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Tricumen A Few Myths And Truths About Investment Banking 05 Jan12
- 1. A Few Myths and Truths about Investment Banking and the Financial Crisis (Cambridge, 5 January 2012) There has been so much lazy journalism on the topic of banking over the last few years that we felt compelled to compile the following to provide some sort of antidote to the groupthink that abounds. Myth 1 Bankers caused the crisis Really? Leaving aside the wholesale failure of regulators, we ask: did all bankers cause the crisis? It is a bit like saying that all journalists hack phones. Lets see how many are really to blame. The staff at high street bank branches seem fairly innocent to us: indeed, we expect very few of them are allowed to decide anything without the head office computers 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 and so on. It seems a little harsh to blame them, too, so we suggest focusing on the so-called Front Office staff. First, there are Advisory bankers, who help companies with M&A deals or raising finance. They didnt cause any (or rather many) losses, so lets exclude them, too. Which leaves just traders and salespeople. But many of these individuals have been making money for banks right through the crisis. In fact, it is only the Residential Mortgage Backed Securities (RMBS) staff - and a few very senior executives - who can be said to be truly responsible: about 700 individuals across the Top 10 investment banks. Pre-Crisis Staffing by function at Top 10 Investment Banks (2007, rounded figures, log scale) RMBS 油staff 油at 油BSC, 油L EH, 油RBS, 油Citi, 油UBS RMBS 油staff 油at 油Top 油1 0 油banks 'Front 油Office' 油staff 油at 油Top 油1 0 油i nvestment 油banks Wholesale 油banking 油staff 油at 油Top 油1 0 油banks 1 10 100 1,000 10,000 100,000 1,000,000 Source: Tricumen. Wed 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 before RBS 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 (if scaled up a little!) Pre-Crisis Average annual RMBS-related revenue (2005/2006, Tricumen definitions) Rank Bank Average annual RMBS revenue 1 Lehman Brothers $1.6bn 2 Bear Stearns $1.2bn 3 RBS $1.0bn 4 UBS $0.7bn 5 Credit Suisse $0.6bn 6 Citigroup $0.6bn 5 January 2012
- 2. 7 Goldman Sachs $0.5bn Source: Tricumen. But stop! Look again: Credit Suisse and Goldman Sachs are on the list and they both came out of the 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 trading book; having spotted this trend, the management quickly took the decision to get out. We note that each banks decision was based on a principles-based judgement, and not a stress test, or a set of rules. This is why we believe that most, if not all, attempts to regulate against future banking crises with enhanced rules and more detailed reporting requirements will ultimately prove futile. Our suggestion for the regulators would be this: Look where the money is being made, and if it looks too good 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 the securitisation techniques of the RMBS market allowed the risk to be distributed to investors according to their risk appetite. Contrary to what many have said, we believe that this was a good thing. The cost of a mortgage dropped and for the Prime market the system worked well. In fact the investor demand for RMBS product outstripped the capability of the Prime market to support it. So banks looked at Sub Prime. It was the flawed business model of Sub-prime that first led to losses, then to mass-selling of mortgage backed securities, and finally to panic that pushed LIBOR rates so high that banks like Lehman Brothers ultimately could not fund themselves. How did the Sub Prime market work? In essence, it involved selling mortgages with low initial interest rates to home buyers who lived on predominantly black estates. After the expiry of the introductory period, the initially low interest rates jumped up to market levels. Banks would typically move 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. We looked at the mechanics of this market back in 2006 and were appalled at the cold efficiency displayed 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 someones house, someones 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. Myth 2 Prop Trading and the use of Derivatives were two of the key factors in the Crisis No. In fact this is fairly easy to disprove as the biggest users of derivatives and the banks with the biggest prop trading operations were Goldman Sachs, J.P.Morgan and Deutsche Bank. These were not 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 businesses before the crisis and were only strong in exotic rate and equity derivatives (neither caused big losses). Your editors bank, RBS, carried out hardly any prop trading and were only strong in exotic rate derivatives (in which they experienced no significant losses). We also disagree with those who say derivatives are bad in principle. Anyone who buys a fixed mortgage in the UK effectively has embedded interest rate swap in the mortgage. At the institutional end, fund managers often use derivatives to fine-tune the risk exposure they want to achieve. Let us say a fund manager thinks that Company X is well run. If they just buy the stock they are exposed to both the sector and the country that Company X is listed and/operates in. Derivatives allow fund managers to remove these risks and even 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 about taking random bets. We have worked for and visited nine of the Top 10 investment banks and have seen not one roulette wheel. To be effective in derivative trading and/or prop trading a bank needs strong risk systems and processes, possibly one reason why Goldman and J.P.Morgan fared so well in the crisis. (Possible) Truth 2 Banks dont always do Gods work There is a story that we have heard, which if true, shows that even banks doing Gods work have flaws. After the crisis, the US Senate launched a series of hearings. In one, they questioned staff at Goldman 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, they had actually lost money in the RMBS trading books. The story does not finish there, however: some have said that while the RMBS traders did not place bets on the RMBS market, they did short the shares of the banks that they knew had the greatest exposure to the RMBS business. If so, the P&L generated from the falling share price of these banks may well have covered Goldman Sachs RMBS losses. We do not know the full truth of this but to us this story certainly rings true. Truth 3 Bankers do sometimes do Gods Work We are aware that your noble editor has recently looked at the charity of bankers past. We wondered if he had also looked at the annual reports of banks present, for many banks do make substantial charitable donations. For example, between January 2009 and December 2010, Goldman Sachs donated $1.2 bn to charity. A portion of this figure would very likely have related to the banks matched giving scheme. Such schemes are common to many banks, and mean that every charitable donation by an employee, is matched dollar-for-dollar by the bank. We estimate the employee donations would probably push the figure for Goldman to over $1.5 bn. 3/4 5 January 2012
- 4. And finally We hope this will not be taken as an apology for the banking sector. Instead, we have tried to highlight the good, the bad and the ugly; and are happy to expand on any point should the reader of this note still be interested or awake. Seb Walker Tricumen, January 2012 4/4 5 January 2012