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Wednesday, February 18, 2015

Building Character on Wall Street

Dec. 1, 2014

By Roy C. Smith

Michael Lewis, in a recent Bloomberg piece, noted that the world’s best and brightest young people have been filing unthinkingly into the Wall Street gladiatorial arena for at least three decades, where they face great pressures that demean their characters and ethical compasses, just to make the money. 

At the elite schools a great many students still want to work in “Wall Street” (i.e., in the global capital markets business) despite Mr. Lewis, the reputational damage the industry has sustained and the many uncertainties about the its future. As soon as the school year began again, students started maneuvering to secure jobs, either full-time or as summer interns. It's a stressful process in which the applicants well outnumber the vacancies.

A number of today’s prospective Wall Street recruits are my students. They know of the difficulties the industry has had to face since 2008, the new regulations, the litigation, the pressures on profits, and the layoffs, pay cuts, long hours and the slowdown in opportunities for promotion, but they still come.

Yes, they are young and relatively inexperienced, but they are not naïve or uninformed about the conditions in the business. Most can make about the same amount of money in other jobs, and are sensible enough to know that one should not take a job one is not enthusiastic about just for the money.

The real, underreported reasons they continue to come are three:

First, the work is dynamic, challenging and exciting.  Modern finance now touches just about everything that happens in the world. It is truly global in scope, very fast paced, and innovative. New recruits work in highly professional specialized areas, often simultaneously on several different teams that focus on a variety of different problems and opportunities for which good solutions are much valued. To get all the inputs they need, teamwork and collegiality is key, and teammates become close friends.

Second, the organizations they join are largely non-hierarchical, where people are accountable for what they do and given all the responsibility they are thought to be able to handle. To be put in charge of preparing and delivering a pitch to a new client can be very challenging for a youngster with only a year or two experience. Getting it right invites further opportunities. Few other professions provide such a steep curve of potential upward mobility, or a better way to test oneself against peers. 

Third, the training in financial market operations is exceptional and wide-ranging. After only a few years, employees at firms with a robust “deal flow” learn a great deal, become certifiably professional and begin to attract offers from other firms. While they are doing all this they also have the opportunity to see what they think of the way the industry works, the toll it takes on personal lives and the degree to which handling conflicts of interest or other ethical issues may be troublesome.

They also have the chance to see how management of the firms in the industry strives to pull together performance, compliance and accountability to shareholders. The managerial role in these firms is increasingly complex, demanding and important, and creates a different, broader set of career opportunities.

Many new recruits today know very well that the power and profits of the industry are shifting from “systemically important” firms to much smaller ones -- boutiques or specialized hedge or private equity firms.  For many years, the number of billionaires (to use one popular metric) in these smaller entities has vastly exceeded those from larger firms.

But what they also know is that the training they get at Goldman Sachs or Morgan Stanley or any of the other top firms is the ticket to new opportunities -- from within their own firms or from competitors or others.

What Michael Lewis misses is that the high-performance Wall Street culture, as controversial as it may be, is essentially one of providing for long-term success in a very competitive, risky and ever-changing marketplace.  This is not easy to do. Misjudgments and abuses occur, but these rarely, if ever, benefit firms as recent legal settlements demonstrate. A well-managed firm competing in capital makers must meet many increasingly transparent standards of professional, regulatory and reputational conduct in order to succeed over the long term. For this the firms seek talented, capable young employees with good character that they hope to fortify and improve on the job.

A couple of generations ago, most young men coming of age were required to spend a few years in the military. For most, then and now, this experience in small unit leadership, handling responsibility and accountability, and in just having to show up on time and get the job done no matter what, was invaluable. Few young people have that experience today.

The real world training the capital markets industry offers is a good substitute for the military. The training it offers in achieving performance objectives, in the context of a myriad of tough behavioral standards, is as good as it gets. A few years work in the industry can help to prepare young people for successful careers anywhere - in industry, entrepreneurship, government, or elsewhere.

Monday, February 16, 2015

Now is the Time for Deutsche Bank to Consider a Split

Roy C Smith and Brad Hintz

16 February 2015,  eFinancial News: Issue 936
It’s long well past time for Deutsche Bank’s long-suffering shareholders to challenge the holy writ of universal banking. The bank’s strategic challenges were made clear in late January when its fourth-quarter results showed return on equity of 2.6%, about 20% of its cost of equity capital. Management said the performance was “encouraging” – but the equity market continues to value the bank’s shares at only half book value.
Jürgen Fitschen and Anshu Jain, Deutsche’s co-chief executives, say they are committed to preserving the bank’s traditional “universal banking” strategy and determined to remain among the top five investment banks. But their “Strategy 2015+,” announced soon after they took over in 2012, now looks hopeless. Goals of a cost/income ratio of 65% and an after-tax return on equity of 15% by 2015 seem truly out of reach.
Yet, Deutsche Bank has been a relative winner, as other banks such as UBS, Morgan Stanley and Barclays have cut back their investment banking or trading activities. In 2014, Deutsche’s investment banking unit ranked third in both global debt underwriting and loan syndication revenue, according to Dealogic. Fitschen said: “We see good opportunities to win market share… when some of our competitors are pulling back from investment banking.”

Disappointing returns

But after four years of disappointing performance, it is time to recognize that shareholders have not profited from the bank’s gains in market share, nor are its unrealized expense aspirations the same as bottom-line performance. The massive regulatory changes since the 2008 crisis have severely affected the universal banking business model, bringing its viability into question. Constraints on the capital markets businesses continue to tighten as regulators pursue a goal of transforming the largest global banks into low-growth, but bulletproof, public utilities. There are now capital surcharges for systemically important financial institutions: “special” national capital buffers, leverage limits, liquidity standards, operating prohibitions against excessive risk-taking as well as proposals for new financial transactions taxes. All of these changes add costs and lower the return on equity of capital markets activities. Among the large banks, only Goldman Sachs has been able to generate returns near its cost of capital and that is because of a sharp reduction in compensation and continued liquidation of a legacy merchant banking portfolio.
And, there has been a tsunami of politically popular, punitive litigation that has stripped all of the universals of precious capital just as they need to increase it.
Deutsche Bank’s strategy of profiting from a war of attrition in investment banking cannot succeed. The firm still faces cost and margin issues, poor trading returns, continued demand for additional capital as well as cultural challenges in its London-based banking unit. Fitschen and Jain have promised a strategy update sometime in the second quarter. Rumors suggest this may involve the sale of recently acquired Deutsche Postbank. But, it is not Postbank that is hurting the bank, it’s the investment bank.
There is one successful example of a spin-off. After more than a decade building itself into a broad-based financial services company, American Express in 1994 reversed course. New CEO Harvey Golub decided to shed the Shearson Lehman investment banking and brokerage units, whose performance had seriously undermined the parent’s stock price. The brokerage business was sold to Smith Barney, and the investment bank, Lehman Brothers, was spun off to shareholders.
While these were controversial moves when announced, it is now clear that American Express shareholders benefited from the restructuring and that operating performance improved significantly, not only at Amex but also the companies it jettisoned.
Since then, however, the capital markets business has become more complex, and separating out trading and market-making from a modern universal bank would have major repercussions. Certain capital advantages related to portfolio risk analysis and netting of positions would be lost. The cost of funding for an independent trading entity would rise as the funding base shifted towards more long-term debt and institutional deposits. The marketing synergies between commercial lending and investment banking would be severed, which would be likely to erode market share. The shared technology and staff support costs of the universal banking structure would end.
Further, the newly independent investment bank would need to maintain sufficient capital and liquidity to meet regulatory requirements and to qualify for Baa/BBB credit ratings. For this to be achieved, the parent would probably have to take back some preferred stock or contingent convertible loans, as American Express did when Lehman was spun off, or third-party investors would have to be brought in.

Change is good

It would not be easy, but it could be done.
And it might create entirely new value. Determined managers of a newly independent investment bank would be forced to rethink their business model and accelerate the glacial rate of change in capital markets dominated for years by the universal banks. On the cost side, compensation ratios would fall, organizational structures would flatten, headcount would be reduced, back offices automated and support staff outsourced.
On the revenue side, an independent firm with limited financial resources would be forced to pursue the highest margin banking businesses and reduce commoditized products, while improving balance sheet turnover and returns on trading assets – all good for investors. After spinning off its investment banking activities, a smaller and de-risked Deutsche Bank, retaining some wholesale lending business, would still be a world-class commercial lender, a leader in serving mid-size industrial companies in Europe, a large and growing wealth manager and a powerful transaction services provider.
Its strong positions in the admittedly over-banked German and Italian retail markets still generate low-cost retail deposits that enable a profitable lending and investment portfolio. And without the siren song of investment banking and its maddening, constant fire-fighting demands on management, Deutsche Bank could focus on improving the banking and distribution businesses it knows best.
Most important, however, is the almost certain increase in shareholder value than would result from a break-up. The combination of the various individual business units might be valued on a stand-alone basis at as much as €55 billion. With today’s market value of €37 billion, reflecting investors’ grim view of the bank’s future, there is a lot of room for creating value through a restructuring. Spinning off the investment bank might be the best way to capture that value.

Roy C Smith is a finance professor at NYU Stern School of Business and former partner at Goldman Sachs. Brad Hintz is an adjunct finance professor at NYU Stern and former CFO at Lehman Brothers and top-ranked banks analyst with Sanford Bernstein

Tuesday, February 10, 2015

John C. Whitehead – Then and Now

By Roy C. Smith
John Whitehead died last week at 92. He had many accomplishments, the most important of which to me were his 37 years at Goldman Sachs, more than 18 of which as a member of firm’s important Management Committee. For the last 8 years he was co-Chairman of the firm along with John L. Weinberg, who was Chairman until 1990 and died in 2006 after 40 years with the firm. Whitehead is the last of the “old Wall Street” leaders to go.
John joined the firm in 1947. He became the principal assistant to Sidney Weinberg, a legendary figure who headed the firm for 38 years. John became a partner in 1956 after assisting Mr. Weinberg in one of his signature achievements, advising the Ford family on the initial public offering of the Ford Motor Company.
John headed the Investment Bank Division for many years, and authored Goldman Sachs’ “Our Business Principles,” the first effort by any firm in Wall Street to publish the ethical standards it followed and to which the firm still adheres.  
He was also the driving force behind moving a reluctant Goldman Sachs into becoming “a truly international firm.” He recruited me from the domestic corporate finance department to join this effort at its beginning in 1968 and for 20 years he was my ultimate boss (I had other bosses too).
His constant peroration to me, and others struggling to create an international business from next to nothing, was “just because these companies never hear of you, or Goldman Sachs, or investment banking, doesn’t mean you can't get them to do business with us.”
John retired in 1984, 30 years ago (and 15 before the firm went public), after feeling that investment banking was steadily drifting away from the world of small, intimate firms with which he identified. Even after leaving, John was one of the most visible individuals identified with the industry, of which he was often quite critical.  
Today, Goldman Sachs has about 100 times more revenue and 35 times more people than it did when John retired. Its market capitalization is $83 billion, as compared to about $300 million of total partners capital in 1984. But the firm is not just bigger; it is in a much more global, complex and dangerous business than he had ever imagined it could be. Even so, there are several investment banks that are twice as large as Goldman.
What used to be “global” meant having offices in London, Zurich, Tokyo and Hong Kong. Today’s Goldman Sachs has 39 international offices (23 in emerging market countries) vs. 16 in the US; roughly half the firm’s business-flow originates outside the US.
The business too is certainly more complex. The Glass-Steagall Act was repealed in 1999 and competition for investment banking transactions increased geometrically, putting great pressures on margins and profits. Trading became the dominant investment banking revenue source, thus requiring new management skills in funding and leverage, hedging and controlling risk exposure, handling conflicts of interest, and the sometimes difficult task “of separating “clients” (to whom loyalties were owed) from “counterparties” (to whom they were not).
And certainly the seismic changes since 2008 in the regulatory and litigation environment of the capital markets businesses has introduced compliance burdens and hazards that have not yet reached their outer limits.
Because of these changes, few of today’s leading investment banking firms earn their cost of capital, and the shares of several trade below book value.
Goldman Sachs has survived the crisis and its aftermath better than most. This is partly because the firm’s DNA still carries some of the essential elements from the Whitehead and Weinberg days.  Most important of these may be the goal of professional “exceptionalism” that has, since the beginning, eschewed large mergers, cultural dilution and loss of hands on control, and insisted on the preservation of a “partnership” senior manager compensation system, that is still unique in the industry.
Goldman Sachs has had several leaders since Sidney Weinberg died in 1968; John Whitehead, though a man of many other interests and activities in the last 30 years of his long, rich life, has been one of the most admired and lastingly influential.

Monday, February 2, 2015

What to Expect In Cuba

Note: In January 2015 your bloggers participated in an 8-day trip to Cuba under the recently liberalized Obama "People to People" program. The timing turned out to be fortuitous since the announcement of US-Cuban mutual recognition and possibly far-reaching liberalization occurred while we were there. Neither of us had focused professionally on Cuba before the trip. In Havana we had access to a number of Cuban academics and scholars concerned with economic and financial affairs. We did, of course, arrive with a number of preconceptions, having lived through some 60 years before and after the Cuban Revolution. In many ways what we found was surprising. 
Feb. 2, 2015

By Roy C. Smith
A recent visit to Cuba revealed as much enthusiasm in the streets of Havana, where signs still proclaim “Socialism or Death,” as in the US for the 17 December announcements by Presidents Obama and Castro to “normalize” relations. Normal relations would change everything, but there is still a lot to do.
Indeed, the Cubans had little choice over whether to do this as their economy is on the verge of collapse.
Cuba was Latin America’s third richest nation when the Revolution occurred in 1959. Today it is the ninth, ranking 110th globally in GDP per capita. Cuba exports some sugar and tobacco but imports just about everything else, including 80% of its food.
Fidel Castro, now 88, declared his regime Communist in 1961; everything was nationalized and turned into a Soviet style command economy with 85% of the workforce employed by the state. Its Utopian economic model depended on massive support from the USSR for 30 years, and, after its demise, from Venezuela, whose continued assistance is doubtful due to falling oil prices and economic trouble at home.
Fidel emphasized social gains: effectively providing schools, medical and other services so his “New Cuban Man” is today literate, healthy, and classless.
But Cubans are also all equally poor with limited opportunity for improvement. Once elegant buildings from the colonial and post-colonial periods are crumbling into decay; there is still a housing shortage so several families share buildings and apartments. The population is aging and the birth rate is low. Few people have savings, and fewer still have checking accounts or access to credit.
A university professor we met earns $30 a month and freelances as a cab driver to supplement his income. His wife, a dentist, is on a three-year contract in Yemen. The doorman at a chic new restaurant for foreigners turned out to be a senior psychiatrist. Even the elite has to hustle to make ends meet.
But, Big Changes Since 2006
In 2006, after becoming ill, Fidel transferred power to his brother Raul, now 83, and Raul succeed Fidel as President in 2008. Unlike his charismatic, fanciful brother, Raul is taciturn, pragmatic and realistic. He has recognized the need to reform the Cuban economy “to provide a more prosperous and sustainable socialism.”
Raul quickly initiated a series of economic reforms that cumulatively have changed Cuban life significantly. Most Americans and Europeans have little appreciation of the considerable amount of deregulation that has occurred in the eight years that preceded the 17 Dec. announcement.
Farmers may now lease land from the government to cultivate whatever they want and keep half the profits. Accordingly, farmers markets have begun to flourish and fresh produce is plentiful.
Cubans may travel abroad, and Cuban-Americans to Cuba, much more freely.
The state still owns your home, but you have a right to live in it that can now be sold. If a family is lucky enough to own a car, it will probably be one that was on the road before 1959. Now, these “old timers” too can be sold in what is now called the “offer and demand” market. 
Small businesses now may be created. New shops, dance studios, art galleries and restaurants have sprung up everywhere in people’s homes or in leased spaced. Until recently these had to be one-family efforts, but now they can be done as “co-ops,” in which several individuals can combine their resources. Entrepreneurs in various forms are starting to get rich, creating some early signs of income inequality.
In 2010 Raul began laying off 500,000 workers from 2,000 state owned enterprises, forcing them to seek “self-employment” wherever they could in the private economy.
This was followed by a second wave of 500,000 that would mean a shift of about 20% of the country’s workforce to the private sector by 2016. This was the most drastic thing to occur in the socialist state economy since its inception, and was shocking to most Cubans, but accepted without social unrest.
In 2011, Raul pushed the Communist Party to adopt a further “311 Point” liberalization program, though much of it is yet to be implemented. One point is to allow much more open discussion of ideas about reforms; an influential cadre of bright, young economists from the University of Havana whom we met has emerged to urge a much faster implementation of the reforms.
But even after all these efforts, the Cuban economy grew only 1.4% in 2014.
On 15 January, President Obama announced a further liberalization of US citizens’ travel in Cuba and remittances by Cuban Americans, encouraging belief that the US is serious about normalization.  
What Next?
Diplomatic negotiations have begun, but are expected to take time and be cumbersome. There is no sign that the US trade embargo will be lifted soon, but its lifting is now widely discussed in Congress and lobbied by various interest groups.
Normal diplomatic relations will lead to more normal economic ones that will open a floodgate of market forces-- of Americans wanting to invest in the next great post-Communist turnaround opportunity, and of Cubans wanting to sell agricultural commodities and anything else they can in the US.
These new market forces will change things in Cuba faster and more profoundly than anything else.
But for Cuba such a sharp conversion to market economics represents a major existential challenge. If change occurs too quickly, as in China, Cuban socialism, the pride and rationale of the Revolution, may disappear. Raul and much of the old guard want to preserve the old system by reforming it, not replace it with modern capitalism. They want to go slow to protect Cuba’s socialism but once market forces are released and public expectations build up, they may not be able to. Raul has said he will stand down as President in 2018.
In the meantime, managing transition to a reformed, semi-market economy is going to a major challenge. Cuba lacks almost all the infrastructure it will need to move to the next level, including a basic financial system (banking, securities, insurance) and modern agricultural and industrial bases.
How well, and how quickly these can be created will determine whether Cuba, with its 11 million well-educated, increasingly entrepreneurial minded population can make the most of the opportunity. Doing so could mean ending up as a successful Caribbean entrepot nation (like Singapore) managing trade and finance throughout the region, transshipping goods, developing light manufacturing and its gorgeous beaches for tourism. This would require large amounts of foreign capital and managerial know-how that Cuba currently lacks and government rules currently impede.
If it falls short of this, Cuba is likely to make it only to being one of several, small, unimportant semi-socialist Caribbean island-economies struggling to get by and competing with each other for tourism dollars.
Thus the stakes are high, and, at this point, the odds seem fairly long. But there will be plenty of investors willing to take the bet. Its going to be interesting one.