Are you familiar with the overwhelming euphoria the media experiences every year come recruitment time at IITs and IIMs? The stars of this yearly drama are launched internationally as professionals commanding highest salaries paid to graduate from anywhere in the world. The best salaries range somewhere around 150,000 to 250,000 US dollars per year – which is equivalent to a whopping one crore rupees in India! Well, what do these guys do? The sky is the limit – but what is it like when you aim to reach the sky and get up close? The newspapers and TV channels normally fail to explain, but these jobs are offered at some of the best investment banking firms in the United States. The two books we have chosen for this post, as promised, Liar’s Poker and Wall Street Meat describe the inner functioning, the politics, and the criteria for success in investment banking which thrived in the 1980s.
Explaining the business of Investment Banks
The best-known investment banks are the biggest and most profitable money making machines in the world, such as Goldman Sachs, Morgan Stanley, J. P. Morgan Chase, Merrill Lynch, etc. While the word ‘bank’ is still attached to them, the functions that investment banks perform are very different from the ordinary banks that we know of, which primarily specialise in lending money to people or companies who need it, and accepting deposits (like fixed deposits, savings accounts) from those who have excess of cash, and performing some minimum value-added functions such as issuing credit cards, help the customers perform transactions over the internet, etc.
Investment banks advise their clients on several matters and design instruments that can generate investments and consequently, profits – they advise companies on how they could could raise money by issuing shares, or bonds, or they manage tremendous amounts of money of different kinds of institutions, which could be insurance funds, pension funds, or rich individuals (who are known as high net-worth individuals or HNIs).
How investment banks are involved in your life
Often, a portion of the money you contribute for your pension, when you retire, or for your insurance premium, goes to such pension and insurance funds, which are advised by investment banks on how they could use the money in areas where there is going to be a huge amount of growth, so as to make the money multiply. A number of funds with these institutions is huge, as it is the aggregate of a huge number of individuals’ money. That is why certain insurance plans and pension funds are able to pay you in the event of a contingency, and reap rewards for themselves at the same time.
Salomon Brothers
Salomon Brothers thrived in the 1980s in a special business known as bonds trading, that is, buying and selling bonds. The frequency and volume of such transactions increased manifold after a decision made by Paul Volcker of the US Federal Reserve to allow interest rates to fluctuate, determined only by market forces without any intervention from the central banking agency. At present in the US, or in India for that matter, an interest rate is controlled by the central bank.
Explaining Bonds Trading
We know that in case of shares, it is a feeling of how a company will perform in the future (arrived at through various methods of calculation and analysis, but we shall not go into that here) which enables us to estimate as to whether the price of shares will rise, and whether we should buy or sell the share of the company. So, the future performance of the company is the only relevant factor for making a decision to buy or sell a share. In the case of bonds, there is another relevant factor – interest rates.
An example of bonds trading
I shall use a simplistic example to explain how interest rates affect the price of a bond – if I buy a bond of any company at US $100, which will pay a 10% interest on the amount borrowed on that bond (that is, $10) when the market rate of interest was 10%, and the market interest rates rise subsequently to 20%, then I can get the same return ($10) if I buy a bond of $50. Hence, the bond that I bought initially at $100 will be worth around $50.
The world of bonds
Bonds may be issued by companies or governments (national, state or at the local municipal) operating in countries all over the world. A company or government in one country can issue bonds in another country as well. So, as we see, the total number and kinds of bonds available in the market could be a very vast number. A good investment bank would have to keep track of all the bonds that were out there in the market. They employ a very large number of researchers so that they have an idea about the price of which bonds could go up, and which one may come down at any given time.
Salomon’s modus operandi
Salomon Brothers was extremely good at predicting the price movements of bonds. Of course, this was done by highly qualified people using complex mathematical models. When they thought that a decision they made was bad, they quickly advised a client to buy the-the bonds held by Salomon, stating (against their own belief) that they believed very strongly that their prices would rise. Subsequently, when the loss occurred, the client would be ‘blown up’, and would always hate the institution for that reason. But the market was very big, and there were always other clients to approach for selling bonds, and Salomon did not suffer for this in the long term. The best bond traders in the bank were adept at this and proud to call themselves ‘Big Swinging Dicks’.
Creation of a new niche market by Salomon
The Salomon Brothers success story reached its pinnacle when they started improvising on something really ordinary – mortgage loans of ordinary home buyers. In simple terms, when you buy a house upon taking a loan from a bank, the loan will be known as a mortgage. If you fail to repay the money to the bank as per the stipulated time period, the bank will have the right to sell your house off and recover the debt from the amount realised from the sale.
Tracing the seeds of the financial crisis of 2008
The mortgages of a large number of home buyers were combined together, and then broken up into different components of small amounts (much like a 10 or a 100 rupee share of a company) and sold by Salomon Brothers to their clients. This started a revolution by creating an entirely new market and established Salomon Brothers firmly at the top of investment banking in bonds.
The process described above – of combining housing loans and then breaking them up into smaller components and selling them to different buyers – is known as securitisation, and as a technique, has received a lot of criticism for its contribution, alongside several other factors, to the present financial crisis.
The Predator’s Threat
The 1980s, as we have already seen in the post on Barbarians at the Gate, was an era where junk bonds are in vogue and extremely useful for smaller companies to take over huge institutions, sometimes one many times larger than the predator in net worth. Junk bonds gave the power to ordinary individuals to take on the might of large institutions.
One such predator was Ronald Perelman, who became famous almost overnight, after his takeover of the well-known brand Revlon. He wanted to acquire Salomon Brothers afterwards. His financier was none other than Salomon’s biggest competitor and the financier of the RJR Nabisco deal described previously – Drexel Burnham Lambert, propelled by the greatest mastermind of securitisation ever: Mike Milken.
As already explained, if Salomon Brothers was taken over, there are high chances that its management may face less favourable terms of employment, irrespective of how senior they are in the hierarchy. Therefore the management of Salomon Brothers desperately wanted a rescue. Ronald Perelman was looking to purchase 14 percent shares from a shareholder called Minorco, and would then attempt to acquire another 11 per cent, which if successful, would threaten the job of the person who headed Salomon Brothers – John Gutfreund.
Why Salomon Brothers could be taken over
This risk faced by Salomon Brothers, however, is not faced by every mom and pop store (in India, known as a kiranawala) or a partnership business. The risk is faced only by those institutions whose shares are traded on the stock markets (public limited companies). Salomon Brothers had lately become a corporation, and its shareholding was not closely held (unlike most of the Indian public limited companies, where normally promoters rule the roost by keeping at last 51%, or the controlling stake with themselves) and was hence vulnerable to a takeover by a person who wanted to acquire its shares.
Warren Buffett’s rescue plan
Warren Buffett, known as the Oracle of Omaha, was approached to rescue Salomon Brothers. He, till today, is world’s most famous investor, and is almost always approached by a failing institution, although he may decide not to help it. In this case, Warren Buffett could have been a simple white knight, who could have purchased some of the shares of Salomon Brothers, which would have reduced the the shareholding of Perelman proportionately and would have placed a fixed amount of shares in safe hands, as Warren Buffett would not sell his shares to Perelman.
However, Buffett was given a more remunerative package. There had been a stock market crash in the United States in 1987, which means that Salomon Brothers’ business was severely affected. Therefore, buying shares for Buffett may not have been a very good option, since if Salomon Brothers did not do well subsequently, the share price would not rise. Dividend on the shares would also be subject to the decision of the Salomon Brothers’ management.
Introducing the convertible bond
Therefore, Buffett bought a hybrid instrument, which is neither a share nor a bond, but has some of the properties of both. Until some time, it would have the features of a bond – he would be paid a fixed amount of interest every year. He was given 9 years within which he could decide if he wanted to convert this bond into shares.
This had an added advantage – if Salomon Brothers did well after 9 years, the prices of his shares would rise steeply. This ensured him security, and chance of high profits. In fact, the book states that even if Buffett had immediately converted his bonds into shares, he would have made a profit of a whopping 126 million dollars!
The risk which Buffett still faced
The only risk was if Salomon Brothers had gone bankrupt, in which case Buffett would have to be repaid his money from the assets of Salomon Brothers, which would include a sale of their offices, and their other investments. In that event, there could have been a chance that he did not get all his money back. However, on hindsight Buffett’s decision to support Salomon was definitely a wise one, as it did not go bankrupt.
Could Salomon have avoided the threat?
Salomon Brothers had known that Minorco wanted to sell its shares – so it could have attempted to ‘buy-back’ the shares from Minorco. In that event, Ronald Perelman would not have been able to acquire the 14 per cent from it. However, Salomon’s management did not pay heed to that threat. Hence, it had to act suddenly in the face of Perelman’s threat. It offered very easy and profitable terms to Warren Buffett. The costs of the same were borne by the shareholders of Salomon.
Wall Street Meat
Liar’s Poker was for bonds, and we now fast forward to the dot com boom of the 1990s – when investment banking firms needed specialised and experienced people to advise them on how the stocks (shares) of companies dealing in different kinds of hardware, software and electronic goods and related technology would perform. Investment banking firms hired engineers with experience in such industries for this purpose. Wall Street Meat offers glimpses into the business model of investment banking firms, through a peek into an investment bank named Paine Webber, which has now been acquired by the Swiss Bank UBS.
Being #1 Analyst
There was a tendency amongst firms to have analysts in increasingly specialised areas. Analysts would be proud to be ranked first by reputed magazines such as Institutional Investor in their chosen field. Ironically, upon further inquiry one would find out that it was so because there were only one or two other firms which had an analyst in that sub-industry.
The Chinese Wall as the barrier to insider trading
The Chinese Wall refers to an internal barrier within the same institution to the flow of information. In the case of investment banks, the analyst wing, which predicts the performance of stock prices and an industry sector, is not aware of some of the details that the investment banking department knows. This is in order to prevent allegations of insider trading – that is, buying or selling of shares on the basis of information which the general public is not aware of. The practice of insider trading is sought to be prohibited so that every in the stock market trades on the basis of the same set of facts which are available to the general public.
The department of an investment bank which is actually involved in a business deal – say, a merger, would have intricate details about how the deal could make the company better off. If such information was known to the general public, then the prices of the company’s shares to which the information relates would be significantly affected. Trading on the basis of such information, which is not available to the general investor community is called insider trading and is prohibited under the law.
If the analyst wing makes recommendations of which shares to buy on the basis of knowledge of these details, it can be accused of insider trading, unless it discloses the information based on which it is estimating the stock prices. The analysts’ wing cannot disclose these details as all the parties and their advisors (that is, investment banks, lawyers, accountants, etc.) involved in a deal are usually required to enter into an agreement requiring them to keep the details confidential. Therefore, the only way it is possible for an investment bank to run an analysts’ wing and simultaneously get involved in doing deals is by maintaining an artificial barrier between the two wings.
Where are the legends now?
The most famous operators of the dot-com boom in 1990s were Henry Blodget, of the famous investment bank Merrill Lynch (which has now been taken over by Bank of America during the financial crisis), Frank Quattrone of Credit Suisse First Boston (where the great dealmaker Bruce Wasserstein had once worked) and Mary Meeker from Morgan Stanley.
Frank Quattrone, who used to make US $160 million during his heyday, and Henry Blodget got into trouble with the Securities and Exchange Commission of the US for securities fraud. Henry Blodget was banned from participating in the securities market, and has therefore shifted to writing on business trends. Mary Meeker is the only one who is flourishing and still in the same industry.
Salomon Brothers was eventually acquired by Citigroup in 1998, and Paine Webber was acquired by the Swiss bank UBS in 2000. J. P. Morgan (which had acquired the failing UK bank of Bear Stearns) and Citigroup were the leaders of the bond market in 2009, as per Economic Times.
We read about how profitable convertible debentures were for Warren Buffett, when he lent his aid to Salomon Brothers. In the Indian market, Dhirubhai Ambani, the founder of Reliance Industries, who also single-handedly catapulted it onto the world stage, had used the convertible debenture on a number of occasions to raise money for his company from the public, although Reliance was not under threat of a takeover. As Reliance performed exceedingly well, its shareholders were handsomely rewarded by the profits it made.
With that, we arrive at the end of this post. A lot of exciting trivia could not be covered here, and so readers are advised to read the books as well so that they may relish the stories even better. Do come back next fortnight, as we cover the story of Skadden – one of America’s largest law firms.
