Relationships, Fees and Genius

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Fees.

One popular story about investment banking is that back in the good old days, investment banks were partnerships built on relationships, making their money by putting the clients first and giving them good advice. Then they succumbed to the lure of trading, went public, and became more short-term, transactional and conflicted, pursuing profits for themselves rather than the best interests of their clients. And now we are in sort of a post-modern phase in which boutique banks are trying to go back to the good old days of giving unconflicted advice to grateful clients.

You might think that the decline from relationship-driven client-focused banking to transactional profit-focused banking would be bad for clients, and I'm sure in some sense it is. On the other hand, relationship-driven banking is by its nature not that competitive. The banker and the chief executive officer develop a relationship over years of working together, and the CEO is not going to abandon his long-time banker just because some upstart comes in with a fancy new derivative or a bigger line of credit or, certainly, cheaper merger-and-acquisition fees. Trusted advice is priceless. Charging less for advice makes it seem like it's worth less.

But once investment banking services are transactional, it's much easier for clients to push back on fees. 

Anyway here is a fascinating Financial Times feature on the fee gap between U.S. and European investment banking. "In 2015, Americans paid fees that were on average 22 per cent higher than Europeans — a decade earlier the difference was less than 10 per cent," and over the whole decade average M&A fees were 1.18 percent in Europe versus 1.34 percent in the U.S. (Equity and bond issuance fees also seem to be lower for European clients.)

The FT mentions a number of possible explanations, including a more concentrated U.S. banking industry, protectionist capital requirements that make it harder for European banks to compete in the U.S., family-owned businesses in Europe pushing harder on fees, higher legal risks in the U.S., and others. But my favorite explanation is about relationships:

A New York-based banker says that in his home market, if you go to a client and offer to undercut a bank already on the deal, the client “will not talk to you”. “It’s more relationship driven,” he adds. Not so in Europe, where undercutting still wins mandates. The second M&A executive says European clients do “negotiate harder” on fees.

A European banker "says European clients do not show pan-European loyalty in the same way that American clients patriotically prefer US banks." When Europe opened up to U.S. investment banks, it moved a bit further toward the notion of purely transactional investment banking than the U.S. did. Something, perhaps, was lost there. But at least the clients saved some money.

Lots of fees.

On the other hand, Saudi Aramco will probably do a comically large and lucrative initial public offering in the near-ish future, so global investment banks will do just about anything to build up their Aramco relationships and get a piece of the action. The math is that Aramco "could be worth $2 trillion to $3 trillion," "could float as much as 5%" (for "proceeds of as much as $150 billion"), and so even at sub-1-percent fees, you're looking at about a billion dollars for the banks involved. The competition here seems likely to be less on deal fees -- though I imagine there are banks who would do the IPO for free to get future advisory business in Saudi Arabia's ongoing modernization and diversification -- and more on what other goodies the banks can provide to Aramco in the lead-up to the offering.

The country is also preparing its first of what’s expected to be a series of international bond sales, which could take place as soon as July and raise as much as $15 billion, according to people familiar with the deal. The lead underwriters are likely to gain an edge in the IPO sweepstakes, they said. Saudi officials have told banks that haven’t already lent money in the kingdom that they should consider doing so, the people said.

Wouldn't it be fun to be an Aramco executive at this point? The trick is, if you know you are going to be paying banks $1 billion in a year or so, and you know they "will pull out every stop to cater to this business," you should try to get more than $1 billion worth of free work in the time before the deal launches. That shouldn't be too hard to do: It is a tournament model, so if (say) a dozen banks are competing for (say) six bookrunner spots, each of them should be willing to do (say) $166 million worth of work to win a $167 million payday. Perhaps Saudi Aramco's managers are less cynical and more relationship-driven than that -- "Likely winners include J.P. Morgan Chase & Co., which appears set to cash in on an eight-decade relationship with the country" -- but if I were in their position I'd be riding around on a golden throne carried by senior investment bankers. It is fun to be the client.

Though the other thing about this deal is, it seems ... hard? A $150 billion initial public offering would be by far the biggest ever; Bloomberg's league tables show about $176 billion in total global equity offerings so far in 2016. And if Saudi Arabia is selling oil shares, who is buying? "There is no guarantee there will be sufficient demand from investors to soak up all the shares," and messing this one up would be many times more embarrassing than messing up, say, the Facebook IPO. If I were Aramco I'd be focused on picking bankers with a good plan to execute the deal, not just bankers who lend the most. But I'd want them to lend too.

Average intelligence.

How smart did you have to be to manipulate Libor? I mean, judging by all the chats and e-mails, you certainly didn't need to know how to spell. I suppose there is a bit of math involved in computing the impact of a 1-basis-point change in Libor on the value of your interest rate swaps, but there are computers that will do that for you, and anyway the direction of the impact is usually pretty easy to figure out. Also the Libor manipulation itself is just writing down a number that is lower than a different number that you could have written down. Anyway:

The lawyer for former Barclays Plc trader Jonathan Mathew said his client only had “average intelligence" and asked jurors to separate him from better educated co-defendants accused of manipulating benchmark rates.

“Truth be told, Jonathan Mathew is no mathematical genius, he’s not a brilliant man, nor was he cherry picked by Barclays" from a premier school, the lawyer, Bill Clegg, said in his closing argument Thursday in London.

Mathew was previously in the news when he "testified at trial that he was routinely humiliated in front of his colleagues," including by "being hit on the back of the head with a 12-inch baseball bat, shouted at and forced to stand on a chair in the trading room to answer a quiz on world capitals." It's a bit rough that now he's being humiliated by his lawyer. 

Elsewhere in criminal enforcement, here is Michelle Celarier on Michael Kimelman, who spent 15 months in prison as part of Preet Bharara's big and now-somewhat-undermined crackdown on insider trading. Under modern insider trading law after the Second Circuit's Newman decision, Kimelman probably wasn't guilty of insider trading. But the decision came too late for him: "Of the dozen or more people whose guilt was called into question in the wake of that ruling, Kimelman is the only one to do time—and the only one whose conviction still stands." He's trying to get it overturned, though that seems like a bit of an uphill battle. 

People are worried about covered interest parity.

I mean, don't hold your breath for this as a recurring heading, but it is filling in for swap spreads today. Here is Hyun Song Shin at a World Bank conference this week:

There is an intriguing market anomaly in the foreign exchange market right now: the widespread failure of covered interest parity. Covered interest parity, or “CIP” for short, is the proposition that interest rates implicit in foreign exchange markets should be consistent with market interest rates.  

Before 2008, CIP held as an empirical regularity with very few exceptions worth mentioning. As an academic, I used to tell my students that CIP is about the only relationship that can be relied upon in international finance. I know better than to say this now. Textbooks still say that CIP holds, but it is no longer true.

Shin tells a macroeconomic story for why the short-term dollar interest rates implied by foreign exchange swaps now tend to be higher than Libor:

The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit. During the period of dollar weakness, global banks were able to supply hedging services to institutional investors at reasonable cost, as cross-border dollar credit was growing strongly and easily obtained. However, as the dollar strengthens, the banking sector finds it more challenging to roll over the dollar credit previously supplied.

But there is also a bank-risk-capacity story:

In textbook settings where someone could borrow and lend without limit at prevailing market interest rates, the cross-currency basis could not deviate from zero, at least not by much, and not for too long. This is because someone could borrow at the cheaper dollar interest rate and lend out at the higher dollar interest rate. However, executing such a trade entails a sequence of transactions, often through intermediaries. As such, it makes demands on the risk-taking capacity of dealer banks as well as counterparties.

More broadly, we might say: People are worried that the financial system no longer provides the conditions for no-arbitrage financial arguments to work. That is, the price of Thing X and Equivalent Thing Y should always be the same, because if they're not, you can buy Thing X and sell Equivalent Thing Y and obtain a risk-free profit. That's the foundation of most of modern financial thought, but it relies on liquid markets and easy leverage, and those conditions are no longer universally available. Swap spreads are one example of an apparent arbitrage going unplucked; covered interest parity is another. (In other places, by the way, those conditions are truer than ever; modern electronic trading makes sure that S&P 500 futures, S&P 500 exchange-traded funds, and the underlying S&P 500 stocks all move very closely together.) As banks, for regulatory and other reasons, get less interested in taking counterparty risk and providing lots of leverage, some of the mechanics of modern finance are breaking down a bit. Anyway here are Izabella Kaminska and Bloomberg's Matthew Boesler on Shin's speech.

People are worried about unicorns.

People are apparently so worried about Theranos, the Blood Unicorn (Elasmotherium haimatos), that there will be a movie about it made by Adam McKay and starring Jennifer Lawrence. On the evidence of McKay's "The Big Short," I assume the movie will play things relatively straight, which means that there is still an opening for someone to take some liberties and turn Theranos (or Thanatos) into a vampire thriller/comedy. I want to see a movie where Theranos/Thanatos is using the blood it takes, not to run possibly unreliable diagnostic tests, but to feed an army of vampires in turtlenecks, and where it is brought to its knees not by intrepid investigative reporting but by an army of werewolves. 

But the wonderful thing about the Enchanted Forest is that the truth is generally funnier than the fiction. Here is a story about "Silicon Valley" -- the television show -- that includes this anecdote about a meeting between the show's writers (including Carrie Kemper) and Astro Teller, the head of GoogleX:

Teller ended the meeting by standing up in a huff, but his attempt at a dramatic exit was marred by the fact that he was wearing Rollerblades. He wobbled to the door in silence. “Then there was this awkward moment of him fumbling with his I.D. badge, trying to get the door to open,” Kemper said. “It felt like it lasted an hour. We were all trying not to laugh. Even while it was happening, I knew we were all thinking the same thing: Can we use this?” In the end, the joke was deemed “too hacky to use on the show.”

The writers get advice from a lot of people, including former Twitter CEO Dick Costolo, and I was pleased to see that they share my belief that the most important factor in modern capitalism is seating charts:

Every Monday morning for three and a half months, Costolo flew from San Francisco to L.A., took an Uber to Culver City, dropped his overnight bag at a nearby hotel, and spent Monday and Tuesday in the writer’s room. Berg, Judge, and ten writers peppered him with questions, both narrow and existential. Where would the most powerful person in a boardroom sit?

I assume that's the existential one. Elsewhere, venture-capital pioneer Tom Perkins died. Uber -- or rather its UberPop service -- is apparently illegal in France. But now you'll be able to schedule an Uber. "These 12 drink recipes reimagine iconic technology companies as lavish speakeasy cocktails." And here's the story of a blood-testing startup run by a 27-year-old that just raised a $5.5 million seed round, if you can still get excited about that sort of thing.

People are worried about bond market liquidity.

Here is the Bank of Canada's June 2016 Financial System Review, which features two staff reports, one of which is on "Securities Financing and Bond Market Liquidity."

The nature of the link between the securities-financing market and bond market liquidity is likely changing as a result of financial sector reforms and the low interest rate environment. The development of the repo central counterparty in Canada and the implementation of the Basel III regulatory framework are changing the incentives for conducting specific types of securitiesfinancing transactions. For example, the new liquidity requirements provide more incentive to conduct longer-maturity transactions. The current low level of the overnight interest rate also diminishes the incentives for timely settlement of securities-financing transactions.

Elsewhere: "Bond Yields Around the World Fall to Records on Growth Outlook." And: "Foreign buyers snap up lowly-rated US corporate debt." And Bill Gross tweeted something about a supernova of negative-yielding bonds.

Miscellaneous nonsense.

The other day I briefly mentioned the coming Martin Shkreli Broadway musical parody. Here is more from the Wall Street Journal, Fortune, YahooVanity Fair, Rolling Stone and Pitchfork. And here, somehow, is a musical parody of the Shkreli musical parody (a parody-squared?), by Jason O. Gilbert at Fusion:

I am the very model of a Market-Moving Pharma Bro,
I’m crushing it on Tinder, and I don’t believe in karma so
I’m buying up a Wu-Tang album for a pretty penny, see
And then I’m getting drunk as ----- on quite expensive Hennessey,

Et cetera. It's pretty good. It might be all the Shkreli musical parody I need. 

Elsewhere, here is a story about Donald Trump and American CEOs that is also a story about how transatlantic networking associations of C-suite executives throw terrible parties:

At a London awards ceremony she attended in May hosted by BritishAmerican Business, a transatlantic networking association of C-suite executives, she was asked to “explain Donald Trump.”

“I said neither candidate is particularly representative of the U.S.,’’ she recalled, referring to Trump and Clinton. “There was laughter -- you know, guffaws. Kind of like when you share an inside joke.”

Wait I don't get it. What was the joke?

Things happen.

Yahoo has received multiple bids at or above $5 billion for core business. LendingClub Held Talks on Funding Deals With Och-Ziff, Soros, Third Point. How a 143-Year-Old Swiss Bank Took a Quick Road to Ruin in Asia. Blackstone Turns to Investment Banking Model to Court the Rich. Venezuela keeps paying its debts. Poland vows to end free market approach despite economic gains. "The fact is that, on balance, Wall Street hasn’t created value in the past and won’t create value in the future," writes John Bogle. Viacom Has Few Options for Fighting National Amusements. Citigroup Calls Guy Hands’ Testimony in EMI Trial ‘Confused.’ Carl Icahn: Bill Ackman is 'dead wrong' on Herbalife. Burger King’s Shareholders Reject Pledge to Add Women to Board. We Studied 38 Incidents of CEO Bad Behavior and Measured Their Consequences. Boards Will Never Be Any Good at Policing Executives. How's Zimbabwean monetary policy going? Starbucks has more customer money on cards than many banks have in deposits. Zero-G espresso. "Today’s strip clubs are increasingly set up to manufacture a fantasy of class and belonging: the chance to be the kind of person who can command eroticized attention at the other end of a stack of bills in view of a contingent of bro-buddies swirling overpriced single malts so they can secret-text each other about it later." Seagull tikka masala. Runaway capybaras.

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net