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Wednesday, September 24, 2008

The Downfall of the Investment Banking Model

Niels Jensen and Jan Wilhelmsen, of Absolute Return Partners via Infectious Greed.

What is truly disgraceful is that investment banks could only manage returns on equity of 15-25% with a balance sheet that was often leveraged to the sky.
Using Lehman as an example, below is a quick and dirty explanation as to why investment banks were "only" able to achieve 15-25% return on equity and why it wasn't necessarily "disgraceful" (on an individual bank by bank basis), but rather a function of how these banks functioned in a framework that should not have been allowed. In fact, I argue that these aggressive return targets played an integral role in the downfall of the investment banking model.

Net Income:
While Lehman's net income did in fact rise dramatically from 2003-2007, it pales in comparison to what Lehman Brothers (and others) paid their employees. In 2007, Lehman paid their employees well in excess of $300,000 per year ON AVERAGE. To see how large this was in comparison to the net income of the firm, if salaries in 2007 were at 2003 levels per employee (still $260,000+), return on equity would have been 30% instead of the 20% level reported.

To pay for these increased salaries and still reach their 15-25% return on equity (from a growing equity base), Lehman increasingly turned to leverage (when a firm needs to return almost $4B rather than $2B to reach their target, strategies that previously would have been turned down, are now accepted. These lower returning strategies are then amplified through leverage).

As can be seen below, this is exactly what happened. From 2003-2007 average salaries skyrocketed as banks outbid one another for new talent (more projects requires more employees), leverage increased dramatically as Lehman's went from less than 24x to 31x (and remember this is more leverage off of a larger base number), all the while return on equity wasn't able to keep up with both the increase in salary or leverage.

So do I think 15-25% is "disgraceful"? On an individual bank by bank level, I don't think so. Lehman (and other banks) had to act in this manner to survive as ALL banks acted in this low-risk (for the most part it's not their money) / high-reward environment.

The thing I find "disgraceful" is that this was was allowed to happen, as it was never really beneficial for anyone besides the bankers and was in fact detrimental to our people, economy, and country.