Monday, February 22, 2010

Investment Banks: how did this happen?

Given Charlie's Recent Parable one question to ask is how did this happen? For that we turn to David Einhorn.
...investment banks out maneuvered the watchdogs, as I will explain in detail in a moment. As a result, with no one watching, the managements of the investment banks did exactly what they were incentivized to do: maximize employee compensation. Investment banks pay out 50% of revenues as compensation. So, more leverage means more revenues, which means more compensation. In good times, once they pay out the compensation, overhead and taxes, only a fraction of the incremental revenues fall to the bottom line for shareholders. Shareholders get just enough so that the returns on equity are decent. Considering the franchise value, the non-risk fee generating capabilities of the banks, and the levered investment result, in the good times the returns on equity should not be decent, they should be extraordinary. But they are not, because so much of the revenue goes to compensation. The banks have also done a wonderful job at public relations. Everyone knows about the 20% incentive fees in the hedge fund and private equity investment banks out maneuvered the watchdogs, as I will explain in detail in a moment. As a result, with no one watching, the managements of the investment banks did exactly what they were incentivized to do: maximize employee compensation. Investment banks pay out 50% of revenues as compensation. So, more leverage means more revenues, which means more compensation. In good times, once they pay out the compensation, overhead and taxes, only a fraction of the incremental revenues fall to the bottom line for shareholders. Shareholders get just enough so that the returns on equity are decent. Considering the franchise value, the non-risk fee generating capabilities of the banks, and the levered investment result, in the good times the returns on equity should not be decent, they should be extraordinary. But they are not, because so much of the revenue goes to compensation. The banks have also done a wonderful job at public relations. Everyone knows about the 20% incentive fees in the hedge fund and private equity...
and...
The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails, you lose. It is a reverse-Robin Hood system.
Read David Einhorn's Private Profits and Socialized Risk.