Cobra Libre!

April 9, 2011

There was a bit of a stir around Gotham a short while back when it emerged that a venomous Egyptian cobra had gone missing from the Bronx Zoo.  We’ve grown accustomed to enduring risks great and small as part of life in this city, perhaps to the point of becoming too jaded by them.  One highlight of the whole affair was an exceptional Twitter feed imagining how a modern snake on the town might entertain herself (my favorite: “Holding very still in the snake exhibit at the Museum of Natural History. This is gonna be hilarious!”).  My younger self, who harbored a mortal fear of snakes (not usually the most obvious source of terror for a city kid), would probably not have been as amused.  But all’s well that ends well, I suppose, and I hope the Bronx Zoo gets a nice uptick in tourist traffic for its trouble (and maybe a few leftover stimulus dollars for better security?).

With snakes on the brain and the subject of fear not far from my memory, I found myself thinking about “snake oil” and the multi-billion dollar industry of products and services that cater to our desires and vulnerabilities without the burden of unbiased empirical proof.  If I were to lose some of my capacity for shame in a tragic personality-accident, I would immediately start a career developing and marketing nutritional supplements.  Sites like and (both of which I frequent) read like catalogues of human insecurity.  Too fat?  Too thin?  Too much hair?  Too little hair?  Are you worried that your feeling of fatigue at the end of the day might be a sign of heart disease, cancer, or Restless Leg Syndrome?  There are dozens of pills, creams, and yoga regimens on DVD for each of those.

One of many valuable lessons I acquired from years of weekend trips to the racetrack is: be skeptical of offers that defy the logic economic self-interest.  If a handicapper were unnaturally skilled at picking winners, why would he publish his recommendations and thereby dilute the returns he’d be able to get from making bets himself? (Or, even better: launching a hedge fund to bet other people’s money!)  Why wouldn’t he have earned so much money from his wagering prowess that he could afford to stop running a business every day?  Investment managers operate similarly, by the way.  “Talking your book” – i.e., persuading people of your investment case for or against a security – can be a pretty good way to create the marginal buyer or seller that pushes a trade in the direction you want it to go.  The issue isn’t that the handicapper or the investor can’t have good ideas — it’s that their greater economic incentive is to convince you that they are right rather than to just be right.  So one should approach such ideas skeptically, and even more so if one is being asked to pay for them.

If it were really true that a supplement could reliably make you thinner, why would there still be so many overweight people?  Well, one answer might be that the treatment is prohibitively expensive, but that is not the case for most supplements out in the market.  (As a sidebar, I think there’s an interesting debate to be had about subsidizing gastric bypass surgery, for example, as a way to fight the health complications and public cost implications of morbid obesity; another story for another time.)  Another answer might be that it only works on certain individuals, or in combination with other supplements, practices, environmental factors, etc.  Perhaps – there is a lot we don’t know about health, medicine, and wellness.  Yet another answer might be that the market just isn’t aware of the benefits of the supplement.  This explanation has the added benefit of giving the consumer the sense that he is in on a special secret that will give him a leg up on the Joneses and Smiths.

None of these explanations is as simple as the racetrack-tout test.  The economic imperative is to convince you that the supplement works, not to create a supplement that works.  If the supplement works, that’s gravy for the distributor and the consumer.  The placebo effect is a win-win.  Why we have a heavily regulated prescription drug industry that places billions of dollars on the line over tiny observable statistical effects (that may not even correlate to health outcomes!) alongside a parallel universe of snake oil businesses wrapped in pseudoscience, nature-shamanism, and shameless exploitation of celebrity is beyond my comprehension.  (Actually, it’s not: there are obviously entrenched economic interests on both sides.)

I will be the first to admit that I am a complete sucker for supplements of all kinds, in spite of everything I’ve just written.  The dissonance reminds me of Pascal’s gambit: if I take this supplement, maybe it does nothing and I lose some money, but maybe it works and I avoid cancer!!! My rational consumer heuristics short-circuit a bit when inconceivably good or bad outcomes are thrown in the mix.  I rarely consider whether the supplement could be actively harmful, even though that seems like the most reasonable prior assumption (after all, it’s something foreign to disrupt my highly evolved homeostasis) and should therefore bias me strongly against taking anything.

Perhaps this episode should teach me to be less worried about snakes on the town than about the snake oil in my medicine cabinet.


Frequent Flyer Bile

March 14, 2011

One of my blog role-models,, relayed an amusing comparison between an interaction he had on Twitter with a corporate representative of Zappos, and one that an unlucky customer had with a representative of United Airlines.  The punchline isn’t too surprising: unlike the slick new-generation retailer (with which, by the way, I’ve only had good experiences), the old corporate dinosaur manages not only to create misery for the customer but also to very publicly bungle the follow-up.

Kottke avoids the easy commentary (i.e., the Seinfeld-ian “what is the deal with airlines??”) and gets to the heart of the matter by suggesting that the “customer communication problems” at United “originate higher up the pay scale” than whatever front-line rep was responsible for the Twitter faux pas (can I coin the phrase ‘dim twit’ here?).  I’ve certainly experienced the frustration of unsatisfying service, but I also tend to give the benefit of the doubt to the people on the front lines if it’s obvious that they’re many layers removed from any real authority (as opposed to, say, an inept waiter).  I’ve seen a couple of call centers first-hand and they can be about the most dehumanizing and miserable work environments that don’t require manual labor.  Imagine being asked to placate angry people all day when you most likely have insufficient information about the situation that causes the customer’s problem, very little discretion in practice to resolve it, and numerous competing objectives to meet in terms of call volume and quality.

I’m going to go a step further than Kottke and say that this evidence doesn’t necessarily indicate a customer communication “problem.”  I think it’s amazing that I ever get efficient customer service from most companies.  I also think it’s amazing that most people seem to expect that they can (and should!) get efficient customer service when they also demand low prices, high convenience, seamless execution and — and this is the big ‘and’ — actually aren’t willing to change their behavior when they don’t get it.

“The Customer Is Always Right” is a maxim that is probably about 80-90% true, but that we like to believe is 100% true.  (I’d posit that lots of rules for health and personal finance are in this category, like “Eating Your Vegetables Protects You From Illness” and “Stocks Deliver Meaningfully Positive Returns in the Long Run”.)  It is certainly true insofar as a business will fail if it doesn’t satisfy a real need in the marketplace (even if it is the enterprise itself that manufactures the need, like Apple and its magical little devices).  It’s also excellent guidance for newer businesses, and/or businesses in very specialized niches, that can learn a lot about how to refine their product and their pitch based on feedback from key customers.  It’s also probably a good rule for avoiding PR embarrassments or, worse, litigation or the scrutiny of sound-bite-seeking politicians.

The 10-20% untruth to this maxim is that it only applies to customers who are worth serving.  This isn’t a moral distinction.  Some customers (or types of customer) are unprofitable for businesses to serve.  You might be one of them!

I suspect it doesn’t often occur to people that they might be something other than a valued customer.  To be blunt, a valued customer is one that is profitable for the business to serve.  There’s some room for nuance — for example, offering different levels of service for different types of customer, or even explicitly charging for better service.  But, generally, a business serves profitable customers well because there is incentive for them to do so, and it’s probably priced into their product anyway.  Similarly, if a customer places disproportionate and costly demands on a business that operates on an insufficient margin to bear them, it literally destroys value for the business to transact with such a customer.  And if it would turn a profitable customer into an unprofitable customer to give them service at the level they claim to demand, the business is probably better off calling the customer’s bluff.  In the case of airlines, I suspect that price, convenience, and availability of flights are by far the biggest drivers of purchase decisions, so it would not obviously give a competitor an advantage to incur greater costs in providing service.

Some examples may help illustrate this concept.  I am clearly a valued customer of American Express.  Even though I never carry a balance, I generate hundreds if not thousands of dollars in interchange fees for them every year just for swiping my card.  The incremental cost of serving me is very low: I’d imagine their costs are pretty fixed in terms of maintaining their actual payment network, and I don’t have weekly calls with a customer service rep to see how they’re doing, so my revenue stream is very profitable for Amex.  If I ever lose my card, they will (and should) fall over themselves to get one back in my hands as soon as humanly possible. But if I ask them for a break on my annual fee, that’s a tougher business case to make, and they probably should call my bluff as to whether I’m really going to change all my recurring payments just to spite Amex out of a tiny percentage of my overall spending (not to mention the horror of having to present a plebian Visa on dates!)

I am not, however, a valued customer of Chase (although I don’t think they realize this).  I keep a pretty small balance in my checking account at most times.  They have the privilege of paying me nothing on my deposits, and they can go out and earn some sort of return by lending or investing them.  Based on the numbers in question, though, I’d be surprised if they earned more than $50 a year on this funding game – and then they have to maintain all these ATMs and branches and personnel and a snazzy website on top of all that.  I’m guessing I’m somewhere between break-even and modestly unprofitable for them.  For a customer like me to be profitable, the bank has to bet either that I’ll decide to buy other financial products for them on a basis other than price (the idea that I will pay for a banking ‘relationship’ is vaguely hilarious to me) or that I’ll screw up and give them reason to charge me a fee.  Is it any wonder that people think their banks are out to screw them?  They are!  It’s how you become a profitable customer!  (By the way, I’ve not had any explicitly bad experiences with Chase’s customer service, mostly because I’ve rarely needed it.)

If you are the customer of an international airline that, in a banner year, would be pushing a 5% profit margin: in how many circumstances will it really be worth it for them to make exceptions to their global logistics enterprise to make your life incrementally easier?

I think our intuitive notion of being a “good customer” goes like this: I’ve been a customer for N years.  I’ve endured various indignities and inconveniences to consume your product or service.  I tell my friends how great your product is.  And I even follow you on Twitter!  There are important nuggets in this narrative that suggest we should take a fairly broad interpretation of what it means for a customer to be profitable.  It’s nice to have loyal customers because you don’t have to keep incurring costs to acquire them.  It’s nice to have customers that have revealed that they are willing to accept less-than-perfect execution, even though they might complain about it.  These features are relevant to the bottom line — but only up to a point.

There are a couple of other confluent explanations for why people persist in having unrealistic expectations for customer service.  One is that it is possible to get excellent customer service from many businesses — namely, the businesses for which you are a profitable customer, and where you might actually walk away from bad service.  Another is that, well, most of us (myself included) like to think of ourselves as special little snowflakes and we don’t like being reminded (even implicitly) that we’re just another entry on a business’ revenue and expense lines.  Nevertheless, I think a dose of economic humility can help us waste less of our time, energy, and emotional capital railing against the service we get from companies that elect not to offer better service for sound business reasons – or at least encourage us to follow up on our threats to pay a little more for better service somewhere else.

On Bankruptcy as Metaphor (or, Chapter 11 and Verse)

March 3, 2011

As a so-called investment professional who hunts for opportunity in the securities of highly leveraged or financially distressed companies, I spend a fair amount of time contemplating corporate bankruptcy.

I developed an instinctive aversion to bankruptcy at an early age, thanks to “Wheel of Fortune” and that dreadful slide whistle sound effect.  It was heart-wrenching!  All that money lost, those dreams dashed; all too often as the morality-play outcome of the promise to take “just one more spin…”  Few perils ranked higher than bankruptcy in my young, impressionable, game-show-watching mind; but of course the Whammy was the undisputed king of the peril kindgom, since it was ‘Bankrupt’ anthropomorphized into a terrifying little gremlin.  A small amount of strategic (if not moral) ambiguity was introduced by the board game of Life, where the last refuge of the hopelessly behind was to bet the game on one number out of ten and spin the wheel.  Nine times out of ten, you’d be consigned to the ignominious “Bankrupt” space, permanently neutered for the duration.  But, if you got lucky, you’d automatically win, no matter how diligently your competitors accumulated their wealth.  In any event, these games gave me the intuition that bankruptcy was a bad outcome of risk-taking that rarely happened to prudent and conservative people.  So it is a rather remarkable reversal for me to consider its virtues, and even moreso for me to become an investor in distressed credit.  But I digress.

The objective of bankruptcy, in a nutshell, is to attempt to make the best of a bad situation — i.e., an individual or business who has an unsustainable amount of debt that it cannot realistically hope to repay.  In America, the bankruptcy process consists of general rules that lend predictability to an endeavor that could easily devolve into a chaos of competing claims; but it also affords some amount of discretion to the stakeholders, and ultimately the judge overseeing the proceedings, to adapt to the facts and circumstances of each case.  It is, in my view, a pretty elegant solution (or, more precisely, a pretty elegant process for arriving at a solution).  This is not to say that bankruptcy cannot be exceedingly painful for many stakeholders, including a company’s employees, business partners, and communities.  But by the time a person or company chooses or is forced to declare bankruptcy, it is well past the point of avoiding pain and arguably does the most justice to its stakeholders by focusing on how to minimize it.  As medical practice has it, sometimes it is necessary to amputate a limb to save the patient.

I will probably gloss over some relevant concepts in the rest of this post, for which I apologize in advance.  It may be helpful to peruse Megan McArdle’s piece from about two years ago, in which she gives a layperson’s overview of various regimes for resolving insolvency.  I don’t think the ‘opinion’  portion of the piece represents her strongest work (and, for the sake of (my) convenience, I’ll punt for now on substantiating this view) but I also think it will resonate with many of my readers, which will perhaps make the medicine of bankruptcy education go down in a more delightful way.

I find bankruptcy a useful metaphor because there are often situations where one can only realistically play for the least-bad outcome.  And I mean this for very mundane matters in one’s personal life, not the sort of mammoth political problems that can actually push societies to the brink of insolvency.  I’m amused to read of e-mail bankruptcy and laundry bankruptcy as strategies for coping with an overabundance of communication and clothing, respectively.  The metaphor isn’t quite right in the instances I’ve chosen, but it seems to capture closely enough the simplicity, starkness, and (one hopes) finality of the remedy.

What I add to this metaphor – and I think this is an important element of its generality – is the notion that there are different classes of ‘stakeholders’ in many complex problems.  In a corporate bankruptcy, for instance, different lenders may have different elements of priority to their claims.  Some creditors, for instance, have specific assets that serve as collateral for their loan, whereas others may just have a general claim on the assets of the estate after higher-priority creditors have been fully satisfied.  The groups of stakeholders will certainly fight for as much value as they can, but the notions of priority and collateral make it relatively straightforward to determine broadly which groups will be more or less heavily impaired (if at all) as a result of the process.

To apply this framework to the case of “e-mail bankruptcy,” it would seem like family and close friends (your senior secured creditors, if you will) should at least receive some sort of personalized apology or acknowledgement for any dropped correspondence.  Perhaps there is a class of your unsecured creditors — your acquaintances; facebook-friends; and figures from your past with whom you sincerely intend to get coffee, but it never quite works out — where a general apology and declaration of bankruptcy is sufficient, at least to give them the courtesy of lodging a protest, or to give them instructions for how to resume dialogue with your post-reorganization self.  And it may be the most efficient path to wipe out your equity-holders without any further consideration — friends-of-facebook-friends, people who only write to ask for favors, random business contacts with whom you at one point felt it advisable to ‘network’ — because they must recognize that their claim on your attention is pretty heavily subordinated.

Could there be a way to declare emotional bankruptcy about specific personal demons, unresolved conflicts, feelings of guilt, anxiety over injustices inflicted or received?  To assert that one’s baggage (either in general, or in particular) is unsustainable and to commit to giving oneself the freedom to start fresh once it has been emptied and divvied up among one’s stakeholders, however one defines them?  The canonical twelve-step program reads somewhat like a playbook for emotional bankruptcy, with a Higher Power as the judge, and a sincere effort required of the indebted party to make whole all his or her senior secured creditors.  The self-help literature has its own way (N.B. I’m extrapolating from a few examples) of defining and encouraging various paths to closure and a clean slate.  There may be different recommendations for how to identify and appropriately compensate one’s stakeholders, but the objective is to give one license to disclaim any further liability for unwanted baggage and to reinvest one’s emotional capital in more rewarding and fulfilling pursuits.

There is another concept that shows up in the world of bankruptcy and adds a wrinkle to the analysis: moral hazard.  The more painless is bankruptcy, the more tempting it is to simply walk away from debts, which has dire consequences for the financial system if replicated on a large scale.  This is why I don’t like the idea that one can simply wash away one’s sense of obligation simply because one wants to.  A plan for emotional bankruptcy should be somewhat incrementally painful up front, while also being healthy and sustainable for the long-term.

I’ve not exactly applied this concept to my own life, and thankfully I don’t have any specific concerns or personal dramas that I expect might compel me to do so.  But as I prepare to celebrate my birthday today, I plan to take an inventory of my emotional liabilities and make sure that I’m at least conscious of the cost of defeasing them.

A bourse is a bourse, of course, of course

February 14, 2011

Is there something about the Big Board that drives otherwise-reasonable people batty?

Last week, merger talks between NYSE Euronext and Deutsche Börse were confirmed.  A handful of friends and relatives, whom I consider a reasonably representative sample of informed and engaged Americans, expressed concerns that I’ve subsequently heard raised by a variety of public figures.  Roughly, the issue boils down to: is nothing sacred in America?  Are we really going to allow foreigners to snatch up such a critical piece of financial infrastructure?  I’d wager, though, that most people have no more than a vague sense of how a stock exchange makes money.  I won’t go into detail here, but suffice it to say that exchanges now more closely resemble technology firms than august financial institutions.  If IBM and Sony were to join forces to develop new technology, reduce costs, and improve efficiency for customers, I wonder whether it would elicit such a strong knee-jerk response?

Senator Chuck Schumer decided to take a break from dealing with the couple of small problems facing our great nation to opine on the marketing strategy of the prospective combined company, as reported by the NYT among others: “It is totally logical to keep the N.Y.S.E. name first. If for some reason, the Germans sought an alternative option, it could be an indication that they are trying to wield an upper hand in the new company and would seek to make other business decisions that could go against New York.”

I mean… really?

I’m glad we’re at least temporarily shifting the conversation about Wall Street away from its incorrigible greed and recklessness, as if those weren’t also iconically American.  But it’s naive and counterproductive to think of business as anything other than global.  This is not to say that one shouldn’t ask questions about how global companies should be governed, or that it’s not sensible to view consolidation (a) among financial institutions or (b) among gatekeepers of infrastructure with some concerns about protecting the public interest.  Let’s just try to be reasonable even if there’s a big stone building with a big American flag on it in play.

I don’t know much about the financial rationale for the proposed merger of the exchanges, although some analysts seem to be excited about it.  I suppose optimists are untroubled by the ideas that: (a) you will have to pry profitable OTC derivatives businesses from broker-dealers’ cold, dead hands; and (b) that there is likely to emerge an incredible amount of competitive pressure via as-yet-unknown technologies to drive down costs in any product, as was the case in cash equities trading.  As usual, the Economist gives a wry précis, which is largely borne out by this compilation of analyst soundbites, for whatever those are worth.

The NYSE floor is nice for photo ops, and well worth a visit for any New York tourist or local.  And of course it gives all those CNBC anchors somewhere to stand while they try to look thoughtful and busy.  I doubt either of those valuable functions will be impaired as a result of a merger.

Bonus? You Just Met Us! (Part 3)

January 25, 2011

Certain professional roles allow individuals to directly and measurably contribute to the success of a commercial enterprise and, in so doing, to generate profits (and losses) on a vastly greater scale than is possible in the roles in which the majority of people work.  As a consequence, these individuals are often in a position to attract outsized (and at times, outlandish) compensation for their effort.  It can be tempting to attribute this earning power to unusual individual skill, education, work ethic, or the like, but these attributes are rarely sufficient and may not even be necessary (certainly not on Wall Street, at least).

On some level, it’s just a matter of being in the right seat at the right time.  An investment banker’s career is heavily influenced by the robustness of the sectors in which she specializes.  An institutional salesman or relationship manager may print money in buoyant markets, but may find himself out of business if a few key clients defect.  A trader who generates profits is progressively given more capital and more opportunity (in dollar terms) to generate future profits, and to capture a share of that increasing pie for himself.  Wall Street is not alone in this regard: how important is the “big break” in a performer’s career, or the opportunity to appear in front of the right talent scouts (and avoid injury) in an athlete’s?  It is extremely competitive to even have a chance at ending up in that right seat at that right time, and it is not guaranteed by any amount of skill or hard work.  I believe this dynamic contributes to the difficulty “Wall Street” and “Main Street” have in understanding each other when it comes to compensation (with continued apologies for the oversimplification and caricature).  Main Street looks at how much those people in those chairs make, and thinks it’s indecent.  Wall Street looks at how bitter the struggle is to even get in those chairs, and thinks it’s justified.

One might think that investors and paymasters would attempt to diagnose to what extent skill, luck, momentum, and ‘beta’ (i.e., general market direction), among other possible factors, contribute to the success of a line of business or to the returns on an investment.  In reality, they do make an attempt, but this is a pretty hard exercise, and it’s a more pleasant and convenient practice for all parties to attribute as much as possible to ‘skill’ – this makes employers look sophisticated and makes their investors happy to believe their capital is in the best hands.  Nassim Taleb is one of several scholars who have explored this topic in illuminating detail (Fooled By Randomness is more on point than The Black Swan for my discussion here).

Is it ‘fair’ that equally skilled, knowledgeable, and hard-working traders can have vastly discrepant career trajectories just as a result of small differences in their initial conditions (e.g., how much opportunity were they initially given to take risk, and how did those trades go over the time-horizon of their manager’s patience)?  On an intuitive level, probably not; but nobody really cares.  Within the Wall Street bubble, there’s the gambler’s mentality that imagines beating the odds and hitting it big, so there are few tears shed for those who weren’t so fortunate.  Outside of Wall Street, people don’t even understand why these people should be making so much money in the first place, so the search for gradations of fairness seems pretty silly.

That all being said, attempting to control for randomness in promotion and compensation seems like a generally good practice for any professional organization, but it doesn’t really tell us how to balance this with the organization’s need to “attract and retain top talent” (howsoever defined).  In my view, the conceptual problem has nothing to do with attracting and retaining top talent, but everything to do with the problem of running an organization where everyone wants to believe that he or she is top talent.  In organizations (not to mention entire industries) with such an orientation, pay expectations will always be anchored to the very top of the spectrum – and as long as the cost of meeting those expectations can be passed through to clients and investors, it will be possible to do so.  What does this mean, in practical terms, for ‘reforming’ Wall Street compensation?  I’ll return to this question some other time.

Bonus? You Just Met Us! (Part 2)

January 20, 2011

Wal-Mart, AT&T, and Goldman Sachs are giants in their respective industries and routinely rank among the world’s most profitable companies.  In the last four quarters for which information is available as of the date of this post, Wal-Mart earned net income of $15.1B, AT&T earned $12.8B, and Goldman Sachs earned $10.3B.  Each of these numbers is staggering, but consider another few morsels of data.  Wal-Mart reports having 2,100,000 full-time employees.  AT&T, 267,720; Goldman Sachs, 38,900.  If you’re looking for a quick answer as to why employees of Goldman Sachs so well-paid, whereas Wal-Mart is often accused of squeezing its ‘associates’ at every turn – divide the figures above.  On a per-employee basis, Wal-Mart earns roughly $7,200; AT&T, $48,000; and Goldman Sachs, over $260,000.  And these profits are calculated even after taking into account the cost of compensating employees!  The reality is that the average employee of Goldman Sachs generates more profits for shareholders than does an employee of Wal-Mart by a factor of 35.  Forgetting about questions of justice and merit for a moment: should it be so surprising that the pay of an average employee of Goldman Sachs is many multiples greater than that of an employee of Wal-Mart?

My former colleagues at McKinsey argue that profit per employee is a meaningful measure of corporate performance; in particular, of how effectively firms in knowledge-intensive sectors leverage their intellectual capital.  (Didn’t that sound so consultant-esque? Full disclosure: I contributed to the research cited in the link.)  My choice of companies for the purpose of this comparison is meant to make a similar point.

  • Wal-Mart’s business model is highly labor and capital-intensive; it’s a logistical masterpiece that sells many goods, on impossibly thin margins, at prices competitors can’t match.  The competitive advantages of Wal-Mart include its size, lean-ness, and omnipresence.  Only a small percentage of employees are truly critical to this equation.
  • AT&T generates its income through a combination of labor- and capital-intensive, traditional telecom business lines; and higher-margin business lines (such as wireless), which include some deliciously rich opportunities to generate almost free money from roaming charges and ringtone downloads.  Certain populations of employees are largely fungible in terms of the overall business plan of AT&T, e.g., those in customer service; others, perhaps highly skilled engineers who come up with the grand designs for the next wave of wireless infrastructure, can directly influence huge successes or failures of the enterprise.
  • Goldman Sachs… well, most people probably have no idea how Goldman Sachs makes money, beyond the suspicion that it must be nefarious.  Truthfully, many of Goldman Sachs’ employees are not as critical to the enterprise as they might like to believe, but theirs is also a lean organization in which the costs of unwanted staff turnover can be significant.  Almost any business function, from big-ticket deal-making to trade reconciliation, carries meaningful economic consequences for success or failure.  It is up to the firm’s employees to create ways to profit from the firm’s financial capital and other intangible assets (e.g., intellectual capital and privileged relationships).

To take the argument to an extreme: why do certain hedge fund founders earn billions of dollars?  Because hedge fund management companies are contractually entitled to a percentage of the dollar profits that investors realize; and hedge fund founders typically own the lion’s share of the economic interests in the management company.  This is a thoroughly ridiculous arrangement that the market seems to tolerate; I will come back to this another time.  But, indulging for a moment: it is not unreasonable to assume that a hedge fund management company may run $5B with a staff of, say, 100.  In a year where their investments are up 20%, they will generate $1B in gross profits, of which investors might receive $800M and the company receives $200M.  In other words, the average employee ‘earns’ the company two million dollars, roughly a factor of 8 greater than our Goldman Sachs superstars, and over 275x the employees of Wal-Mart.  And people wonder why Goldman Sachs gets jealous about hedge fund compensation!

Defenders of Wall Street pay practices often make tone-deaf arguments about how hard their professionals work, and how the pay is necessary to “retain top talent.”  Many people toil in unglamorous roles and if ‘working hard’ were a meaningful criterion for determining pay, there would be many more millionaires coming out of slaughterhouses and classrooms.

A more intellectually honest argument (which I am going to make in a tone-deaf way, just to be clear) is that Wall Street is one of the few sectors of the economy in which a significant proportion of workers are not individually irrelevant to the success of the enterprise.  Wal-Mart may have some extraordinarily competent and diligent minimum-wage staffers in its stores, but the consequences of their exceptional performance is virtually invisible in the results of the enterprise.  However, the departure of just one senior investment banker and her small team could cost Goldman Sachs millions of dollars in annual revenue.  When the performance of a specific individual is so closely tied to the economic results of the enterprise (particularly if it is tied in a measurable way) it is obvious that such an individual will be positioned to capture a significant share of the value they create for shareholders.

This observation holds across other sectors with professionals who are generally paid well, and where some individuals receive shockingly high compensation: law, technology, medicine, media, sports, etc.  It is tempting to draw the wrong conclusion that these salaries are a justified consequence of individuals’ effort and educational attainment (e.g., in law or medicine) or of individuals’ innate talents (e.g., among celebrities and star athletes).  Those may matter, but they are nothing without a context in which they belong to someone who has measurable individual influence over the success of a commercial enterprise.  Many talented athletes will never play professionally.  Many exceptionally smart and highly-educated people will not have (or seek) the opportunity to become a partner at a white-shoe law firm.

A much better question to ask with respect to compensation, particularly on Wall Street, is: why are certain roles (and the people who fill them) so critical to the success of the enterprise?  The head of a major trading desk is in a unique position among human worker bees: he or she can make or lose millions (in some cases, billions!) of dollars.  Billions of other humans will never have that chance – but of course, at least three billion people out there would be better than average at it.  To put a less facetious point on it: why is there rarely an attempt to normalize for the conditions that enable certain individuals (by virtue of their institutional roles as well as their innate abilities) to exert significant individual influence over the results of the enterprise?  I will explore this question next time.

Some house-keeping notes on the above:

  • Any company data cited above were pulled from Yahoo! Finance on 1/20/2011 and pertain to the most recently available SEC filings as of the date of this post
  • One can quibble over how to appropriately measure profitability; I choose GAAP net income here because it’s consistent, but I would argue that the choice is immaterial to my argument
  • AT&T reported an $8.3B increase to its Q3 2010 net income as the result of a one-time tax settlement with the IRS, which I subtract from the reported GAAP net income to arrive at the figure I report above; again, I claim this is immaterial to my argument

Bonus? You Just Met Us! (Part 1)

January 19, 2011

Financial institutions and investment firms (to which I will sloppily refer as ‘Wall Street’ here) have been busy tallying the numbers for 2010 in preparation for the annual ritual of bonus payments.  Predictably, there will be some jaw-dropping headline numbers about the size of firms’ payouts and the amounts received by certain individuals; and there will be some uproar from politicians, talking heads, and ordinary people about how such compensation is unjustifiable and probably evil.  Over the next several days, I intend to share some thoughts about the compensation model of Wall Street that I hope will frame the issue in relatively non-judgmental terms, as the pragmatic and moral conclusions one draws from this spectacle will be incorrect absent an objective diagnosis of its root causes.  My general view is that Wall Street’s compensation model exists because clients and investors are willing to pay for it, rightly or wrongly, and that whatever reform one might hope for is a fool’s errand in the absence of meaningful pressure from those stakeholders.  And, more broadly, this model reflects the reality that individuals can generate profits on an enormous global scale, and that our society will (and should) struggle to balance a number of competing values — meritocracy, compassion, liberty, community — in figuring out how to adjust to this reality.

But, first, a small attempt to reframe the narrative of the Wall Street bonus, although one might instead euphemize it as profit-sharing, variable compensation, or simple blood money.   The conventional term ‘bonus’ does not really help Wall Street from a PR point of view, because it connotes something over and above the fair and expected compensation for an employee.  In reality, expectations for bonuses, which may constitute half or more of an employee’s total compensation, are explicitly part of employee’s career decisions.

A better reference for Wall Street bonuses, although at a different scale, would be tips for restaurant servers.  A server would likely not be induced to work just on the basis of his stated wage – it is expected that tips will contribute as well.  His take in tips depends on some factors he can control directly (e.g., his level of service and skill at cross-sales at his tables), some he can influence indirectly (e.g., by exhibiting hospitality and creating a good atmosphere for other servers’ tables), and others totally beyond his control (e.g., whether the economy makes people more or less likely to dine out).  On Wall Street, an individual’s bonus is a function of her personal contribution to the firm’s profitability, her group’s or business unit’s contribution, the firm’s overall results, and other variables such as her political savvy or competitors’ practices.  There may be some mechanisms for pooling tips across tables to mitigate the randomness that comes with table assignments, as banks have multiple business units with different profits and losses.  And I think one can argue reasonably about whether it’s fair that a waiter at Per Se is entitled to the same customary percentage service charge as a diner waiter who “works just as hard” filling orders at a fraction of the check size – just as one might debate the absolute compensation levels on Wall Street relative to, say, the manufacturing sector.

I draw this distinction because narrative matters to our intuitions about fairness.  Take the case of a senior investment banker whose annual compensation is, say, typically $200k of base salary and $800k of bonus.  (I’m making these numbers up.)  She does a phenomenal job and brings in some hugely profitable deals for the bank and its shareholders, but the bank had an awful year because a bunch of traders made bad bets on, hypothetically of couse, mortgage-related securities.  When bonus time comes, perhaps she is only awarded $300k.  From the public’s perspective, it is still outrageous that a struggling bank would pay out any sort of bonus, particularly an amount that is so far above the median income.  From her perspective, however, her wage was unexpectedly cut in half through no fault of her own – a situation not unlike that of displaced factory workers, for instance, but for which the public lacks sympathy because of a sense that she is still “paid enough” already.  Would it be fair for a contractor to finish remodeling your house, only to have you pay half his agreed-upon invoice and escort him outside?  I think the right answer is, “no, except under certain circumstances” and a more constructive debate is whether any of those circumstances obtain rather than whether the overall level of construction costs is too high.  (One such circumstance might be: you would have been forced into bankruptcy if you paid his whole bill, in which case a costly process would have ensued that potentially left everyone worse off – not that I’m trying to find analogies for the financial crisis at every turn…)

I don’t think it’s fair to imagine that Wall Street employees demand ‘lavish’ bonuses because they believe they deserve it for doing God’s work, but rather that they (like everyone) work under certain expectations for what their level of pay will be, and that it’s generally lousy to change the rules after people put in the work that they committed to.  But it is fair to examine critically the myths and realities that drive (total) compensation in the financial sector, which I will take up next time.

Some tidbits in the meantime: the Economist has a fairly reasonable take, and their third point is one of the better arguments in the debate — although I’d note that it doesn’t directly apply to investment firms, which make up a considerable portion of the ‘overpaid’ elite; and I don’t think it goes far enough in examining the way bank employees extract personal rents by virtue of their privileged positions in the economy. This latter point is touched on by RBS’ chairman in this thoughtful interview from the Beeb, although his point is a slightly different one (with which I, generally, agree) — that much of the talent mythology in financial services is, as our friends across the pond might put is, bollocks.