"Implicit" Hedge Fund Regulation: Moving in the Right Direction

Today's article in the Financial Times chronicling concerns over hedge fund collateral has only reinforced a theme that I've pounded on for the past six months: HEDGE FUNDS ARE ALREADY REGULATED. Why this realization is only now coming to the fore in mainstream media and, potentially, in our regulatory bodies is beyond me, but thankfully it seems to be here. Now this is an issue worth thinking about. And it is properly being addressed to the banks and prime brokers extending credit to hedge funds, in their capacity as entities regulated by the Federal Reserve and the OCC.

US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis.

The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements.

The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults.

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One Wall Street executive acknowledged that regulators had a "legitimate concern" that such agreements might not be enforceable in the face of a hedge fund collapse. However, he did not believe regulators would find that banks were taking on excessive risk.

The questions are part of a broad new effort by the New York Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the UK's Financial Services Authority and European regulatory bodies to understand better how much exposure large banks have to hedge funds and whether that could present a significant risk to the financial system in the event of a market disruption.

So far, detailed discussions have been held with a group of five of the largest Wall Street securities firms that some time ago agreed to volunteer for a "consolidated supervised entities programme". Members of the programme are among the most active in lending to hedge funds.

Officials have found that some firms have been extending credit on less liquid instruments but relatively little credit is being extended under these circumstances - and at higher cost to borrowers, regulators say.

This is great stuff. This is the way it should work. Regulators spending time interviewing the market participants in order to gain a deep understanding of the issues. They then develop cooperative relationships with the top players in the market in order to standardize data collection, have early visibility into trends across the industry, and have a direct line into senior management should urgent questions or concerns arise. This is a process for intelligent, fact-based oversight outside the reach of political agendas and perverse motives. What a breath of fresh air.

And the issue they've targeted, the appropriateness of collateral practices, seems particulary timely in light of the frothy markets and ever-tightening credit spreads (the FT is on a roll - they also had a story on this today). The credit markets appear priced for perfection, and we know what happens when most large players are caught leaning one way: inevitable pain and suffering ensues. Selling premium seems like a good way to generate returns; I mean, the real economy is strong, earnings are strong, corporate balance sheets are healthy (except those that have been LBO-ed in the private equity frenzy), so what could go wrong? Oh, I don't know, maybe Iran, Iraq, terrorism, return of Russian stateism, and about 300 other things? Naaaaah. And this same motivation is what can drive, shall we say, more liberal collateral lending practices in the prime brokerage community? This would seem to be a logical extension of tightness in the credit derivatives market, but somehow I'm not getting this vibe. Banks have gotten much, much smarter in the wake of LTCM and other hedge fund meltdowns. Risk controls have, in fact, gotten much more sophisticated and robust. This doesn't mean that someone won't drop a several hundred large in some purportedly 10-sigma outcome (ha!), but I really don't think that banks are going hog wild lending to hedge funds. The risk/return is just not skewed in their favor by making stupid loans with crappy collateral. They don't have to do this to mint money. I mean, they've still got stock lending, right?

Anyway, I am just happy to see the bodies that should be doing the overseeing actually doing it without the assistance of Congress or like bodies in the UK. Let's hope this favorable trend continues for the good of the hedge fund community, the financial markets and investors everywhere.

Wallstrip Post #2: Me on Wallstrip!

Yes, it's true. The lovely Lindsay and the entire Wallstrip gang came into Monitor110 and checked us out. I speak about Monitor110, our pending launch, search technology and my blogging at Information Arbitrage. I gotta tell you, it was a lot of fun. But after seeing myself on the small silver screen I am now clear as to why some are on TV/video and others are not. Let's just say I'm no Howard. After seeing Jack-in-the-Box yesterday, it is clear I need more bling!

Wallstrip Post #1: Jack-in-the-Box Rocks!

As some of you know, I've been a regular contributor to Wallstrip since its inception. I think Howard Lindzon, Jeff Marks, Adam Eland and yes, the fetching Lindsay Campbell, have done an absolutely phenomenal job bringing both intelligence and humor to investing. But I have to say that they have really outdone themselves this time with their show on JBX - Jack-in-the-Box. For those of you SNL groupies out there, you might find the production reminiscent of a certain episode with Justin Timberlake that aired during the holiday season. If you're not sitting down please do so now, click on the show link, and get ready to split a gut. It is truly that funny. And have a nice day. You'll thank me later.

"Intentional Programming?" How About "Intentional Search?"

I really enjoyed Jason Pontin's article in today's New York Times concerning Charles Simonyi's venture, Intentional Programming. I certainly knew of Mr. Simonyi's exploits as a programmer, both at Xerox PARC and later at Microsoft, but knew little of his current focus. A focus which I happen to think is both tremendously brilliant and sorely needed - that of making programming easier, less costly and more intuitive.

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Charles Simonyi, the chief executive of Intentional Software, a start-up in Bellevue, Wash., believes that there is another way. He wants to overthrow conventional coding for something he calls “intentional programming,” in which programmers would talk to machines as little as possible. Instead, they would concentrate on capturing the intentions of computer users.

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The method begins with the intentions of the people inside an organization who know what a program should do. Mr. Simonyi calls these people “domain experts,” and he expects them to work with programmers to list all the concepts the software must possess.

The concepts are then translated into a higher-level representation of the software’s functions called the domain code, using a tool called the domain workbench.

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Thus, programmers and domain experts can fiddle with whatever projections they prefer, editing and re-editing until both parties are happy. Only then is the resulting domain code fed to another program called a generator that manufactures the actual target code that a computer can compile and run. If the software still doesn’t do what its users want, the programmers can blithely discard the target code and resume working on the domain workbench with the domain experts.

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Intentional programming has three great advantages: The people who design a program are the ones who understand the task that needs to be automated; that design can be manipulated simply and directly, rather than by rewriting arcane computer code; and human programmers do not generate the final software code, thus reducing bugs and other errors.

Wow. Cool stuff. Is it just me or could this article have been written about vertical search?

• The system is set up to know what you are thinking - sounds like a vertically-focused search algorithm.


• Capturing "intention" via domain experts - sort of like using domain experts to train machine learning/AI-based intelligent search tools.


• Programmers and domain experts can "fiddle" - kind of like tinkering with term weightings, etc., with easy adjustments that can be made on the fly.

I can't get over the similarities between the two problems. The goals are similar. The language is similar. The requirements are similar. Maybe those of you who are real techies (unlike myself) got this analogy right off the bat, but I was struck by the revelation. And presumably the problems are equally as complex and multi-dimensional. Mr. Simonyi has been at it for quite some time, as have we at my company. It is a sacred mission for him as it is for us. And we will both win. I'm sure of it.

Banking vs. Trading - Breaking into Wall Street

I get a decent amount of email from readers who ask my opinion on various issues (poor, misguided souls), and one recent note hit on a theme that has been the source of many inquiries over the past six months - "Where should I start - banking or trading?" Some of the text from this catalytic email is as follows:

I've read your blogs on how to succeed on Wall St. and also S&T vs IB and have found them incredibly informative for someone in my situation. I noticed that you've worked both in IB and in trading (and apparently all the shades in between). Ironically, I'm facing the decision of choosing between trading and IB right now; with an engineering undergrad, I have concerns that choosing trading would pigeon-hole me fairly quickly into that area. While trading is certainly something I want to do right now, I see myself doing something more along the capital market side of things 7 or so years from now.

I guess I'm asking, given the stigma and the attitudes of these two fields, how hard was it for you to personally move across the gradient? Without much experience in this area, I would don't really want to force myself into anyone area but on the other hand, I think I could really enjoy doing trading for a few years.

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Great question. To which I provided the following answer:

 

I’d say, in general, that it is hard if not impossible to move from banking into trading, whereas the converse is not necessarily true. While I did “this” (banking into trading) let me be clear: I have never actually traded. I have run massive groups of traders and run large books of risk, but this is not trading. I was a trading manager. Do I wish I had actually traded at some point? Yes. But once I was a successful banker and derivatives pro was this ever going to happen? No. So I’d say that if you’ve got the fire in your belly to give trading a shot, do it first. Also, if you are worried about the “pigeon-holed” element, go into a trading discipline that is at the intersection of trading and corporate finance, like credit derivatives. This requires understanding companies as well as markets, so it is kind of a cool area. FX trading, conversely, prepares you for nothing beyond FX trading, except maybe FX structuring. The more commodity-like the underlying asset, the less relevant the trading skills into value-added disciplines. At the more complicated end of the continuum you’ve got credit derivatives, mortgage-backed securites, etc. whereas at the other end you’ve got FX trading, futures/bond/swap traders, etc. So these are my thoughts. Hopefully they are useful. Hmmm, I may write a post about this.

After re-reading my answer, I'm sticking to it. If you are smart, hungry, quantitative and have the chance and desire to trade early in your career, take it. I'd argue that it is much harder to take this up later in life, particularly after you've become successful in other high-paying disciplines that don't train you to trade, ergo, you'd come in as a shoe-shiner on a desk (if they'd even have you) and take a 97% pay cut for the privilege. It just doesn't happen. And you know what, if you don't go for it early on you'll end up like me, as someone who will never know if he could trade and was too chicken to find out. And this sucks. Also, if you've never traded, whether fair or not, your credibility as a trading manager, regardless of your success in related areas (say, complex derivatives structuring and M&A, not that this is personal) will always be in question. Again, sucks. So this is a post about satisfaction and long-term happiness, not pure cash. Which is always the right way to think about stuff.

The other point is that if you do have the sense that capital markets, financial structuring or M&A might be areas of future interest, do pursue trading opportunities in more complex, less commodity-like asset classes like credit derivatives and mortgage-backed securities. In these areas you really need to understand the documents, the companies, credit, structuring, etc., not just the markets. You become conversant in issues of law, finance, capital structure, bankruptcy, rating agencies, and other non-trivial areas that prepare you for a career in banking later on. Besides, these are areas that will require smart people and not just machines for quite some time, whereas humans in the more commodity-like areas are rapidly being displaced by machines. And it wouldn't be fun to be replaced by a machine.

Anyway, this is my advice to young people after searching my soul in the wake of my Wall Street career. It was great and fun, don't get me wrong. But I will always be missing that little piece of the puzzle that says "I've traded." And my asshole trading friends from the Street will always have this over me!

Power to the People: China and the Internet

While social commentary in China, either via public demonstrations or offline media, is still heavily controlled by the Communist Party, there is one place where it is alive and well:  on the Chinese bulletin boards. And it is a force best given its due by those who are the target of its ire, as the power of the Chinese Internet community to shape offline public opinion is, well, quite significant. This is a phenomenon that was most recently chronicled by The Economist in a story concerning Starbucks and its presence inside the Forbidden City:

IF THE strength of Chinese nationalism were to be gauged by its expression on the internet, it would seem a powerful force indeed. A blog posting a couple of weeks back complaining about a Starbucks branch in the Forbidden City, an ancient imperial palace in the centre of Beijing, has triggered a torrent of online criticism against the American firm and those who allowed it to open there.

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Why should Starbucks, or the Forbidden City's management, pay attention to online chatter? The answer is that, in a country where the media are fettered by Communist Party censorship, and public protest of any kind is discouraged by the authorities, the internet plays an unusually prominent role as a barometer of public opinion.

Even senior officials say they pay attention to it. Online protests sometimes appear to influence party policy. Four years ago the government revised its vagrancy laws, after heated online debate about the fatal beating of a university graduate held in jail for lacking correct identification papers.

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Starbucks may yet weather this storm, as it did a smaller one soon after opening the Forbidden City outlet. At that time it removed some signage, to answer complaints that it was not blending in. Its small shop is now hard to spot. Better that than the fate of KFC, the seller of Kentucky Fried Chicken, which was obliged to close an outlet in a park north of the Forbidden City four years ago when the government feared for the garden’s “imperial style.”

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This is just a small example of the power of the BBS denizens who have shown their displeasure with both local and foreign companies. A stark example of this was in the case of Avon, which in mid-2005 was given the ability to engage in direct selling following a 1998 government ban. Avon responded to this news by immediately creating a massive 3,000-strong direct sales force, and sharply limiting support to the Chinese distributors that had helped it grow during its successful expansion in the late 1990s/early 2000s. Further, the financial markets expected Avon's metoric growth in the emerging markets to move forward unabated, a significant component of which was its continued success in China. Following its ham-handed transition from distributor-based to direct selling, the Chinese BBS was afire with complaints over Avon's handling of its distributors, 74% of which demanded inventory refunds. This fury was then picked up in local print media, and there was even a picture of an enraged distributor pointing his finger in the nose of the head of Avon China. Needless to say, this was not good news for Avon.

But believe it or not, this story was not picked up in Western media until after Avon released its earnings over two months later. And guess what - they whiffed. Terribly. And why did they whiff? Because sales in China had fallen 16% in the wake of channel conflict. All you needed to do was connect-the-dots. The "smoking gun" was out there to be seen. So I guess there are two key take-aways: (1) don't think that China is some repressed society without an outlet for expression. It has an outlet, and it's called the BBS; and (2) what happens in the East can effect the West, and for some reason it often takes a long time for relevant information to find its way over here. Unless you have the right tools. Remember the adage "Think Global/Act Local" - whoever said it was right.

Proxy Voting and Economic Ownership: Getting the Big Things Right

Paul Atkins, a commissioner at the SEC, is in a snit over the potential influence of hedge funds in the wake of proxy voting reform. This was chronicled in an article in today's Financial Times:

Short-termist activist hedge funds could gain undue influence on companies' boards as a result of expected new rules allowing shareholders to vote on company directors, Paul Atkins, a commissioner at the Securities and Exchange Commission has warned.

In a speech to company directors and corporate governance experts on Monday night, Mr Atkins said giving investors greater say on the composition of boards could have the unintended consequence of increasing the power of hedge funds.

He said hedge funds' ability to borrow and short-stock before crucial corporate meetings and use financial derivatives to own shares without having an economic interest in the company could lead to the appointment of "special interest directors".

"What if a shareholder who participates by voting at a meeting holds no economic interest or possibly a negative interest in the corporation?" Mr Atkins said at the Corporate Directors' Forum in San Diego, California.

"Who is making the nominations and what are the interests and the conflicts involved?"

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The SEC is expected to revisit the issue in coming weeks, four years after an earlier attempt to allow such access failed. The subject is part of growing calls by investors for greater influence on corporate governance matters after the scandals of the past few years.

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Opponents of such access, chiefly the Business Roundtable and US Chamber of Commerce, have long argued that opening up the proxy for voting purposes could allow companies to be "hijacked" by special interests - usually a reference to unions and environmental activists.

But Mr Atkins said the increasing role of hedge funds and other activist investors in pushing for change to underperforming companies, or influencing the outcome of takeovers, means any debate should now also include the role of such interests.

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"As the financial markets are moving towards instruments where you can artificially boost your shareholding it is important to have disclosure, and a system that shouldn't be able to be gamed by people who have marginal economic interest," Mr Atkins told the Financial Times.

Quite frankly, Mr. Atkins, I agree with you. It is great that the SEC has finally reached the level of sophistication where an issue this subtle - voting power vs. economic ownership - is in the minds of its commissioners (though, to be fair, this issue was first flagged in Europe. Those European derivative shops were ahead of the game, let me tell you). The concept of the bifurcation of vote and value has long been a bedrock in the fields of taxation and partnership structuring, not to mention in the dual class shareholding structures so prevalent in the media business. But let's not confuse the issue of proxy voting reform with the particular issue you raised. They should be dealt with separately and in a focused manner.

There is no question that proxy voting needs a face-lift and that entrenched Managements and Boards of Directors need the bejeezus scared out of them (if not appropriate checks-and-balances) to do what they are, in fact, hired to do. If I read of one more example of a stupid, irresponsible Board or of a self-serving, self-aggrandizing, shareholder-unfriendly CEO I seriously might barf. The necessity of reform is simply a fact, regardless of the cronies populating the Business Roundtable and US Chamber of Commerce who are against such changes. All I have to say to them is - grow up and lose that sense of entitlement. Hijacking by special interests? You've got to be kidding me. This isn't a movie, guys. This is life. Get on the clue bus, ok? It's leaving the terminal as we speak.

Now the issue raised by Mr. Atkins is legitimate, to be sure. Anyone who has been hanging around M&A, derivatives or prime brokerage knows of the ability to split off voting power from economic value, which can be used to great effect during hotly contested corporate fisticuffs.  And I've got to say it does seem somewhat unethical (if not illegal) to wield voting power in the absence of economic interest or, more precisely, to use disproportionate voting power to impact a substantially smaller economic interest. It doesn't cost that much to buy votes, and if it can be used to sharply increase the odds of maximizing value on a position without risking a like amount of capital that is pretty cool. But is it fair, and does it go against the very principles or one share/one vote, when the shares and votes cease to be inextricably linked? I am neither an ethicist nor a moralist, but I can certainly appreciate the objections to this type of financial engineering.

In sum, two thumbs-up for proxy reform as well as a review of the voting power vs. economic ownership issue. These are the kinds of substantive, non-trivial discussions I like to see being had by the SEC. Let's hope they can stay on track and get the big things right. Because it is easy to get tangled up in the details.

ADDENDUM: Today's Wall Street Journal has a big article on this very issue. It raises a lot of the same points noted in my post, as well as providing some examples of when these tactics were used to sway outcomes.

Sell-Side Analysts and Option Expenses: Is There Anybody Out There?

I've commented quite a bit lately on the topic of sell-side research, its plight and its problems. Unfortunately, many of the problems it faces it brings upon itself, as highlighted in Herb Greenberg's interesting piece in Saturday's Wall Street Journal titled "How Expensing for Options Throws Analysts Off Course." Before I dig right in, I'd like to tell you what I'd expect from sell-side analysts (or analysts of any stripe, to be truthful):

1. Honesty;
2. Intellect;
3. Analytical rigor;
4. Critical, independent thinking; and
5. A digestable, informative work product; that gives me
6. A reason for me to read their stuff

I mean come on, is this really too much to ask? I've known and worked with many sell-side analysts in my career, almost all of whom have been good, caring people. But the problem is that many missed several key items on the list above, with numbers 3 and 4 the most frequently omitted. Analytical rigor and critical thinking? Shouldn't these be the two bedrocks of investment research, regardless of whether or not one is talking buy- or sell-side, retail- or institutional-oriented, etc.? Am I missing something here? I think not. And there are structural issues for why these problems have become embedded in the [sometimes] dysfunctional Wall Street architecture, i.e., analysts covering too many companies, being forced to release work product too frequently, pressure from clients and bankers to emphasize the positive and downplay the negative, etc. But the bottom line is that research is and should be treated as a profession with the same degree of standards expected from other professions, i.e., law, accounting, medicine, etc. And in the absence of this recognition of research as a profession, it will be frought with inconsistency, conflict and bias.

Anyway, so what of Herb Greenberg's article? The bottom line is that earnings estimates reported to the biggest aggregrators and distributors of such things are not prepared in a similar manner, because not all analysts taken option expenses into account in their estimates.

One tried and true way to analyze a company is to compare its value with its peers. When it comes to tech and biotech, more than any other industry groups, you're on your own -- especially if you're relying on the most widely used consensus earnings forecasts.

Earnings per share estimates for many companies simply aren't created equal, largely because of the uneven treatment of options expensing by analysts. While it has been a full year since new accounting rules required companies to include options expenses in earnings, there is no such standard for analysts or companies that compile estimates.

That can lead to confusion and even misleading valuations, especially for investors who don't pay attention to the details or, worse yet, who use computers to pick stocks based exclusively on the numbers. "Consensus EPS estimates do not provide an apples-to-apples comparison among large-cap technology stocks," writes Sanford C. Bernstein analyst A.M. Sacconaghi Jr., in a recent report.

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The trouble comes when analysts, for whatever reason, don't include options expenses in their primary earnings estimate. Their numbers are then compiled -- and consensus is created -- by three companies: Thomson Corp.'s Thomson Financial, Reuters Group PLC's Reuters Estimates and Zacks Investment Research. Zacks, which claims to have created the industry nearly three decades ago, is the only one whose consensus always includes options expenses, even if it means manually figuring it out; as of the third quarter, it had to do that for 300 of the 4,500 companies in its database. Reuters Estimates and Thomson Financial base their consensus on majority rule. "We need to conform to market standard," says Ashwani Kaul, senior research analyst for Reuters Estimates.

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And that's where this story gets weird. Only a handful of brokerage firms, including Bear Stearns; Bank of America Corp.; Goldman Sachs Group Inc.; and Sanford C. Bernstein, a unit of AllianceBernstein LP, require analysts to include options expenses in estimates that are picked up by Thomson Financial, Reuters and Zacks.

Why don't all of them? Good question -- and viewing earnings any other way is puzzling even to the CFA Institute, which charters analysts. "Our view is that options are a form of compensation," says Rebecca McEnally, a spokeswoman for the institute's Centre for Financial Market Integrity. "And the fair value of options expense should be treated as any expense in the forecast. To fail to do so is to underreport expenses and overreport the earnings." If that's the case, then why are we having this discussion?

I've got to say that Ms. McEnally's sentiments perfectly reflect my own. As a person who was a derivatives transactor and ran derivatives teams, and spent a tremendous amount of time working with large corporations on strategies for managing their option costs, the avoidance of these costs when modeling earnings estimates borders on malpractice. If the companies themselves acknowledge that options represent a real cost to shareholders, and any credible academic in the fields of financial engineering or corporate finance echo the same, then what exactly is the analyst community doing? What are they thinking? Is it laziness? Is it unwillingness to adjust complicated historical models to take into account such valuation effects? Is it the uncertainty of the assumptions underlying option valuation? It could be any or all of these reasons, but frankly I don't care. It is the analyst's job to make assumptions, state them clearly, argue their position and make a recommendation. And sticking one's head in the sand or simply ignoring a complicated, hard-to-quantify issue is not part of the job description.

This is a serious issue. If sell-side analysts want to prove their worth and solidify their role as a key part of the buy-side investment process, they've got to up their game, up their rigor, up their critical thinking and internalize their position as a professional. Otherwise, the marginalization of their historic role will continue unabated.

 

SAC Rips It In 2006: I Told You So!

Remember in mid-September, when Stevie Cohen was the subject of a big story in the Wall Street Journal in which he was practically pessimistic about the likelihood of putting up big returns given the increasingly crowded and competitive environment? I posted on this two days later, in which I basically said: this is a load of crap. Steve and his team at SAC are a bunch of forward-looking rock stars with great brains, great technology and the resources and vision necessary to stay a step ahead. Don't believe me? Here are excerpts of what I wrote on September 18th, 2006:

This does not sound like a multi-billionaire running an eleven figure sum for some of the most powerful investors in the world. Where's the hubris? What has changed? Is he right that the easy money has been made and it will be tougher sledding from this point forward?

I'm not buying any of this. SAC and its team is way, way too smart to be pigeon-holed by a single strategy. If there is too much money chasing too few ideas, invariably there is a lot of dumb money out there that can be exploited by someone smarter and more experienced. I mean, come on, he is up 18% YTD on a big, big number. That is pretty good based upon the stats I've seen.

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Given the trend towards more and better data and information being put out there on the Internet, it will be those with the vision, the brains and the tools to take advantage of this alternative data set that will establish a true edge on the competition. Again, SAC is a very forward-looking organization with the resources and trading acumen necessary to exploit the massive opportunity for discovery that is the Internet, so I am also certain that they will lever their expertise into this area as well.

So, from my vantage point things don't seem so bad for Stevie. Maybe he is showing his soft side so we'll all get complacent and he'll clean our clocks! That seems far more likely than the defeatist attitude on display in the WSJ article.

So now the numbers are in: Stevie and Co. put up 34% (on $10+ very, very large) during 2006 vs. 12%-14% for most of the hedge fund indexes.  So who was right - me or Stevie? Answer? ME! But he's taking home 10 figures and I'm taking home - well, let's just leave it there. I appreciated his humility and willingness to let us all inside the tent a bit, but at the end of the day he is a smart, resourceful, competitive performer at the top of his game, and there is no doubt in my mind that he is ultimately confident in his ability to find new and improved ways to make money, regardless of the environment (and regardless of what he says). Thought he shaded it during his interview, I called bullshit. Hooray for me. And hooray for him.

 

Valuing Apple Inc: Pricing the "Jobs Put Option"

Overview

Today's article in Bloomberg got me thinking about how investors are dealing with the uncertainty surrounding Steve Jobs, namely the possibility of his removal in the wake of the options backdating scandal.  However, I think this mis-characterizes the true underlying fear investors have (and which is the real risk facing the stock): the negative impact on Apple's share price given Job's departure, regardless of reason. It just happens that the backdating scandal is currently in the forefront of most investors' minds, yet this is a man that has fought cancer, and faces that same risks that any of us do who buy insurance to protect our families and loved ones given an unexpected adverse event. Yet I'm not confident that this is how investors are valuing Apple's shares, and pricing in the array of risks facing Jobs (and, therefore, Apple investors) in an insurance oriented, value-weighted, probabilistic manner.

Apple's shares have behaved like a yo-yo as different interpretations of the SEC and DoJ's likely actions concerning Job's role in options backdating have come to light:

Jan. 17 (Bloomberg) -- Apple Inc. may find its most valuable asset is something it can't protect through patents or secrecy: Chief Executive Officer Steve Jobs.         

If Jobs were to leave, shares of the Cupertino, California- based company might drop 25 percent or more, analysts say. That would erase about $20 billion in Apple's market value.                

``It would be a disaster,'' said Gene Munster, an analyst with Piper Jaffray & Cos. in Minneapolis, who's had an ``outperform'' rating on Apple's shares since June 2004. ``He would be almost impossible to replace.''         

The computer maker's dependence on its CEO was illustrated the last week of December, when the stock dropped as much as 5.8 percent after the Recorder, a San Francisco-based legal publication, reported Apple had faked documents to backdate stock options.                 

On Dec. 29, the company said its own investigation, led by Apple director and former U.S. Vice President Al Gore, cleared Jobs of any wrongdoing. That eased concern Jobs may have to step down and sent the shares up 4.9 percent.   

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When "analysts" say the shares might lose $20 billion in value, how are they quantifying this amount? Are the oscillations of Apple's share price when each piece of news concerning the options investigation come to light reflective of shifting probabilities of his ouster, or something on a more visceral level? I don't know. But I'd certainly like to know.

Analysis

As an ex-derivatives guy, it seems to me that the rational investor would value Apple's shares in the following fashion:

Fair Market Value of Common Shares (Apple) = PVFCF (Apple) - Put (Impact of Jobs' departure)

And to value the "Jobs Put" correctly, one needs to consider the following three factors. And this analysis needs to be run for each of the different risks that could give rise to Jobs leaving Apple's helm:

1. The timing of an adverse outcome
2. The likelihood of an adverse outcome
3. The negative payoff associated with an adverse outcome

These are all complex issues, but the negative payoff is certainly the most difficult to quantify. How much of Jobs' DNA has been embedded in the organization? How deep is the creative bench at Apple? What is the real value of his PR glamour status? How long would it take for his departure to impact the fundamentals of the stock? Is he the single most valuable executive in the U.S. today? All hard yet critical questions to consider when seeking to quantify the absolute impact of his not being the CEO of Apple. But, of course, this number needs be discounted by the probability of his not being CEO together with the timing of when this outcome might occur. What the rational investor should probably do is construct a matrix of possible scenarios by flexing factors 1-3 above, and build a range of values for the Jobs Put that is netted against Apple's discounted free cash flow projections.

Conclusion

The Apple situation is very interesting. I'm not sure I can think of another firm whose share price is so inextricably tied to its CEO, a person whom is facing an array of serious risks that could be of great consequence to the firm. And it is precisely because of this unique dynamic that Apple's share price subjects itself well to an options pricing framework, essentially bifurcating the value of the firm into two distinct pieces: Apple (with Jobs) - Apple (without Jobs) = Value of Jobs Put, or by shifting terms;

Apple (without Jobs) = Apple (with Jobs) - Value of Jobs Put

Whether Apple investors are aware of it or not, they are short an option - a big, valuable put option, which they should be attempting to value. If not, may the force be with them. And be careful out there.

Institutional Investors and Research: A Landscape in Flux

On Friday I was speaking with a writer, Tiernan Ray, about harnessing the power of the Internet for investment research, among other issues. As he and I were talking I found myself having pretty well-defined views on the topic, e.g., the expanding use, power and impact of the Internet on investment research and its ramifications for traditional sell-side and independent research products. Tiernan commented that I should write a post addressing these issues. He was right. As a result, I wanted to be sure to give Tiernan credit for serving as the inspiration for this post.

So the key question that needs to be addressed: what are Institutional Investors really looking for from an externally-generated research product?

In order to consider this problem properly, I believe the analysis needs to take into account a few salient facts:

1. Institutional Investors are increasingly sophisticated, building ever-more robust internal research capabilities;
2. Institutional Investors suffer from an increasingly acute case of information overload, being bombarded with data, information and dreck from an array of sources;
3. Institutional Investors have increasingly abundant financial resources denominated in either hard- or soft-dollars at their disposal, giving them the ability to pay for new and valuable research products and services; and
4. Institutional Investors are facing an increasingly competitive investment landscape, with the structurally and demographically-fueled increase in AUM highlighting the fact that finding unique tradeable information and insights is more important than ever.

Ok, that's cool. But how do these facts impact the day-to-day behavior and attitudes of Institutional Investors? I can hear the following responses rolling off the tongues of a wide-range of buy-side pros:

1. "Don't give me a canned, verbose, broadly distributed research product, and, by the way, I really don't care about your Buy/Sell/Hold ratings or earnings models, so save the paper. I am smart and know these companies better than you, sh*thead. Your ratings, if anything, might serve as a contrarian indicator in my pricing models."
2. "Give me stuff I can't get myself, i.e., meetings with relevant senior executive officers. Yes, serving as as a relationship broker is one demonstrable way you can add value. Your skills as a secretary are highly valued by me. So do it fast, ok?"
3. "Thick reports, unless they are chock-full of differentiated, unique data, are virtually meaningless. Global sector perspectives have value if they are copiously researched and contain unusual, valuable data and insights. Most of the time, they don't. In that case, save it."
4. "I may be rolling in cash but I am really f*cking cheap. Mama needs new shoes, ok? I'll pay but only for valuable stuff, not that historic processed crap I'm used to getting. And don't pull that bullshit relationship card on me, ok? You used that one last year."

A little cynical, yes? I think not. But anyway, based upon my knowledge of the buy-side, what do Institutional Investors really want and need as part of their research process? I believe it is fair to operate on the assumption that in an increasingly unbundled world (research and commissions, that is), investors know exactly what they want and what they are willing to pay for. I think the list below includes some of the key items:

1. Unique and hard-to-access data on a global basis
2. Insider perspectives on business prospects
3. Access to subject-area domain experts
4. Understanding of "buzz" related to a company or a product
5. Intimate understanding of supply-chain relationships and the interdependencies among companies and their key suppliers
6. Getting 1-5 in a manner that doesn't chew up too much valuable time

There are many others but I think this is a pretty representative list. So in light of this list, how does the traditional sell-side research product stack up? How about the independent research offering? And what about alternative tools for research, data collection, financial intelligence and analysis?

Sell-Side Research: Old dog in need of new tricks

I still get sell-side research reports. Pretty much the same stuff I've seen for the last ten years, except maybe worse. Now I am being purposely general here - clearly not all sell-side research is bad, only some of it. But a lot of it. Reports generally come in three flavors, in my experience: (1) The broad company piece, which includes lots of text, lots of models and takes up lots of pages. I'm not sure I get much more from this than I do a thorough reading of the 10-K, 10-Qs and Proxy, however. But that's just me. (2) The periodic update piece, which is a very short blurb which says "Hey, Company X just released a new product" or "The Management of Company Y just made an announcement." And, oh yeah, there are some pithy sentences laying out the analyst's interpretation of the announcement. Says the buy-side analyst: "Sure, I saw this come over the wire. I know goddamn well how to interpret this information." Yawn. (3) The Sector Tome, which is a zillion pages and goes into macro themes for an industry with supporting pieces on each company. These can be pretty cool when well-written and well-researched. Otherwise, the authors should be taken away in shackles and dragged to eco-jail on charges of first-degree tree homicide.

Sell-side research also has the requisite Buy/Sell/Hold, which I don't think any self-respecting Institutional Investor really cares about. But investors do care about the meetings senior research analysts can set up with senior management of companies. And these management road shows are an important part of the value creation process for sell-side firms. And these sure cost less than having 300 research analysts globally. And I'm not sure that the current Wall Street research spend, which has dropped precipitously from its lofty highs around 2000 (when research budgets reached $700 million-$1 billion per year), is still low enough relative to the value created for the franchise. I'm not sure. But I am sure that much of the product that is generated by the sell-side is not given the desired weight by the buy-side. Namely because the value frequently isn't there. Look at the list above - how many of those six are truly addressed by traditional sell-side research? Maybe two? And this is a problem that will get fixed by natural market forces, the most dominant of which is the incredibly shrinking research department. So some new approaches are required in order for the sell-side research complex to remain relevant. Only time will tell if they are able to adapt to a changing world.

Independent Research: You need more than the Research Settlement to be relevant

Independent research has been a nice, value-added cottage industry for a long time. Ex-domain experts, economists, macro strategists, forensic accountants, etc., putting out a shingle, producing a solid piece of differentiated research and selling it by report or by subscription. I think of Howard Schilit's forensic accounting shop CFRA as one of these niche-oriented, value-added independent research providers. This worked pretty well for the research firms and the clients and represented a good way to augment one's mainstream knowledge base and homegrown research efforts. Then came the Research Settlement in the wake of "Blodget-gate" and the rest of it. Out of the nether-world sprung a bevvy of independent research writers, independent research distributors, and many others who wanted their piece of the Research Settlement gravy train. And what was once an industry characterized by moderate volume became very noisy very fast.  Very, very noisy.

As a result, we have a very croweded and confusing landscape in independent research-land, one which will rectify itself very, very soon. When the Settlement dollars run out and it becomes a business driven purely by buy-side demand, the wheat and chaff will be separated lickety-split. And this will be good. Because top independent research providers can almost be thought of as an extension of a buy-side research desk. As a buy-sider I've got knowledge, I've done research, I've got my thesis, but if I can buy research from deep domain experts that can complement my in-house work then I'll view that as money well-spent. Because I need all the smart perspectives and targeted, valuable data I can get my hands on. Because it is a competitive environment out there. And I've got money to spend on the right things that add value to my investment process.

Alternative Data Sources, Tools and Services: Focused resources for a dynamic environment

Over the past ten years a variety of companies have sprung up to make the lives of the Institutional Investor easier. These companies either better organize existing information to make it more usable, like CapitalIQ; provide easy access to experts who can add value to the investment process, like Gerson Lehrman Group; or offer platforms for rapidly identifying valuable information from the sea of noisy data out on the Internet, like my company, Monitor110. These types of companies all operate on the assumption the Institutional Investors are smart, don't want to be told what to do or how to do it, but to bring valuable intelligence to the investors' attention in a straight-forward, easy to consume manner. It is a fundamentally different paradigm than traditional sell-side research, which is set up to be something an investor looks at, reviews in conjunction with other analysts' views, follows the view they most agree with and trades with that firm. The alternative information  providers don't care about getting the trade. They care about getting paid a subscription fee for generating value and becoming embedded in a client's investment process. In short, they are valuable tools for helping the investor make better decisions. Very focused. Very clear value proposition. Very easy to incorporate into the existing investment process.

Conclusion: An a la carte world for the discerning investor

Has traditional sell-side research become marginalized? Yes. Can it fight its way back? Not to the level it once was, but it can become relevant again. How? By focusing on the ability to gather unique data and insights and to present them in a way that is easy and straight-forward for the Institutional Investor. I see many fewer 200-page tomes in our future. I do see the sell-side making better use of alternative information tools for their own research process, and delivering more data-driven, analytical pieces to their buy-side clients. I believe the independent research world will contract as well, as only the strong (read: value-added) survive in a brutal shake-out. That said, I can see high-quality independent research (as well as the alternative information providers) plugging some of the gaps left by the sell-side research contraction, as Wall Street research budgets continue to come under pressure as the buy-side is increasingly focused on easy access to capital and less on using commissions to pay for unwanted research spend. Finally, alternative information providers will continue to thrive as greater spend is devoted to these focused resources that help to more easily bring the planet's information to investors' fingertips. Whether it is CapitalIQ organizing financial statements, Gerson Lehrman organizing the world's experts or Monitor110 organizing the Internet for Institutional Investors, the overriding theme is the same: Helping Institutional Investors make money more easily through the use of powerful tools and networks. And if the sell-side internalizes these principles, I believe the sell-side can become a "buy" once again.

Investment Returns from the Long Tail and the Marginalization of Wall Street Research

A particular statistic has been burning a hole in my head since I first read it in Alan Abelson's Barron's column this weekend - according to Rich Bernstein, Chief Investment Strategist at Merrill Lynch, the best of 40 trading strategies tracked by the firm's quants in 2006 was to buy the 50 S&P 500 stocks least covered by the sell-side analyst community. Huh? The return of this strategy was 24.6%, fully 11% better than the 13.6% return generated by the S&P 500 for 2006. This isn't outperformance - this is an a**-kicking. But the real question is why, and what might the implications of this be?

Alan made a funny reference to the legendary investor Gerald Loeb, and his view on the usefulness of security analysts: "In bull markets, you don't need 'em; in bear markets, you don't want 'em." Now Gerald wasn't the most socially sensitive guy, but you kind of get his point. I am personally more curious as to why "orphan" stocks outperformed better-covered shares, because, on its face, one might find this counter-intuitive. Could it be that more information levels the playing field, rendering the ability to develop and act on truly differentiated information extremely difficult? Or that there is so much data, good and bad, around an actively covered share that it is hard to separate information from noise? Might it possibly be that a valuable piece of information on a lighly-covered stock has much greater marginal value, both because of lighter trading volumes (thereby pushing up the stock on a big buy program) and the resulting follow-through from momentum-based traders?

I'd argue that it is these and many other factors that can explain the difference in performance cited by Rich, but that it is hard to argue that the marginal value of information on a less-covered stock is apt to have a greater impact on price than that same piece of information on a more actively-covered stock. Why? Because the information is less expected; is less likely to be discovered before-hand; and the trading volumes are likely to be smaller. If one buys these arguments, and if one views the S&P 500 as a microcosm of the overall equity market, then it stands to reason that there is one very straight-forward way to generate outsized returns: get more and better information on poorly-covered stocks in the face of weak sell-side analyst support. But how?

By using powerful tools to look for "long-tail" information that can augment information that is generally available through conventional media outlets. My company and a handful of others have recognized this and are trying to bring this capability to the investment community. I am firmly convinced that we are entering the "Third Wave" of information for investors: with Reuters pioneering dissemination of news with undersea cables in the late 1800s; Bloomberg revolutionizing granular cross-market pricing data and analytics leveraging client server technology in the 1980s; and tools for extracting valuable and timely information from the Internet in the 2000s. And this Third Wave has the potential of being even bigger than the first two, principally due to the proliferation of content on a global basis finding its way onto the Web, and the increasingly high-quality sources contributing to the global dialogue on companies, products, and macro themes on a 24-7-365 basis.

This is extremely exciting stuff that is screaming for new tools and technologies. And we are very early in the evolution of the Third Wave. It is just when people like Rich Bernstein crunch the numbers and highlight the fascinating yet counterintuitive that it makes the inexorable trend towards more and better internet information increasingly clear.

Who Says Hedge Funds Aren't Regulated?

So it came across Bloomberg this morning that the SEC (US), the New York Fed and the FSA (UK) are doing an investigation into the margin requirements of the leading hedge fund prime brokerage units:

Jan. 9 (Bloomberg) -- U.S. and European regulators, turning a spotlight on one of Wall Street's most profitable businesses, are conducting a joint probe into whether banks and securities firms set strict enough limits on loans to hedge funds.         

The U.S. Securities and Exchange Commission, the Federal Reserve Bank of New York and the Financial Services Authority in London met last month with some of the biggest lenders to the hedge-fund industry, seeking information on how they decide the amount of collateral required, SEC Commissioner Annette Nazareth said in an interview in Washington. Swiss and German authorities were also involved.                

``The purpose of the meetings was to discuss margin practices,'' Nazareth, 50, said. ``It was a fact-finding effort.''

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Officials want to know how much margin banks require hedge funds to provide up front to obtain loans and cover potential losses. They're hoping to avoid the kind of turmoil that engulfed financial markets when Long-Term Capital Management LP's losses forced the Fed to organize a rescue in 1998.         

For hedge funds, private pools of capital that speculate on everything from interest rates to weather patterns, leverage also can multiply trading losses and put stress on the financial system.       

``We are doing work on credit-risk management with the SEC,'' said David Cliffe, a spokesman for the FSA in London. ``It's looking at the prime brokers in relation to the hedge funds.'' The Swiss Banking Commission in Bern has worked with British, U.S. and German authorities on the issue, spokeswoman Tanja Kocher said.

********************

The meetings last month included New York-based Goldman Sachs Group Inc., Morgan Stanley, Bear Stearns, Merrill Lynch & Co., Lehman Brothers Holdings Inc., JPMorgan Chase & Co. and Citigroup Inc.; UBS AG and Credit Suisse Group, both based in Zurich; and Frankfurt-based Deutsche Bank AG, according to a person helping to direct the examinations. All of the firms declined to comment.         

The person, who declined to be named because of the confidential nature of the discussions, said the regulators are concerned that there has been a decline in lending standards because hedge funds are such lucrative customers. The agencies plan to meet in the next couple of weeks to decide what to do with the information, the person said.         

Now doesn't this sound like, uh, regulation of hedge funds? Not to play the "I told you so" card, but here is text from a post I had written about six months ago titled "Much Ado About Nothing - the Hedge Fund Regulation Debate:"

Hedge funds are already subject to significant regulations, SEC rule or not. The SEC can ask for a hedge fund's books and records if they have basis for a concern that places investors at risk or believe a violation may have taken place. Investors can (and often do) request extensive information from hedge funds during the due diligence process, and this process can often take months for large, sophisticated institutions. Furthermore, investors who are also fiduciaries (like pension funds) have an obligation to do thorough due diligence prior to investment in order to protect the individuals who make up their constituency. Finally, the allocators and managers of risk capital, the prime brokers, can alter margin and credit requirements based upon the strength of a hedge fund's management structure, risk reporting, operating environment and returns.

So here we are, with the "Big Three" overseers of the lion's share of global hedge fund AUM examining the prime brokers and their lending practices. This is exactly the kind of regulation I was talking about when I scripted the July 16, 2006 post. Writers, politicians and many in the general public just don't seem to get it - an SEC "hedge fund rule" or not, much more powerful levers are already controlled via oversight of broker/dealers, federally chartered banks and the ability to walk into any hedge fund at any time if there are suspicions of fraud or malfeasance. Today's Bloomberg article goes on to say some stuff that really worries me:

Nazareth said it's not clear what steps, if any, the regulators may take. New York Fed President Tim Geithner described the question of margins as "very complicated'' in comments to a Nov. 29 meeting of the American Institute of Certified Public Accountants in New York.

Because hedge funds let managers participate substantially in the gains on money invested they provide an incentive to boost returns with extra leverage. Fed officials have been troubled for months by the possibility that banks may be cutting margin requirements for hedge funds too far and in some cases demand no margin at all for potential losses on over-the-counter derivatives.

``It's very hard to figure out what's right,'' Geithner, 45, said at the November meeting. ``It's maybe as hard or harder to try to figure out whether you can bring about change that may be in the broader interests of all market participants.''

When you have the President of the New York Fed saying that the issue of margin requirements is "very complicated" and that "It's hard to figure out what's right," I'd be very afraid of the potential outcome. Mr. Geithner is right - margin requirements are extremely powerful and complex tools. And they need to be examined very carefully and with the utmost care before change is enacted. And hopefully Mr. Cox of the SEC will prevail upon him and his UK-based colleagues in the FSA to proceed thoughtfully. Because abrupt changes in things like margin requirements can have very powerful (and unintended) ripple effects throughout the financial markets and, therefore, the real economy. So don't tell me hedge funds aren't regulated. They are and they always have been. The SEC and the Fed has the equivalent of "regulatory nuclear weapons" at their disposal, and this is just one of its potential manifestations. Let's hope the suitcase with the red button remains in storage for a long, long time.

The Wall Street Series Part III: Ten of the Keys to Success on Wall Street

Let me first say: feel free to disagree and please, please feel free to table constructive suggestions based upon your own unique experiences. I am a data point of one, but at least one whose balding pate and 40-something age is indicative of nearly two decades of experiences on the Street from which to draw. There are so many elements to a successful Wall Street career that it is impossible to list them all, so here is my list Top Ten of the keys to succeeding on the Street (with a bonus #11 thrown in for good measure). They are not listed in any particular order.

Key #1: BE HONEST

With others as well as with yourself. Seems self-evident, right? But wait, isn't Wall Street a cutthroat, kill-or-be-killed type place, where you do what you need to do to win the deal, get the trade done on your desk, crush the competition, etc.? Answer: sure, it can be that kind of place, but honesty can't be the thing that gets chucked out the window. Ever. You know why? People have memories. And if you are shown to be a dishonest person, even one time, it sullies your reputation forever. It is kind of like the Web: once it's up, it's up for eternity. So you know those MySpace pages, college kids? Be very, very careful. And on Wall Street: you know how being economical with the truth can sometimes seem like the right thing, the easy path to take? DON'T DO IT. It is equally as important to be honest with yourself, particularly as it relates to strengths, weaknesses, good points and bad. This is critical for self-development, how and whom you recruit, how you position yourself at bonus time and how to interview for new positions at either your current firm or another firm. Self-awareness is an extremely valuable quality, and one that is witnessed far too little on the Street.

Key #2: BE THE KIND OF PERSON PEOPLE WANT TO WORK WITH

It is impossible to over-emphasize this point. Regardless of whether you aspire to be the schmooziest relationship Investment Banker or the geekiest stat arb trader, you still need to be the kind of person others like and respect. This effects your performance evaluations (managing upward), your day to day work environment (relationships with your peers and subordinates) and your ability to attract and retain the best people (recruiting). Jack Welch pioneered this concept of blending performance with how the performance is achieved in talent assessment, e.g., if you are a top performer but a total sh*thead, this is not an acceptable long-term state. And you know what - he was right then and he is still right today. Unless you are a prop trader locked in a closet with a very strong COO-type dealing with the outside world you need to be concerned with not just how well you play but how you play the game. And in the long run, if you are a good partner, a good teacher and a good boss to go along with being a top performer, you will create a virtuous cycle of attracting and retaining the best people around you. And this is one of the most important keys to sustained success on Wall Street and in life.

Key #3: FIND A MENTOR AT EACH STAGE OF YOUR CAREER

One of the most fortunate aspects of my career was in finding people senior to me and more experienced than me in each of my jobs from whom I could learn - and not just about the technical ins-and-outs of the business, but about the more subtle aspects of functioning and succeeding on Wall Street and how to become the best professional I could be. To this day I remember each and every one of these people and the contribution they made to the professional that eventually emerged:

• Fred Dawson, Latif Sayani and Madhav Misra - Citicorp Global M&A
• Asher Fogel -  Citibank Equity Structuring 
• Rufus Cole, Lynn Feintech and Dipak Rastogi - Citibank Global Derivatives S&T
• Rick Goldsmith and Ralph Reynolds - Deutsche Bank Equity Derivatives  S&T
• Kevin Parker - DB Advisors

Upon reflection, I think the combination of good fortune (in meeting these people) and my desire to learn all I could from these mentors had a substantial and positive effect on my career. And I would encourage you to seek out develop these relationships as well.

Key #4: HIRE PEOPLE SMARTER AND BETTER THAN YOU

What is success on Wall Street? Making money and winning, the right way. How do you do this? By being really good and having a great team. Ok, and how do you do this? By hiring rock stars who, yes, may even be better than you. Is this threatening? Does this make you concerned about your ability to contribute and not be over-shadowed? If it does stay off the Street, because these insecurities will eventually catch up with you. There is no stronger sign in a manager than the ability to attract, manage and retain rock star performers, and to hire people that have skills and attributes that plug gaps in the manager's own repertoire. This is a sign of self-confidence, of laser focus on the goal, of the desire to grow and get better, and of the willingness to put team ahead of self. Because at the end of the day if the team wins the manager wins. And this is a manager who will be slated for increasingly big and challenging roles because they know how to build and manage high-performance teams. And this is what Wall Street is all about.

Key #5: BE A GOOD LISTENER

One thing I've noticed over the years: really smart people often like to hear themselves talk, and are frequently piss-poor listeners. And this is too bad, because it really puts them at a strategic disadvantage. The neat thing about working on Wall Street is that you are often surrounded by high-IQ people who are more experienced than you are, and from whom you can learn a lot of stuff. So by checking your ego at the door and saying "Yeah, I'm smart, but I can get a hell of a lot smarter by shutting up and and listening to these smart people who know stuff I don't," you can substantially enhance your knowledge base and, believe it or not, appear likeable in the process. Huh? That's right. People who like to talk a lot really appreciate people who will listen to them talk. So not only are you sucking the juice out of these people and augmenting your database, but you are building positive and valuable relationships in the process. But even though this is sickeningly logical, it is the rare Wall Street brainiac that can shut the f*ck up, admit to themselves that they have something to learn and take advantage of these golden opportunities. It's just not a fixture of the Wall Streeter's DNA. So if you can suppress these urges to look smart and to instead BE smart, you will have a leg up on all the other high-IQ clowns out there.

Key #6: DON'T BE AFRAID TO GO FOR IT

Think of Wall Street in the same light as those old recruiting ads: The Army: It's Not Just a Job - It's an Adventure. A successful career on Wall Street is an adventure, and it is one about which you need to take control. But how? Won't I just be a cog in the big machine, gradually ascending the ladder and making progressively bigger paychecks? Well, it doesn't really work that way. If you want to do BIG things, you've got to have vision, and you've got to communicate that vision to the right people in the right way. And you can't be afraid to do it. Basically, you need to bring the skills of entrepreneurship to Wall Street. Senior Management of Wall Street firms love to have people generate ideas that they can back and that will make them money. Design a new and lucrative product addressing an important client base. Create a new trading algorithm. Develop a plan for cracking a new market. Incubate a team that leverages existing strengths to better serve a deep-pocketed client set. This makes Senior Management's job so much easier. My advice to you: be one of those people who goes for it. Be an entrepreneur on Wall Street. It is the path to gathering great riches and doing great things. 

Key #7: ALWAYS BE MOVING FORWARD

As an old gray-hair (or an old no-hair in my case), I frequently get calls from people asking for advice and counsel concerning their career. The first question I ask in order to assess their current situation is: "Are you still growing and moving forward in your current job?" If the answer is no, THINGS HAVE TO CHANGE. And fast. The phrase I utter at this point in the conversation is "If you're not moving forward, you are moving backward." And it's true. Stagnation on the Street is death. You're not learning. You're not growing. You're probably not happy. You've lost passion. And this undoubtedly shows. And, eventually, this will impact compensation, performance reviews, and the ability to move into new and exciting areas with better opportunities. So if you find yourself in a position where you are trudging into work, going through the motions and constantly thinking about the weekend, STOP. Think. Ask yourself why. And put a plan in motion to get your career on track. Maybe it is the content of the work. Maybe it is your boss. Maybe it is the firm. Figure out what it is and what want to do. Reach out to a mentor. Speak to friends at other firms. Solicit input from people whom you respect and who know you. This self-assessment process is critical and will have a signifcant impact on your career. And if you don't do this it will also have a significant impact on your career - a negative one. Guaranteed.

Key #8: WORK IN AND FOSTER GOOD CULTURE

If you've read this blog at all you know how important I feel culture is. And you know why? Because it is. Working in sh*tty cultures sucks, and these cultures are not sustainable over long periods of time. And life is too short to find yourself in a culture that is dysfunctional, unsupportive, stifles innovation or any of the other deadly sins. Find a firm, a team whose culture you respect and that fits with you own world view. And when you get to the point where you are building and running teams, focus on building a great culture. This will help with recruitment, management and retention, and will help create the foundation for the building and operation of a high-performance team. It is just so important.

Key #9: COMPORT YOURSELF WITH INTEGRITY

Integrity is kind of like pornography - you know it when you see it. It is more than honesty. It is being a good person and yes, an honest one, but it also has something to do with being trustworthy, thoughtful, and whole (as the word is derived from integer, meaning "whole"). Someone with integrity has the whole goodness package. They are someone for whom the "karma boomerang" concept is a guiding force, e.g., if you do the right thing, good things will happen. And you know what, they do. Someone needs help, help them if possible. It means going to bat for your team at bonus time. It means helping mentor people and assisting with career management. It means being a good coach to your team. It means helping other groups get deals done if it is within your power to do so. This doesn't mean being a sucker and letting people burden you with requests. It just means being a good and commercial person. And this is reputation that is durable and builds over time. And again, helps with recruiting, managing and retaining that team that is so key to being a star on the Street.

Key #10: BE PASSIONATE ABOUT YOUR WORK AND HAVE FUN

Bottom line: you work your a** off on Wall Street. If you aren't passionate about what you are doing it will show, and you will be unhappy. Who the hell wants to work 90 hours a week and feel like crap about it? Can you say misery? People going through the motions - even if they are super smart - are easy to spot and are really unattractive. Managers want people who want to get after it with all their heart, not some half-hearted analyst who does the work but doesn't offer up their own ideas, suggestions, or go the extra mile. Even though you will inevitably work with some a**holes on the Street (as you would in every other vocation as well), you have to enjoy what you are doing. This point is not only about succeeding on Wall Street but about being a happy person. Believe it or not, Wall Street is wicked fun if you find the area that is right for you. M&A, Derivatives, Trading - I gotta tell you, it was a blast. Not that there weren't hard times, times when I wanted to put my fist through a wall (or through someone's face) - of course there were. But at the core I enjoyed each of my jobs and worked hard to be with people and on teams that were "work hard/play hard." And I NEVER questioned my decision to be on Wall Street. And you know what - it showed. I do believe that my passion, my intensity and my love of the game was a key component of my success. And when it was time for me to move on, I did. If you let your passion be your weathervane, you will invariably make smart career decisions on Wall Street.

Bonus Key #11: BE HYPER-ANALYTICAL

You might be saying "duh?" No, I'm serious. There are lots of Investment Bankers that aren't hyper-analytical - and it is a problem. Why? Because they are scared of people in Sales & Trading, and of the products and services they offer. This is just pathetic. This makes them sickly protective of their relationships, acting as dopey gatekeepers and putting roadblocks in the way of better serving the client and helping the firm make money. You'd be surprised how many bankers are out there that fit this mold. Being a banker and being hyper-analytical is a huge asset, because while you will never have the knowledge of a derivatives pro or a convertible bond trader, you will know enough to know the power and value of more complex products and strategies that, at the end of the day, will help you better serve the client and make you more money. And bankers that have this level of comfort and confidence with Sales & Trading get a lot of respect from those in S&T, and this is really, really important, especially when a client wants the firm to step up and take risk which S&T ordinarily wouldn't take except in the face of a super strong relationship led by such a banker. And this happens in real life. So for G-d sakes, if you are planning on being a banker, get the skills and confidence necessary to interact as a peer with those in S&T. Because if you don't, you'll always be the bitch.

I hope you have found this interesting and potentially useful. I never really thought about this stuff in such a concrete manner, but writing it down brought back a rush of memories that made for a really, really great evening. So thanks for being the catalyst for the post - I had an awesome time.

The Wall Street Series Part II: Investment Banking vs. Sales & Trading - Can't We Be Friends?

Answer - NO. It's Us versus Them. It always has been and it always will be, given the structure of the Street and the chemical differences among the species in question. And the issue is, in fact, much more textured than Banking vs. Sales & Trading - what about Sales vs. Trading? This conflict is older than time itself, and sometimes even more electrifying that Banking vs. S&T. Ah, Wall Street is such an interesting (and contentious) place. Where else can you find such an amalgam of smart, highly motivated, self-interested, egocentric and combative people? It's a good thing my wife (whom I've been with since college) has her Ph.D in Clinical Psychology - believe me, it often came in handy during my tenure on Wall Street. So why are these species frequently at each other's throats when it is often the case that cooperation can yield a better overall outcome? One word: MONEY. Not "our" money. Not shareholders money. MY MONEY. It is really that simple.

Banking vs. Sales & Trading - It's that "We're from Venus, You're From Mars" Thing

At a macro level, governance of a Wall Street firm is kind of like Congress - "Who's in power, is it the Democrats or the Republicans?" And it changes over time. Simply replace "Democrats" and "Republicans" with "Banking" and "Sales & Trading" and you get the picture. Remember when Goldman was run by bankers? Well that certainly has changed, hasn't it? And this shift back and forth has happened in each and every firm on the Street, altering the balance of power and the divvying up of spoils at year-end. Given the ability to control bonus pools and to influence the spreading of cash, this is power worth fighting for. And it sucks if you lose.

But getting down into the weeds, the issue, at its core, is that Banking feels they own relationships, and that any money resulting from these relationships is theirs (or at least a big chunk of it should be theirs). Why? Because the Banking worldview is: Revenues resulting from client transactions don't arise because of the firm's brand or the quality of its products, but the quality of the Bankers. Bankers generate advisory assignments. Bankers generate capital markets issues. Bankers generate IPOs. Bankers lean on Research to write the stuff which helps the stock which helps Institutional Sales and generates commission flow. Right. If you are a Banker and drink your own Kool-Aid. And this self-centered perspective works really well if your party is the one in power. But if, say, Sales & Trading is in power, it is doubtful that you will get as receptive a hearing at bonus time as you might if your own species were in power. Too bad.

This stands in sharp contrast to the Sales & Trading view of the world, which is more akin to: We're smart. We're creative. We know how to monetize an asset. Bankers are stupid and weak, bending over backwards to kiss the client's a** while jamming us. Screw them. We deserve the big cash. Sales & Trading says things like, "You got that deal because the client wanted to expand the syndicate to diversify financing risk" or "The Equity Trading desk took on a load of principal risk to get that block trade done for your client" or "The creativity of the Tax Structuring team was the catalyst for getting that buy-side assignment that saved a client $20 million on a cross-border acquisition." In essence, Bankers are overpriced pieces of sh*t in suits that benefit from the creativity, capital and risk-taking skill of those in S&T. And it gets really complicated when you have client-type guys in Sales & Trading who, in fact, have better relationships with the clients than the Bankers themselves. This really, really pisses Bankers off. This is just too in-your-face for these guys to tolerate. And it just turns up the volume on the systematic conflict that already exists.

I could write about this in gory detail but I will spare you. The bottom line: each side has an over-inflated opinion of themselves, and it is to their benefit to maintain this posture in order to fight to get credit and, therefore, the cash. And at the end of the day, this is all that matters. To them.

Sales vs. Trading - The Mother of All Embedded Wall Street Conflicts

This conflict makes all others look like Romper Room. Now why is this? Sales creates the asset for Trading to monetize, so why can't we all just dig each other? One couldn't exist without the other, right (except in proprietary trading where traders are, in essence, running an internal hedge fund with no salespeople to worry about. This has its pros and cons for the trader - and really is a separate topic for a future post)? Well, let's say a trade makes $1 million (not that Sales would ever really know what a trade made because Trading has no incentive to tell them, unless the outcome truly sucked so they can bitch about it and hold it over Sales indefinitely). Was the money made because of the quality of the trade and the relationship brought by Sales, or the risk management and trading expertise delivered by Trading? Excellent question with no clear answer. Does a trade get marked at mid? At bid? At what level does Trading take over the risk and rewards of the position and begin recognizing their own P&L?

There have been countless models tested in this area with no clear winner. The key problems: (1) lack of transparency; (2) lack of trust; (3) MONEY. The incentive, of course, is for Trading to moan and groan about the crappy position being brought by Sales, how hard it is to hedge, etc., and to make a lousy price, while Sales is motivated to say, "Hey, trader a**hole, give me a f*cking real price or I'll check with my friend over at Bear." And it is really hard because Sales doesn't really understand how Trading is monetizing a position - it doesn't generally happen instantly but happens over time through hedging delta, vega, gamma, etc. So how can Sales really ever know? Answer: they can't. This is a dialogue that happens at every shop on the Street, and is a dance that is danced every single day. At the end of the day the firm makes the same amount of money, unless the firm is so dysfunctional that a trade is missed because a trader makes such a bad price that by the time sales layers on their target profit the trade is done away. But in the scenario where this doesn't happen, all you are doing is fighting over who gets the bigger slice of the pie. And this is the point. And this is the source of the pitched battles because the dollars at stake are huge, almost all comp is a function of year-end bonus and "G-dammit, I'm just not going to get screwed again this year by those a**holes." And let me tell you, this movie gets really boring over time. By the time you are an MD in S&T it is something like "Bonus Hell VII: From Tears to Eternity." You get the picture.

Conclusion

Is there an answer to these structural conflicts on Wall Street? Not an easy one, that's for sure. The degree of cultural change that would be required to fundamentally alter the system would be tectonic. And as long as the key term of trade - MONEY - is really all that matters to the key players, it is hard to see this conflict abating without Senior Management starting to rate people on teamwork, and paying people based upon the intersection of teamwork, team profits and individual performance. This requires substantive, tough, detailed evaluation, unlike any system that I've either witnessed or become aware of on Wall Street. But the catalyst has to be Senior Management, with real teamwork modeled and displayed every single day, with economic consequences to match. Because without this degree of buy-in and putting your money where your mouth is, any fundamental change in the current system has no chance of happening. No chance.