Banker Pay Limits on the Way?

Bloomberg details:

World leaders are poised to crack down on banker pay and better coordinate economic policies as they seek to temper the excesses that helped trigger the worst financial crisis since the Great Depression.

President Barack Obama and other Group of 20 leaders meeting in Pittsburgh are uniting behind a plan to force banks to tie compensation more closely to risk and tighten capital requirements, U.S. officials said.

“There will be broad agreement around many elements of a compensation package,” Michael Froman, Obama’s liaison to the G-20, told Bloomberg Television today.

For those newer to EconomPic, let me dust off the old Investment Banking Bonus Matrix to show everyone how things currently work in the banking world.



As for the new limits... I will believe it when I see it.

Source: EconomPic

Good News Alert! Australia May Show Positive GDP

We had to travel around the world for some good economic news, but here it is. Business Day reports:

Companies ramped up plans for spending in the final months of last year, providing enough momentum for the economy to trigger a fresh look at 2008 growth estimates.
Business spending expectations for the three months to the end of December skyrocketed 6%, to $24.8 billion, seasonally adjusted, from an upwardly revised 1.6% rise in the September quarter, the Australian Bureau of Statistics said.

''This will provide vital support to fourth quarter GDP growth,'' said ANZ economist Katie Dean. ''Australia may well avert a negative read.''

''Today's data will prompt forecasters to rush to upgrade expectations for fourth quarter GDP growth,'' she said.

Source: ABS.gov

Berkshire Goldman Preferreds Yield over 17% at Initiation

Barry points out that Doug Kass thinks Berkshire's effective yield on the Goldman preferred's is ~17%. Here's the calculation to support that:

Berkshire Hathaway will receive warrants to buy $5 billion in common stock at a strike price of $115 a share, which can be used at any time in a five-year period.

Using the good old Black-Scholes model with the pre-"Buffett Bounce" $115 Stock Price, a $115 Strike, 5 Years to Expiration, and 40% Volatility (roughly the level it has been trading) we get an "option" value of $47.89 per share. Berkshire can buy $5 Billion of Goldman stock with these warrants, thus he owns 43,478,261 shares. This amounts to $2.082 Billion. Taking the $5 Billion Berkshire paid less the value of the warrants at initiation equals $2.917 Billion for the Preferreds.

Berkshire will receive $500 Million per Year, which divided by that $2.917 Billion = 17.14% Yield. If Goldman is willing to capitalize at this value, it makes me question how desperate they really are...

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.


Leverage:
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.