the trading desk--which should belong to the firm and not the trader.

Ironic that what we really need is a lot more bank...

2009-10-25T22:31:14.438-04:00

Ironic that what we really need is a lot more banks and bankers to enable more competition. Best way to do this would be to make it much easier to be a bank, i.e. a whole lot less regulation, capital requirements etc. If politicians want bankers to have lower salaries they should remove much of the regulations, and let competition (battle) commence. Oh, but instead they want more regulation. Lovely!

Rick, What percentage of these "bankers&qu...

2009-10-25T17:25:07.755-04:00

Rick,

What percentage of these "bankers" are actual in sales. They have titles like "senior account executive" or "product specialist" but they are working with customers to sell products. It is difficult to assess correct compensation for a lot of sales jobs.

Did the realator who sold a $10M house do $600k worth of work? Probably not, but would the house have sold 6% less without their work?

Does the software salesman deserve 2% of revenue because of his talent, or did he just fill out some paperwork for a customer that had already decided what he was going to buy?

Finance and sports aren't really comparable be...

2009-10-25T14:34:22.567-04:00

Finance and sports aren't really comparable because the wages in sports are almost entirely supported by people with essentially full knowledge of costs and products paying a price to voluntarily watch high-level sports. I disagree with the government/public subsidy of sports teams, but you have to realize that people pay the price to see the Red Sox because they want to see good baseball. You can see that people place a value on watching the best players because cheap/free baseball is widely available at high schools, colleges, and minor league stadiums.

In finance, I'm comfortable with the compensation of hedge fund managers because it's similar to the sports model (wealthy people are willing to pay a premium for what they see as the best, in spite of cheaper alternatives such as Vanguard). I have more of a problem with institutions that have captive uninformed customers or institutions that compensate executives on arbitrary standards and then need bailouts because of inadequate retained capital.

Athletes are in the entertainment business; their ...

2009-10-25T13:47:01.101-04:00

Athletes are in the entertainment business; their pay is derived from what people pay to be entertained. Athletic performance may or may not matter; charisma and public notoriety are also valuable to the employer. The leagues are also monopolies.

Bankers? Well, there are similarities.

2009-10-25T13:43:39.143-04:00

This comment has been removed by the author.

Larry, Your sports analogy does not really work h...

2009-10-25T13:34:46.862-04:00

Larry,

Your sports analogy does not really work here for a number of reasons:

1) It's much easier to distinguish talent in sports. After watching a player for a year, you know whether the player is good vs. lucky. After a year of returns it's hard to distinguish alpha from noise in finance.

2) There is little agency / monitoring problems in sports. A better analogy may be that you have a bad or mediocre player who gets paid millions because they have tremendous influence on the board that manages the team.

3) Football players actions do not cause or contribute to a meltdown of the whole economy requiring trillions in bailouts.

You seem to be supporting both the bail-outs and the salaries, which makes no sense. What would stop me as a banker from writing out of the money puts and receiving a bonus, and getting a bail-out when the put gets in the money?

Dennis

I highly recommend reading Fool's Gold by Gill...

2009-10-25T12:12:11.846-04:00

I highly recommend reading Fool's Gold by Gillian Tett if you want to know more about credit derivatives, how it began at JPMorgan as well as how it became a devilish instrument to make huge profit on subprime mortgage.
Doug

Rick: I'm a little confused and I'd appre...

2009-10-24T21:40:43.382-04:00

Rick:

I'm a little confused and I'd appreciate your assistance.

Could you please compare and contrast financial industry profitability/compensation with those of Major League Baseball, the National Football League, the National Basketball Association, and the entertainment (movies/television) industries?

All of the industries that I mentioned have excessive returns (or potential returns) and compensation structures throughout their business that many would consider excessive (even more than investment bankers). Each of those industries benefit, as part of their business models from government beneficence, (as opposed to the finance industry, which, aside from insured deposits, has had to bear regulatory COSTS in their business models - but, of course, needed assistance to prevent the collapse of the financial system).

I really don't understand how network anchors can complain about banker salaries with a straight face. The news tends to be a loss business for the networks (part of the social bargain to pay for their monopoly of the airwaves), but anchors are paid quite well, more than one could seemingly justify from their contribution to society (and from a supply/demand perspective).

In fact, while the banking industry is a critical component of the world economy, the other businesses don't exactly add to society (not like physicists, medical researchers, etc. anyway). You can't conduct scientific research these days without functioning financial markets.

I know that the Government (and, therefore, we as taxpayers) had to invest TRILLIONS to fix the problems in the financial markets. It should be pointed out, however, that ALL OF SOCIETY benefited from avoiding the cataclysm that would have resulted from a failure to act (not just the financial institutions). Nor were financial institutions the only culprit in the creation of the problem. There was complicity from home buyers, mortgage brokers, regulators, and elected officials in the creation of the bubble.

Willingness to endure the massive trade deficits and budget deficits also was a major contributor. China owns our bonds because they needed to both keep their currency low and sterilize the funds from exports to avoid inflation at home. We became addicted to their cheap products and they were our willing dealer as we borrowed, and spent, and let our industries die.

I'm not arguing against free trade, but that was a MAJOR contributing factor because of the impact on the yield curve - leading investors to seek yield in the riskiest places (and made them willing to believe that 90% of a pool of sub-prime mortgages could support a AAA rating).

I'm interested in your thoughts when viewed from that perspective.

You might find it interesting that the minimum NFL salary in 2009 is $310,000. The minimum salary for a Major League Baseball player this year was $400,000. The NBA has a graduated schedule, depending on years in the league, with the minimum for a rookie in 2009-10 of $457,588; $736,420 for a second year player; up to $1.35 million for veterans with 10 or more years in the League.

Those are the minimum salaries for THE BENCHWARMERS!.

When compensation of most people is considered from a "life isn't fair" perspective, it will seem outrageously high (or, as in the case of teachers, low).

I hope you are doing well and I look forward to your next book (it's been to long since the last).

Yours truly,

Larry Loeb

Hi Sir, Thanks for explaining a very pertinent no...

2009-10-24T16:01:44.851-04:00

Hi Sir,

Thanks for explaining a very pertinent notion. However, I don't completely agree with you on the two sub-questions.

"Do the banks operate in a competitive market?"

Contrary to your viewpont, I think that banks operate in a market which is as competitive as any other competitive market we can think of.

For the first point that you mentioned, I find that in the financial sector (FS), the basic premise of perfect competition still holds, i.e. there are multiple sellers and buyers, and all sellers are price takers. In the FS, if a company raises price without improving its product offering, customers can easily switch to its competitors, given the higher mobility of the resources. Admittedly, that doesn't mean the absence of information asymmetries because however the best intentions of sellers, not all clients have wherewithal to understand subtleties of every financial product. And even if they have, they don't always want to expend their energy in doing that.

Moreover, I think it's wrong to assume that only banks should bear the fallout when things turns bad, whereas clients only reap benefits. Clients, along with the financial institutions, have to bear both rewards and pains of the market, as is applicable in a capitalist economy.

I don't think that barriers to entry in the banking industry in the US is high, given that there was 8,430 FDIC-insured commercial banks as on Aug. 22, 2008, as per FDIC. And as far huge size of the bank and ensuing (dis)economies of scale are concerned, these are equally applicable to other markets also.

"Are the workers getting paid fairly for their efforts?"

I agree with you all who get hefty paychecks in the FS are not deserving. Perhaps. this is due to fact it's very difficult to differentiate between real and fake talent. However, this problem with varying degree has persisted in every sector for many decades.

And some (or many) time companies don't even bother to look at performance before doling out hefty bonuses or promotions, as suggested by a famous study done by Fred Luthans et. al. in field of the Organizational Behavior.

In the study, Fred Luthans et. al. answered a question "Do managers who move up the quickest in an organization do the same activities and with the same emphasis as managers who do the best job?". And answer to question, as per study, was that social managers were more successful than effective managers in terms of promotion, salaries and perks. I guess anyone who has worked in any company must have observed this.

So, I believe that the financial industry is only a model of the whole system, and it just manifests the problems that plague our system.

Pushkar

Well we all know how executive compensation has gr...

2009-10-24T15:39:16.784-04:00

Well we all know how executive compensation has grown like crazy in the last 25 years (compensation consultants to blame?) and investment banks have a very flat organizational structure. So perhaps it's as simple as: you have to pay the analyst a lot because you pay the CEO $20 million and there's not as much that separates the two as at most companies.

I'm a confused here. What is your actual poin...

2009-10-24T10:30:05.996-04:00

I'm a confused here.

What is your actual point about long track records (10+ years) with high Sharpe Ratios (1.0+)?

Are you saying that it is hopeless to try and identify great hedge fund managers and traders?
Are you arguing for an entirely different compensation scheme for hedge fund managers?
Are you saying that there are billionaires in the hedge fund community who have no edge or talent and became billionaires through sheer luck (obviously crooks don't count in this question)?

That's right. I have adjusted to post to preve...

2009-10-23T15:02:09.938-04:00

That's right. I have adjusted to post to prevent a misunderstanding.

Agree with the broad story but here is one error. ...

2009-10-23T14:27:54.576-04:00

Agree with the broad story but here is one error.

Sharpe ratio does have its problems but it is not correct that a 20yr Sharpe ratio and a 1yr Sharpe ratio are the same thing in terms of statistical inference. Sharpe ratio and t-statistic (as a standard measure of statistical significance) are proportional by the square root of sample size. Thus, a given Sharpe ratio has more than 4x larger t-stat if it is over the 20yr window.

Even when it comes to non-normalities / peso problems, the 20yr window has many more chances to see rare events than the 1yr window.

Antti