Tuesday, 20 July 2010

where are the shareholders' yatchts??

Its another investment banks results tomorrow, perhaps the most notorious investment bank's results, aka the face sucking vampire squid, or Goldman Sachs. The Raven doesn't have too much commentary to give on this particular firm, he's got a very small short in the name, however he does want to make a wider point about investment banks.

It is a famous saying, particularly on the buyside, "where are the customers' yatchts?". The question comes from a buyside fund manager being shown a fancy new corporate toy by a Wall Street broker, and the question is to highlight that in general given the level of risk, "intermediation" is far more profitable than investing, or allocating capital correctly, its the brokers with the fancy yatchts and not the customers.

The Raven would like to refine and distill another gem of truth from this scene. In our story (pre 1999) the firm's yatcht, is ultimately owned by the partners, as it is their firm. Updating the story today, it wouldn't be the firm's yatcht on display it would be a senior MD's yatch or a pan-galactic-global-head-of european exotic volatility derivatives trading. Just to illustrate here are some numbers from Barclays;

2009: Staff costs £9.95bn, gross profit £4.56bn

2008: £7.2bn, £5.09bn

2007: £8.4bn, £7.1bn

2006: £8.2bn, £7.2bn

2005: £6.32bn, £5.3bn

So for 5yrs employees have received £40bn and shareholders £29bn, representing a split of 58%, 42%. This is not atypical.

The vast amount of the Raven's time in the markets has been in the buyside space, specifically HFs. There is next to no chance of an investor giving you 58% performance fee, especially for trades that have so much systematic risk and require so much leverage. The other key point is that no hedgefund could in any way have a balance sheet that looked anything like a bank's, its creditors just wouldn't allow that much leverage, 5% equity, borrowing 20x your equity?? The Raven can imagine his PB's face; "I'd like 20:1 leverage and I'll pay libor+50bps", "ha ha ha, you're 'aving a giraffe mate"...

This poses two important questions; How do banks borrow on such competitive terms, both in the absolute amount borrowed and the low interest rate? and why do shareholders reward staff with such a high split of the profit when they essentially wear all of the real risk?

This chart is a gross oversimplification of the situation, however it does illustrate the point which he feels lies at the heart of the answers to our questions.

The red curve is a modified distribution of returns. In simple terms, the IB (investment bank), chooses to win a slightly higher amount, 4.39% instead of 3%, but when they lose are prepared to lose 10% more. This is attractive to shareholders because they effectively have a call option on the return of the assets. They typically have put up $5 of capital, borrowed $95 and bought $100 of assets. If the value of those assets drops $50, $15, or any number greater than their initial stake $5 they still lose the same amount, $5, however if the assets rise in value they get all of the upside, so $4.39 rather than $3 in our example. How much is this option worth? in the normal case $7.9, in the modified case $11.8. That would imply a fair book value of 1.58 and 1.78 respectively.

It should be very clear even to the casual observer that as a shareholder you become far more sensitive to the distribution on the right. Shareholders are MADE to care about the left hand distribution by their CREDITORS. As a lender to the IB, the potential for the assets to fall 15% means having lent $95 you would be facing a loss of $10, whereas in the unmodified distribution you wouldn't expect to make a loss!

However creditors appear not to have been sensitive to the risk of these potentially large losses, and that is because they believed these institutions where TBTF (too big to fail), so they correctly believed that the $10 loss would be underwritten by the government. To the Raven this perfectly explains why investment banks were allowed to borrow so much by the market, and our example shows clearly why they would chose to do so maximize this.

As we said before shareholders only have sensitivity to the majority of the time when they are making money if creditors do not impose a cost for leverage. Thus shareholders are willing to give up 60% of the revenue to the most aggressive traders and prolific deal makers, because these employees maximize returns in the right hand side of the distribution, even if their risk adjusted performance is no better.

So where are the shareholders' yatchts?

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