Want to Reform Wall St.? Bring Back Partnership Investment Banks

The fact that there is a culture of greed and excess on Wall Street is no secret. The blogger Cunning Realist wrote that in his experience, Wall Streeters are not exactly rocket scientists (and being a rocket scientist has its own problems) but focuses on how to be a BSD:

The culture rewards speed, opportunism, and quite often recklessness. It does not reward what most people consider "intelligence" -- advanced mathematics ability, or knowing or caring about the difference between Shia and Sunni.

Efforts to rein in risk are not working because of the culture of revenue generation. A recent survey shows that risk managers are still second-class citizens at banks despite the onset of the financial crisis.

A case of misaligned incentives

The downfall of WaMu, Bear Stearns, Lehman (LEHMQ.PK) and so on can be laid at the feet of the agency problem. If you work at a bank or broker, your compensation is tied to revenue generation and not risk control. It’s not your money!

Compensation payoffs on Wall Street, whether it’s at an investment bank or hedge fund, are asymmetric. If things go right, the investment banker, broker or hedge fund manager gets a disproportionate part of the upside and the investor gets a limited part. If things go wrong, the investor bears virtually all of the downside.

There is a really simple answer to all this. Bring back the partnership investment bank. Let Goldman Sachs (GS) and all the i-banks be partnerships again. That way, it’s the partners’ money again. If the partners want to lever the balance sheet up to 30-1 or 40-1, let them. If it doesn’t work, the partners get personally wiped out and some may have to declare personal bankruptcy.

In the end, the return function becomes symmetric and the net aggregate effects will be positive. I don’t believe that partners of i-banks would collectively be willing to take those kinds of risks again, nor would they be willing to sacrifice long-term liability for short-term profits.

I would like to say that Rubin's departure from Citigroup (C) marks the end of this era of greed, but until the incentives are made symmetric and a large portion of future Bob Rubins' personal wealth are tied up in the investment bank, nothing will change.

Comments

[Ricard:]

Great idea. Private ownership would solve the problem of private risk becoming a public burden.

Jan 11 01:36 PM

[Savage Capital:]

if the banks had the ability to go private tomorrow, do you think they wouldn't?

guy who commented above: do you actually think that if any of the "too big to fail squad" were private institutions it would create a scenario where this situation would not have become a public burden? furthermore, claiming that this should have been a solely private issue seems naive given that everyone benefited. maybe the banks' employees, at least those that were smart enough to trade out of their positions or those who were overly compensated, benefitted disproportionately, but the real estate/credit bubble arcade was open to anyone who had enough change to put in the machine.

Jan 11 03:15 PM

[Ricard:]

@savagecapital:

The point is that if they had their own money at risk, more than likely they wouldn't have taken unnecessary risk, and thus may have helped to avoid this entire catastrophe before it started.

The fact that they went public allowed them to shift much of this risk upon the public shareholder. It may seem a bit naive...I agree - it was very naive of the firms to go public with this kind of mindset. More importantly, it was even more naive of the shareholder to buy these companies knowing (or ignorant) that they had trillions of dollars of derivatives on their books. Their 10Ks were full of very large numbers, "too big to fail" in your words, yet their stock prices continued to climb. Do you see my point now?

Jan 11 03:21 PM

[Stocking Horse:]

This is a great idea, I hope more people consider it. You should also talk to some of the national politicos who are looking to make a name for themselves.

Jan 11 03:28 PM

[Oregonrain:]

I agree with this article. Others have made the same comment.

But it appears that once the individuals balance sheet was no longer on the line this "freed them up" to become a good deal more "innovative" I think the term was.

Funny how people behave very differently when it is their own money on the line and not OPM. This is a concept that as a small buiness person I am very familiar with. No small business person would or was allowed to lever up their balance sheets 30 or 40 to 1. It is insane. Yet...this was the standard operating procedure it seems on Wall Street.

Jan 11 03:29 PM

[Crocodilian:]

Yes, yes, yes!

Think about:

Lazard Freres
Brown Brothers, Harriman

Haven't heard from either firm lately, have you?

Why? 'Cuz they're not going broke.

Why not?

Because they're private, and the equity partners at those firms guard partner equity jealously. They didn't borrow billions of dollars short against that equity . . . because they are on the hook for the losses.

Jan 11 03:46 PM

[Crocodilian:]

* just remembered that Lazard is now public. Too bad.

Jan 11 03:49 PM

[CautiousInv...:]

Like most of you, I like the author's thinking but since most of the broker dealers are already publicly held companies.......we must deal with the situation as it is.

First, limit leverage to something like 15 to 1. Commercial banks are limited to around 10:1, while some investment banks were over 30:1 last year.

Next, and where money management is involved, base compensation for the firm, whether a partnership or LLC, on a small percentage which would applied to the assets under management. These revenues would be used to pay typical overhead costs, including small base salaries.

Incentive compensation, though, would be some percentage of earned profits, typically around 20% in the hedge fund space. But, put in place high water marks which come into play when there have been losses and which require that investment managers recover prior losses before any incentive compensation is paid.

Thus, should the fund lose $10 million in any given year, the fund manager would have to recover that amount before becoming eligible for incentive-based compensation.

Jan 11 05:11 PM

[Jeffrey A. ...:]

I wholeheartedly endorse this concept.

To Ricard: it was NOT naive for the companies to go public it was smart! Look at the outcome. The managers sold their ownership for tremendous profits and then proceeded to use the public money (e.g., stockholders) to earn huge bonuses and salaries. What's not to like - if you were an insider. To the public that bought those shares? Caveat Emptor.

To savagecapital: there is a distinction between "Wall Street" (e.g., investment banks) and the large commercial banks (e.g., Citi, BofA etc.)

To CautiousInvestor: anytime a rules based situation is created (as opposed to an outcomes based situation) the big money will hire the smart poeple to game the rules. That's just reality.

As for commercial banks that are "too big to fail" I believe that if any private institution (or semi-private as in Fannie / Freddie) is deemed "too big to fail" then they are "too big" period and need to be split up. It should be obvious that under any so-called free market system if there are no regulations or limitations then the ulitmate outcome is a series of sector monopolies. That is, the strongest will prevail and ultimately own it all.

The key for a responsible capitalist is where to draw the lines?

Jan 11 08:57 PM

[Alf Landon:]

But how would they access secondary markets for more money? And bailout money? How would equity holders defer risk onto simpletons? I don't understand. Being too big to fail has its advantages, and state dictated economic activity is socialism. Yeah.

Jan 11 09:26 PM

[Research123:]

I agree with Cam's conclusion, and Redst8r is dead on regarding the ibanks going public.

What's really disgusting is the fact that institutionsal investors who should have known better bought in to the ibanks IPOs and enabled the expansion of WS greed.

Jan 11 10:25 PM

[Ricard:]

Redst8r:

"it was NOT naive for the companies to go public it was smart! Look at the outcome. The managers sold their ownership for tremendous profits and then proceeded to use the public money (e.g., stockholders) to earn huge bonuses and salaries. What's not to like - if you were an insider. To the public that bought those shares? Caveat Emptor. "

I think you misunderstood my point. My point was that it was naive for them to think that there would be no spill-over effects. It's Budd Fox circa 2008 - "no one gets hurt" - except everyone does. Otherwise, I absolutely agree with you.

Jan 11 10:49 PM

[baitshopbilly:]

I think that financials balance sheet spread should be right on the stocks quote next to the P/E box.......this will allow the public to trade more efficiently. it doesn't have to be real time or anything, but updated weekly would be nice. How else can I justify the earnings of these companies relative to their risk?

Jan 12 01:46 AM

[Anthony Alfidi:]

Definitely an idea whose time has come (back). Unfortunately this will be hard to do now that the remaining i-banks have morphed into bank holding companies. Any FDIC-insured deposits they collect (still OPM) will further underwrite their agency problems.

Jan 12 02:35 AM

[bosun.j:]

Responsible capitalist? Isn't that an oxymoron?


On Jan 11 08:57 PM redst8r wrote:

> I wholeheartedly endorse this concept.
>
> To Ricard: it was NOT naive for the companies to go public it was
> smart! Look at the outcome. The managers sold their ownership for
> tremendous profits and then proceeded to use the public money (e.g.,
> stockholders) to earn huge bonuses and salaries. What's not to like
> - if you were an insider. To the public that bought those shares?
> Caveat Emptor.
>
> To savagecapital: there is a distinction between "Wall Street" (e.g.,
> investment banks) and the large commercial banks (e.g., Citi, BofA
> etc.)
>
> To CautiousInvestor: anytime a rules based situation is created (as
> opposed to an outcomes based situation) the big money will hire the
> smart poeple to game the rules. That's just reality.
>
> As for commercial banks that are "too big to fail" I believe that
> if any private institution (or semi-private as in Fannie / Freddie)
> is deemed "too big to fail" then they are "too big" period and need
> to be split up. It should be obvious that under any so-called free
> market system if there are no regulations or limitations then the
> ulitmate outcome is a series of sector monopolies. That is, the strongest
> will prevail and ultimately own it all.
>
> The key for a responsible capitalist is where to draw the lines?

>

Jan 12 03:33 AM

[southbeach:]

I agree. The asymmetric returns issue was critical what's happened in the last 18 months. Also, let's not pretend what happened was unforeseen. Many people made a ton of money shorting the banks, the real estate players and the home builders. Goldman dumped partnership in favor of cheaper and more efficient capital raising. Also, to compete, all banks had to take more and more risk, and lever up increasingly to generate the right deal and return profile. The US government and financial regulators have been deemed to be asleep at the wheel here, but they were wide awake - just too close to the money and their buddies at the I banks.

Jan 12 06:23 AM

[learnmoney:]

Why don't you all read Greed and Glory on Wall Street by Ken Auletta and published back in 1986.

What happened to Lehman's was not the fist time it got into trouble. The first was 1973 and the next 1986 and now finally 2008.

What happens next is that the Glass/Steagall Act should be brought back but never will you ever see parnership banking.

Jan 12 08:06 AM

[bosun.j:]

Is Auletta also the author of Three Blind Mice? If so I'll have to get it. Thanks.


On Jan 12 08:06 AM Libourne wrote:

> Why don't you all read Greed and Glory on Wall Street by Ken Auletta
> and published back in 1986.
>
> What happened to Lehman's was not the fist time it got into trouble.
> The first was 1973 and the next 1986 and now finally 2008.
>
> What happens next is that the Glass/Steagall Act should be brought
> back but never will you ever see parnership banking.
>

Jan 12 01:21 PM

[Financial A...:]

Agreed with most of the comments. Ownership is the key to our problems today, and there are precious few individuals who actually have a stake in how things turn out for their company, or for the public.

Jan 12 10:24 PM