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Re: Wall Street profits

A reader thinks I'm selling the banks a bit short:

In your post about Wall Street profits you make the mistake of treating professional services as if they were a commodity. Some of them are close to this -- competent tax preparation should be roughly comparable, for instance -- but some high-end professional services cannot be valued this way.

The services of a superior litigation attorney are worth the incremental chance of winning a lawsuit he or she provides. An advertising agency's services are worth the additional business that a superior campaign will provide. Likewise, an investment's bank's services are worth the additional value that superior execution provides in bond underwriting, M&A, an IPO, or whatever the business line is.

What builds this margin up is the winners-take-all effect. Clients will understandably gravitate to firms with the experience and relationships from previous similar deals, so success tends to build on itself. This explains why firms pay so much to retain talent too; they don't want their competitive advantage of experience to be leaking out to competitors.

This is not to minimize the factors you indicate ... of course trading on their own account and the opacity of the derivatives market is a big part of the reason for Wall Street's massive profits. My only point is that Wall Street will always be a high-margin business because companies will always pay big money for the increased likelihood of marginally better performance on big-dollar deals.


By Ezra Klein  |  April 20, 2010; 5:12 PM ET
Categories:  Financial Regulation  
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Comments

"...companies will always pay big money for the increased likelihood of marginally better performance on big-dollar deals."

Fiction.

A company would not pay $100,000,000 more for a predicted 1% increase on a $1B deal. Math says that would be a bad idea.

"Always" in this sentence is far too strong. I might always pay more for a better defense attorney, because jail is a cost that transends money (though the seeming existance of a serious barrier around the $1000/hour billing rate calls that into question), but better performance on big-dollar deals is explicitly all about money.

Posted by: DJAnyReason | April 20, 2010 5:19 PM | Report abuse

An opinion comparing "professional" bankers with professional physicians, attorneys, and engineers doesn't quite hit home with me: if the winner-take-all effect needs to be considered as part of compensation schemes, life and death matters (actual death, incarceration, bridge/building collapse, etc.) would seem to be of greater importance than banking matters.

I am amazed that financial service providers are _allowed_ greater profits than physicians, attorneys, and engineers (and hair stylists, for that matter). I'm also concerned that product-producing occupations are disfavored when compared to non-productive banking operations.

Posted by: rmgregory | April 20, 2010 5:30 PM | Report abuse

Trading on your own account with free money from the Fed is bound to be lucrative. No one else gets these interest-free loans, certainly not with their lkind of leverage. The banks don't lend enough to businesses because they make more trading with the money. Add to that the ability to front-run. It's a rigged game. That's why we need a transaction tax, say .025% on all stock, bond, commodity and derivative trades. Let the gov't mnake a little from all this action made possible by the taxpayers and the gov't's assurance of reasonably stable markets and enforceable contracts.

Posted by: Mimikatz | April 20, 2010 5:40 PM | Report abuse

@ Mimikatz : I am with you. I think that the transaction tax needs to focus on speculative short term (day trading) investments and computer arbitrage trading. The tax can exempt securities held over 90 days and also exempt retirement accounts up to some predetermined limit (3 million or so). Derivative trading should have its own tax that separates farmers and other commodity producers who need to hedge against bad weather, bugs, broken pipelines, etc.) and naked traders that buy derivatives without owning the underlying commodities. Stiff penalties should be imposed on those who short a currency and then use their influence (or money) to drive the value of the currency down. Simple things that would discourage speculation and add to the treasury. After all, it was these kinds of trades that drove the economy off a cliff.

Posted by: srw3 | April 20, 2010 6:22 PM | Report abuse

DJAnyReason,

"A company would not pay $100,000,000 more for a predicted 1% increase on a $1B deal. Math says that would be a bad idea."

Well duh. But Wall Street doesn't get paid $100 million to close a $1Bn deal. However, if you're looking between fees for $5 million and $12 million, and the $12 million fee is from a bulge bracket investment bank and the $5 million fee is from some no-names from who-knows-where, you'll take the bulge bracket firm. Best execution can easily mean $10 million+ in value on a $1Bn deal. It's the LeBron James effect - he gets paid millions while the 500th best basketball player in the U.S. doesn't get paid at all to play. That said, James still has competition, but his extra little bit of skill creates a lot of value.

rmgregory,

Unfortunately, the bankers actually create more value than the physicians, engineers and attorneys, as measured by the amount people are willing to pay for the services of each (I'm speaking primarily to investment banking such as M&A and debt/equity raising here). Who allows the investment bankers to make so much money? It's their customers. Investment banking fees come straight out of money that could have gone to the bottom line or executive compensation, so to me there's reason to think firms actually get their money's worth when they hire world class investment bankers, most of the time.

Posted by: justin84 | April 20, 2010 6:40 PM | Report abuse

The real reason I found the article is misleading, is because of the translation of profits into the statement " meaning for every dollar of business it did, it kept 27 cents ".

Just to use figures from the latest fiasco, Goldman's ABACUS deal, this was a 2 billion dollar deal Goldman brokered... They didn't make 27% of that money (540 million) off it though. They made 27% of 15 million in profit, i.e. around 4 million on a 2 billion dollar deal.

It's still a lot of money, but of the 2 billion that passed through their door, they wound up with about half a percent.

When you talk about Walmart making 3.5%, it's something like, for every dollar you spend at Walmart, 86.5 cents goes to the manufacturers/goods who Walmart is fronting for, 10 cents go to Walmart's overhead, and 3.5 cents go to Walmart's profit.

To rephrase the Goldman case this way, 2.015 billion came through Goldman's doors. 99.2 cents of each dollar went to the people backing the financial product, 0.6 cents went to Goldman's overhead and 0.2 cents went to Goldman's profit.

I don't really like the criticism quoted by Ezra above, which seems circular. They make a lot of profits because they deserve a lot of profits, and you can tell they deserve a lot of profits because they make a lot of profits.

Posted by: MattSully | April 20, 2010 6:53 PM | Report abuse

I highly doubt the share of profits of the US economy made by investment banks growing to almost 50% is the result of people paying top dollar for professional fees.

Answer the following quiz:
A.count the financial products created in the 1940s - 1980
B.count products created > 1980
C.count the regulations enacted > 1980
D.count deregulations enacted > 1980
E.name the average leverage ratio for an investment bank from the 40s on
F.the average leverage ratio for an investment bank from the 80s on
G.count the countries that enacted anti-free market reforms 1980s on
H.count the countries that enacted pro-free market reforms 1980s on
I.name the average percent of families that owned common stocks from 1940-1980
J.name the avg percent of families that owned common stocks from 1980 on
K.count the IPOs and privatizations before 1980
L.count the IPOs and privatizations after 1980
M.name the average # of investment banking partnerships 1940-1980
N.name the average # of investment banking partnerships and public co's after 1980

If the sum of A,C,E,G,I,K,N < the sum of B,D,F,H,J,L,M ,then maybe the reason for wall street's dramatic rise is the increase in complexity, industry concentration, demand, and lawlessness.

Posted by: rglvr | April 20, 2010 7:20 PM | Report abuse

if it's not greater, then your love life is doomed!

Posted by: rglvr | April 20, 2010 7:24 PM | Report abuse

i meant that the other way around. your love life is doomed anyway if you like this stuff.

Posted by: rglvr | April 20, 2010 7:26 PM | Report abuse

"An investment's bank's services are worth the additional value that superior execution provides in bond underwriting, M&A, an IPO, or whatever the business line is."

If the service is handpicking the elements of CDOs the way John Paulson did, sure they'll pay big money. In poker it's called cheating, using a stacked deck to insure the outcome you favor.

How much skill is involved in fabricating securities where the buyer has no knowledge of what's really being bundled except the word of the fabricator who has enormous incentive to be less than truthful?

High-end scam artists really are a commodity. Wall Street is lined with them.

Also, with over 40 years experience in advertising, I can tell you without reservation that most clients nowadays see ads as commodities. When agencies could hide behind the 15% media commission, they made easy money. But with the decline of traditional media, agencies have to contend with clients that see ideas as something they can get from the lowest bidder. If you'd ever been involved in a speculative pitch for an account, you'd know.

The rare clients who do recognize the value of their agencies ideas (Apple and IBM come to mind) can probably be counted on one's fingers and toes.

Posted by: tomcammarata | April 20, 2010 7:44 PM | Report abuse

Most activities that Wall Street partakes in aren't fraudulent. They really do help with M&As and accessing the capital markets. Where there is fraud, well by all means go after it.

Anyway, if you end up overpaying by 0.5% on your $5 billion term loan, that's $25mm each year down the drain (well, less the tax treatment). If the syndicated loan deal doesn't clear the market, well then your company is remembered as the dud when you go back to the capital markets to refinance and you'll probably end up paying for it.

If anyone thinks investment banking is easy and basically a glorified commodity, feel free to open up a discount Ibank. I like economic efficiency, and what a boon it would be for the economy if the cost of financial services fell 90%. It would certainly free up lots of resources to produce other things. I honestly don't think it would work, but I'd love to be proven incorrect on this one.

Posted by: justin84 | April 20, 2010 9:10 PM | Report abuse

I don't think that the treating banks as either a commodity or not changes the math for whether they should be making profits in excess of other industries.

Remember that profit figures are after wages are paid to all of the employees. We would of course expect a company that offers a good service to earn more per hour of work than a company that offers a worse service, but we expect that extra revenue to get paid to their employees, who are presumably more productive. So, in the end, the company with the good service shouldn't actually have a higher profit margin.

With current numbers, someone could start an investment bank, hire a bunch of employees from other investment banks at 5% raises, reduce the price of their services by 5% and *still* make profits in excess of other industries.

This is what traditional economics would expect to happen, and the fact that it hasn't happened is what makes it so puzzling.

Posted by: JSC7 | April 20, 2010 9:35 PM | Report abuse

Comparing companies' profits can be tricky, especially between sectors such as retailing (Wal-Mart) and banking (Goldman Sachs). Profits as a percentage of revenue is one metric, but not necessarily a revealing one. (Otherwise Wal-Mart would be in the banking business.) Return of investment (ROI) is perhaps the most relevant metric. Ezra, usually sharp as a tack, appears to have baked-in his conclusion when comparing Goldman Sachs' profits.

Posted by: fredbrack | April 20, 2010 10:50 PM | Report abuse

The biggest flaw with that argument is M&A is much more about perceived value than actual value. Most large mergers destroy, rather than create value. The banks all "compete" to get you bigger deals. The bigger bank can get you the bigger deal - but that is likely not in the interest of the buyer. Companies still overpay for the service.

Posted by: iag4 | April 21, 2010 1:56 AM | Report abuse

justin,

you're correct, most of what Wall Street does isn't fraudulent but if you didn't cherry pick who you bash and when (TIMING) then how would you get done what you want to get done. How could you justify it politically without pointing to Paulson and claiming that this is rampant on Wall Street. Facts be dammed.

Same as healthcare, just a different demon.

Posted by: visionbrkr | April 21, 2010 9:38 AM | Report abuse

What's hidden in here is that "better execution" and so forth is complete baloney. We've just seen the trillion-plus in losses that came from the guys offering better execution.

Twenty years ago, this question was asked and answered by compensation consultants for the case of law firms. And what they came up with is that high fees bolster the social credit of the person paying them, and insulate that person from recriminations if things go badly. When you can't actually measure the quality of someone's work, then what you go by is the price. If you pay a no-name investment banker $100K to arrange a deal and it craters, everyone will look at you as if you should have known better, and your shareholders will sue. If you pay Goldman $5 mil for the same deal and it craters, you obviously did the best you could, so the fault must lie elsewhere.

Posted by: paul314 | April 21, 2010 9:55 AM | Report abuse

Paul,

I'm not sure if it is complete baloney, although I think your social credit theory is compelling. After all, in addition to the bulge bracket firms you've got lots of little boutique investment banks with experience and a track record as well. For some reason, prices don't get bid down, even though I'm sure JPM would love to steal of Goldman's long-term business and somehow I doubt anyone would get into trouble by taking a lower bid from JPM, or from another firm. It does explain why you and I can't read a book on M&A and then go start marketing ourselves as an IB firm, doing deals for $100k.

Posted by: justin84 | April 21, 2010 7:49 PM | Report abuse

I am OK with wall street making money, even high margin money as long as those profits come from actual market value.

Hiding the costs of products and services, as the costs of derivatives have been, is not honest value. I don't think Ezra has ever said that Wall Street should make zero money so I think he is right on the mark so far.

Posted by: chrynoble | April 26, 2010 1:17 PM | Report abuse

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