Tricumen A Few Myths And Truths About Investment Banking 05 Jan12


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Tricumen A Few Myths And Truths About Investment Banking 05 Jan12

  1. 1. A Few Myths and Truths about Investment Banking and theFinancial Crisis(Cambridge, 5 January 2012)There has been so much lazy journalism on the topic of banking over the last few years that we feltcompelled to compile the following to provide some sort of antidote to the groupthink that abounds.Myth 1 – Bankers caused the crisisReally? Leaving aside the wholesale failure of regulators, we ask: did all bankers cause the crisis? Itis a bit like saying that all journalists hack phones. Let’s see how many are really “to blame”. Thestaff at high street bank branches seem fairly innocent to us: indeed, we expect very few of them areallowed to decide anything without the head office computer’s say-so).Which brings us to people working in Wholesale Banking. Of those, many work in support roles;middle office functions helping to process trades, technology staff, finance staff producing reports andso on. It seems a little harsh to blame them, too, so we suggest focusing on the so-called “FrontOffice” staff. First, there are Advisory bankers, who help companies with M&A deals or raisingfinance. They didn’t cause any (or rather many) losses, so let’s exclude them, too. Which leaves justtraders and salespeople. But many of these individuals have been making money for banks rightthrough the crisis.In fact, it is only the Residential Mortgage Backed Securities (RMBS) staff - and a few very seniorexecutives - who can be said to be truly responsible: about 700 individuals across the Top 10investment banks.Pre-Crisis Staffing by function at Top 10 Investment Banks (2007, rounded figures, log scale) RMBS  staff  at  BSC,  L EH,  RBS,  Citi,  UBS RMBS  staff  at  Top  1 0  banks Front  Office  staff  at  Top  1 0  i nvestment  banks Wholesale  banking  staff  at  Top  1 0  banks 1 10 100 1,000 10,000 100,000 1,000,000Source: Tricumen.We’d further argue that it is only the staff at the RMBS units of five banks that are really to blame:Lehman Brothers, Bear Stearns, RBS (or, rather, ABN Amro that piled into RMBS market just beforeRBS purchased it), UBS and Citigroup.It is also worth taking a look at average annual revenue generated by RMBS teams in during 2005-2006. The losses suffered by each bank seem well correlated with the revenues they generated (ifscaled up ‘a little’!)Pre-Crisis Average annual RMBS-related revenue (2005/2006, Tricumen definitions)Rank Bank Average annual RMBS revenue1 Lehman Brothers $1.6bn2 Bear Stearns $1.2bn3 RBS $1.0bn4 UBS $0.7bn5 Credit Suisse $0.6bn6 Citigroup $0.6bn 5 January 2012
  2. 2. 7 Goldman Sachs $0.5bnSource: Tricumen.But stop! Look again: Credit Suisse and Goldman Sachs are on the list – and they both came out ofthe crisis relatively unscathed! It turns out both banks saw the warning signs and exited the market.The key to this was simply that they saw a trend emerging of small P&L losses on the RMBS tradingbook; having spotted this trend, the management quickly took the decision to get out. We note thateach bank’s decision was based on a principles-based judgement, and not a “stress test”, or a set ofrules. This is why we believe that most, if not all, attempts to regulate against future banking criseswith enhanced rules and more detailed reporting requirements will ultimately prove futile. Oursuggestion for the regulators would be this: “Look where the money is being made, and if it looks toogood to be true, then……”.Truth 1 – The Sub-Prime business was “not a good thing”In the US, the big drive was for home ownership. Mortgages were made aplenty and thesecuritisation techniques of the RMBS market allowed the risk to be distributed to investors accordingto their risk appetite. Contrary to what many have said, we believe that this was “a good thing”. Thecost of a mortgage dropped and for the “Prime” market the system worked well. In fact the investordemand for RMBS product outstripped the capability of the “Prime” market to support it. So bankslooked at “Sub Prime”. It was the flawed business model of Sub-prime that first led to losses, then tomass-selling of mortgage backed securities, and finally to panic that pushed LIBOR rates so high thatbanks like Lehman Brothers ultimately could not fund themselves.How did the “Sub Prime” market work? In essence, it involved selling mortgages with low initialinterest rates to home buyers who lived on predominantly black estates. After the expiry of theintroductory period, the initially low interest rates jumped up to market levels. Banks would typicallymove to cover losses by foreclosing on the property and selling it. Setting aside the human misery,this worked well from a financial perspective …… BUT only as long as house prices were rising. Welooked at the mechanics of this market back in 2006 and were appalled at the cold efficiencydisplayed by banks like Lehman Brothers. For example: Collection calls started as soon as a “Sub Prime” mortgage holder was 2 days late with payments. These calls were made not by a human being, but by an “auto-dialling computer system”. After a number of automated calls, automated letters were sent. In these, the smallest of nods was made to Spanish speakers as the letters contained a paragraph in Spanish, which informed the borrower as to the severity of the letter and suggested that the borrower contact the loan servicing arm of Lehman to have the letter translated. Even when the homeowner got to speak to a human being, the operator had little time for them as each staff member in the foreclosure and bankruptcy departments handled an average of 200 and 620 files at any one time (‘a file’ is, of course someone’s house, someone’s life!); Eviction time averaged 52 days; It then took an average of 136 days before the empty house was sold. 2/4 5 January 2012
  3. 3. Myth 2 – Prop Trading and the use of Derivatives were two of the key factors in the CrisisNo. In fact this is fairly easy to disprove as the biggest users of derivatives and the banks with thebiggest prop trading operations were Goldman Sachs, J.P.Morgan and Deutsche Bank. These werenot the banks with the big losses.Pre-Crisis Prop Trading & Derivative Revenues (2007, US$ million)Source: Tricumen.Turning to a couple of the biggest “loser banks”: UBS span off most of its prop trading businessesbefore the crisis and were only strong in exotic rate and equity derivatives (neither caused big losses).Your editor’s bank, RBS, carried out hardly any prop trading and were only strong in exotic ratederivatives (in which they experienced no significant losses). We also disagree with those who sayderivatives are bad in principle. Anyone who buys a fixed mortgage in the UK effectively hasembedded interest rate swap in the mortgage. At the institutional end, fund managers often usederivatives to fine-tune the risk exposure they want to achieve. Let us say a fund manager thinks thatCompany X is well run. If they just buy the stock they are exposed to both the sector and the countrythat Company X is listed and/operates in. Derivatives allow fund managers to remove these risks andeven to hedge against market shocks through products such as volatility swaps.As for Prop trading, it is about arbitrage opportunities and spotting market trends. It is not abouttaking random bets. We have worked for and visited nine of the Top 10 investment banks and haveseen not one roulette wheel. To be effective in derivative trading and/or prop trading a bank needsstrong risk systems and processes, possibly one reason why Goldman and J.P.Morgan fared so well inthe crisis.(Possible) Truth 2 – Banks don’t always do God’s workThere is a story that we have heard, which if true, shows that even banks doing “God’s work” haveflaws. After the crisis, the US Senate launched a series of hearings. In one, they questioned staff atGoldman Sachs about rumours that the bank had placed prop bets on the falling RMBS market.Goldman executives denied this and provided evidence to show that far from making “a killing”, theyhad actually lost money in the RMBS trading books. The story does not finish there, however: somehave said that while the RMBS traders did not place bets on the RMBS market, they did short theshares of the banks that they knew had the greatest exposure to the RMBS business. If so, the P&Lgenerated from the falling share price of these banks may well have covered Goldman Sachs’ RMBSlosses. We do not know the full truth of this but to us this story certainly rings true.Truth 3 – Bankers do sometimes do God’s WorkWe are aware that your noble editor has recently looked at the charity of bankers past. Wewondered if he had also looked at the annual reports of banks present, for many banks do makesubstantial charitable donations. For example, between January 2009 and December 2010, GoldmanSachs donated $1.2 bn to charity. A portion of this figure would very likely have related to the bank’s“matched giving” scheme. Such schemes are common to many banks, and mean that everycharitable donation by an employee, is matched dollar-for-dollar by the bank. We estimate theemployee donations would probably push the figure for Goldman to over $1.5 bn. 3/4 5 January 2012
  4. 4. And finallyWe hope this will not be taken as an apology for the banking sector. Instead, we have tried tohighlight the good, the bad and the ugly; and are happy to expand on any point should the reader ofthis note still be interested or awake.Seb WalkerTricumen, January 2012 4/4 5 January 2012