Investment Banks - Are you, Dear Investor... the Sucker?

While this Bloomberg article speaks to the 5 major investment banks (Goldman Sachs, Merrill Lynch, Bear Stearns, Morgan Stanley, and Lehman Brothers) - I'd argue our whole public market system is based off the same theory. Outsized rewards for the few, and shared risk by the many. Risky bets are fine, because in this era of compensation that is so enormous as long as you hold a top position for a 3 year period you have generational wealth built for your family. [You're Fired! Now Here is $160M to Help Ease the Pain] There are very few true geniuses in the executive suite. Certainly very few that deserve to be paid 5,000:1 ratio in relation to the average worker. Get fired? Even better - huge compensation for that too. So there is no way to lose.

So, are we all suckers? One day I think we will look back and say, yes those people were. But it might be decades before people realize it. Anyone who brings up such subjects is suddenly anti-capitalist as capitalism decrees the top 2-3 people in a corporation by birthright deserve hundreds of millions. (much like anyone against Iraq war wants the terrorists to win?) Somehow companies in Europe seem to survive without the same compensation packages. And each time a subject like this is brought up, people say "leave it to the shareholders" - as if all of us with 250 shares in a stock have any power.

• Less than a decade after Wall Street's last major partnership went public, stockholders are paying the price for bankrolling the industry's expanding risk appetite.
• Four of the five biggest U.S. securities firms lost about $83 billion of market value last year, almost 90 percent of their net income since 1999, data compiled by Bloomberg show. That cut the annual average return for Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. during those nine years to 9.7 percent from 16.8 percent
• The private partnerships that once dominated Wall Street guarded their capital, used less leverage and limited their risk to trading blocks of stock for clients and shares of companies in mergers, said Roy Smith, a finance professor at New York University's Stern School of Business and a former partner at Goldman Sachs Group Inc. Since raising money from the public, many of the biggest firms have abandoned that caution.
• ``If you're betting with other peoples' money, you're more willing to take risk than if it's your own,'' said Anson Beard, 71, who retired from Morgan Stanley in 1994 after 17 years at the New York-based company, where he ran the equities division and helped with the initial public offering in 1986. ``You think differently if you're paid in cash and not in ownership. It's heads you win, tails you don't lose.'' (Bingo)
• Merrill, which went public in 1971, outperformed the Standard & Poor's 500 Index in just five of the past 10 years. The largest U.S. brokerage paid more to employees last year than it collected in revenue. Morgan Stanley, public since 1986, beat the index in four of the past 10 years. Both New York-based companies diluted investors' stock last year when they sold stakes to foreign governments to shore up capital.
• ``Shareholders share in the downside and not necessarily in the upside, that's the whole story,'' said John Gutfreund, 78, who ran Salomon Brothers in the 1980s when it was renowned for the size of its trading bets. ``It's OPM: Other People's Money.''
• To be sure, the firms have been good investments over a longer period. Merrill rose at an average annual rate of 14.7 percent, including dividends, from 1980 through the end of 2007, according to data compiled by Bloomberg. Bear Stearns returned an average 15.2 percent since the end of 1985 and Lehman's average annual gain was 25.5 percent since it became a separately listed company at the end of 1994.
• While none of the companies are more than one-third owned by employees today, senior executives typically receive at least half their pay in shares. At Merrill, top managers get 60 percent of their compensation in stock; they're required to keep three quarters of it each year and are prohibited from hedging it, according to the brokerage's proxy statement.
• James E. ``Jimmy'' Cayne, who stepped down as Bear Stearns's chief executive officer last month after the firm reported its first quarterly loss, is the company's fourth- biggest shareholder, according to Bloomberg data. The value of his 5.7 million shares has dropped to about $460 million from $971 million at their peak in January 2007.
• Cushioning the blow are the millions in cash bonuses that Cayne and other Wall Street executives took home during the profitable years. While he forfeited a 2007 bonus, Cayne collected almost $40 million in cash payouts in the prior three years on top of salary, stock options and restricted shares, according to company filings.
• `We're essentially running all these investment banks and even the large universal banks on the same basis as if they were hedge funds,'' said Smith, the NYU finance professor. Executives ``make big gains on any gains in the firm's income, whereas they're not exposed, they don't have to pay it back in the loss.''
• ``The firms had to go public because to do these businesses you need so much balance sheet,'' Beard said. ``When the firms were private partnerships, you had to worry about how you were going to replace the capital'' when a partner retired. ``After we went public, we upped the cash compensation dramatically.''
• Merrill's then-CEO, Stan O'Neal, was forced out in October after the company reported a third-quarter loss that was six times what it had forecast less than two months earlier. Rather than fire him, the board allowed him to retire so he could keep $161.5 million in restricted stock and options he'd been awarded during his tenure. In the prior two years, he'd also received $32.6 million in cash bonuses.
• ``There are no partners of Merrill Lynch, there are employees,'' said Peter Solomon, a former Lehman executive who's now chairman of New York-based investment bank Peter J. Solomon Co. ``So they don't share in the losses and gains the way they should, they are able to shed those on to shareholders.''
• ``The partners at Lehman Brothers and the partners at Goldman Sachs and the partners at Morgan Stanley didn't take risk that was disproportionate to their resources, and when they did, they paid the consequences so they tried not to,'' Solomon said. These days, ``shareholders and the customers are the people who are financing these guys. They're financing casino operators.''

Head you win, tails you don't lose. Financing casino operators. Classic.

And the saddest statement is at some point you need to be long these names because the whole system is rigged for them. Banks in trouble? Federal Reserve on white horse. Bank losses? Issue more shares - always a new sucker somewhere. Losses? Send them to the people, keep rewarding insiders? Gains? Give a little to the shareholders, but keep rewarding insiders.

Again, the article is about the investment banks but the truth is it is our whole public capital system. Aside from a few guys like Costco's CEO who takes a modest salary - this is massive redistribution of wealth at it's best. And of course I am un-American for saying it. Let me be clear, if you start your own business from scratch you deserve every reward you could imagine. You took the risk, you put your capital and sweat equity in. Enjoy. But if you are simply installed in the CEO post to keep things running? Well most of these people are just stealing from the coffers. Many guys making $70K in middle management can make the same decisions and run the same company.

No position