Decoupling Risk and Reward

"The Credit Crisis of 2008: Opportunity in the New Economy, Who’s Winning, Who’s Generous"

(written for the Spring 2009 edition of the APRA-UNY Chapter Newsletter)

Although much financial news these days is bad, we as fundraisers need to look ahead and adjust our strategy to deal with a new economic reality. This new reality challenges us to focus on discovering new sources of wealth as well as to place a greater emphasis on discovering who is most generous. In the future, where will the economy perform best? Where will the chase for high returns resume? Of those who are successful, who are the most generous?

DECOUPLING RISK AND REWARD
Before the subprime meltdown, the economy produced eye-popping incomes for many investors, investment managers and executives. Much of the outsized compensation earned by hedge fund and other investment managers over the last several years was the result of an unsustainable practice of chasing high upfront fees through securitizing both good and bad debt and passing off the risk to others, fueled and disguised by a housing bubble, and made possible by under-regulation and inaccurate ratings by credit ratings agencies. In 2000, after federal law made it legal to place side bets on securities under the Commodity Futures Modernization Act, investors, including investment banks, purchased huge numbers of credit default swaps, literally betting on the performance of the U.S. mortgage securities markets. In other words, investors placed bets by purchasing unregulated “swaps” (swapping “the risk of default with someone else” ) often on securities they didn’t own themselves, in a correlated market (where losses are not scattershot but come all at once, like in a flood or hurricane), with little capital set aside to cover losses. Ostensibly, this scheme of insuring against losses on securities created from mortgage debt was supposed to disperse risk and reduce the need for banks to hold capital to back their investments. In reality, selling insurance (bets, when buyers didn’t own what they were insuring) in a correlated market without capital to back up claims concentrated risk, just as bucket shops did at the beginning of the last century. This is what caused the financial panic and credit freeze. As the economist Joseph Stiglitz explains: “The problem is that, with this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else—or even of one’s own position. Not surprisingly, the credit markets froze.” According to voluntary reports there exist as much as $62 trillion worth of unregulated credit default swaps, and it is these side bets, not the subprime mortgages themselves, that have proved so destructive to the global economy. To put that figure in context, U.S. GDP in 2007 was about $14 trillion. When this giant casino, built on top of a Ponzi-pyramid scheme that used debts as assets, collapsed, the paper profits that much of the outsized compensation had been based on disappeared. It is unlikely (in the near future, at least) that such an extraordinarily high profit, high-compensation situation will recur—and we would not wish it to.

Financial planners will tell you that the higher the risk presented by an investment, the higher the potential financial reward. Conversely, if you want less risk, you have to settle for less reward. But that’s not how derivatives came to work over the years leading up to the economic collapse at the end of 2008. Derivatives were often specifically designed to separate risk from reward, allowing investment managers to reap huge rewards with very little risk to themselves. But decoupling risk from reward distorts decision-making, and there was little incentive for investors to be vigilant, and even so-called “smart” investors participated in investments that proved hugely destructive. Derivatives have been called “financial weapons of mass destruction,” an “unsupervised doomsday machine,” “the monster that ate the world economy,” and the investment banks who produced them “financial meth labs.” Some people, like William K. Black, Associate Professor of Economics and Law at the University of Missouri and former senior regulator during the S&L crisis, contend that financial services CEOs and investment managers on Wall Street knew this high fee- and bonus-creating scheme was fraudulent and unsustainable. Janet Tavakoli makes a persuasive case that investment managers “knew or should have known” that the financial products they were selling were over-priced and over-rated. Others believe the crisis was caused by incompetence. Whatever the explanation—corruption or incompetence or both— it is human nature to try to minimize risk and maximize reward. Disregard of this basic truth about people is the “flaw in the model . . . that defines how the world works” that Alan Greenspan had to rethink after the economic collapse in October 2008, and it is why we need regulation.

REGULATION AND COMPENSATION IN THE NEW ECONOMY
The US economy in the last thirty years became increasingly based in the financial services sector. Until around 1985 the financial services sector accounted for up to about 16 percent of corporate profits in the US. By 2008 the financial services sector accounted for 41 percent of corporate profits. Average compensation in the financial services sector grew from being comparable to that earned in other private industries thirty years ago, to almost twice as much by 2007. While financial products can help to create value, without an adequate legal framework to prevent excessive risk-taking, over-rated financial products can destroy value, and during the last several years the government failed to oversee this explosively growing sector of the economy. While it remains to be seen how governments will regulate the financial services sector in the future, they will certainly try to establish and enforce new rules designed to prevent systemic risk. Perhaps governments will regulate banks more like utilities, a policy advocated by Simon Johnson, who claims that a “tax on bigness,” meaning high capital requirements for large banks who engage in relatively risky investing, would prevent investment managers from passing on risk to others while reaping the rewards for themselves. Governments will likely establish rules to reduce the conflicts of interest between stockholders and managers and to realign incentives so that executive managers will be as serious about long term profitability as they are about short term stock prices. Because of this, it is unlikely that executive and investment managers will be able to negotiate hugely outsized salaries or bonuses that are not tied to real company performance.

The new administration intends to focus its recovery efforts and economic policy in general on what Obama calls a “post-bubble economic growth model.” Now that the prospect of hyper-profits in the financial services sector is diminished in relative terms, many investors, executives and entrepreneurs will go back to other economic sectors for returns—returns which will be modest compared to those available in a finance-based bubble economy. Not only is it likely that smart people and capital will go back to making things and providing services, but people who work for wages will likely see their incomes rise relative to that of those at the top of the income ladder. That is because productivity gains going forward will likely be more evenly distributed than they have been in the recent past, particularly if the new administration and the likely democratic majority going forward implement policies more favorable to the middle class and to people who work for wages, including making the tax code more equitable, making health care and education more accessible, and removing barriers to unionization.

A flatter distribution of wealth has implications for fundraising. A relatively better-off middle class presents an opportunity for fundraisers to implement strategies focused on increasing participation at all levels, while continuing to focus on securing the largest gifts. Even as major gifts are the mainstay of our fundraising activity, strategies to secure annual gifts from a larger pool of better-off donors can have a significant impact, not only in the present but also in terms of building the foundation for more giving in the future.

Cornell economics professor Robert Frank sees a similar potential upside to an economy that distributes wealth more evenly and grows more slowly than in the recent past. In the April 2009 issue of The American Prospect, Professor Frank argues that the rapidly rising incomes of top earners in the last several decades caused what he calls “expenditure cascades,” wherein hyper-wealthy people “spend most of their extra income on positional goods, things whose value depends heavily on how they compare with similar things bought by others.” This “shifts the frame of reference” for people with incomes just below those of the hyper-wealthy, and so on down the income ladder, until middle income people find prices escalating for necessities, like homes and cars. Professor Frank illustrates the wasteful nature of these “positional arms races” with the metaphor “in which everyone stands up to get a better view, yet no one sees any better than before.”

Overspending on positional goods is a problem because “the ability to achieve important goals often depends on relative spending. Because of the link between housing prices and neighborhood school quality, for example, the median family would have to send its children to below-average schools if it failed to match the spending of its peers on housing.” These “wasteful positional arms races” do not add to the happiness of those who buy more and bigger things (for example, single family homes, which are now on average about 50% larger than they were 30 years ago), but make everyone worse off, decreasing the resources available for other valuable things. If Professor Frank is right that “[m]any of the most spectacular increases in high-end consumption in recent years appear to have been driven almost entirely by positional forces,” and that a flatter distribution of wealth actually increases the resources available to more people since they don’t need to “keep pace with escalating consumption standards” that are brought about by the concentration of wealth at the top, then more people will not only feel better-off, they will actually be better-off, and may choose to direct the portion of their resources saved on over-priced homes and other necessities, to other things they value, like charitable causes.

SOURCES OF WEALTH IN THE NEW ECONOMY
Investment Managers and Investment Banks Goldman Sachs and Morgan Stanley are no longer investment banks but will become bank holding companies within two years. As bank holding companies they will no longer be able legally to take the kinds of risks—particularly the overuse of leverage—that contributed so much to the current financial crisis, and will therefore not be able to generate the outsized compensation that investment managers were used to receiving. Because investment managers at the large banks will receive less compensation than before, Frederick Lane of Lane, Berry & Co. International and Paul Miller of FBR Capital Markets predict a “brain drain” out of those more regulated banks. Mr. Lane says that “the smartest guys are going to go to more entrepreneurial environments where they can make the kind of money that they were making before at Goldman Sachs and Morgan Stanley.”

According to Alan Johnson of Johnson Associates, a New York compensation consultant who advises many financial firms, the pay structure of investment banks prior to the economic collapse, according to which investment bankers received relatively small salaries and large bonuses, encouraged inappropriate risk-taking. “Such a pay structure can create a stressful and chaotic environment within a company . . . ‘There is the possibility that people take risks just so they can earn a pay that they can live on,’ said Johnson.” According to Alexander Swirko-Godycki, “It’s not just about shifting from bonuses to salaries . . . The overall emphasis right now is on forcing people to take a longer-term perspective in the decisions they make, and also trying to change the culture to where behavior is much more risk-averse.” Johnson says that while “bonuses at Wall Street firms will fall about 20 percent from last year’s levels . . . salaries could double to cover some of that loss. A person making $250,000 in base pay last year could get paid as much as $600,000 this year.”

According to Martin Lipton of Wachtell, Lipton, Rosen & Katz, the “new financial order . . . will be dominated by large banks and filled with lots of smaller boutiques [investment firms]” —or or what Diane Swonk of Mesirow Financial calls “niche players.” Existing small boutique investment firms have not been as profitable as the now-defunct larger firms, but they also did not over-leverage and so “have cleaner balance sheets.” According to an article in the Wall Street Journal that begins with the phrase “The exodus has begun,” “[s]ome of the [Wall Street] refugees are seeking to join boutique firms, such as Evercore, Greenhill or Centerview Partners, while others are getting out of the game altogether.” Lee Fensterstock, who is chief executive of Broadpoint, “a Manhattan firm that has hired more than 240 people since fall 2007, when the financial crisis started taking root,” says that “[w]e would never have been able to do this five years ago, but now, it’s as if all of Wall Street got turned upside down, and they shook out all these people.” The same article reports that the big banks’ “new competitors have greater flexibility to attract talent with creative pay structures. With the public outcry over bonuses, some boutique firms are instead dangling hefty commission packages.”

What sort of work will be required in the finance services sector? According to Tara Weiss in “A Wall Streeter’s Guide to Finding a Job,” “Wall Street refugees will be able to put their deep experience to good use at finance jobs in the hot fields of health care, government and alternative energy. The bonus structure won't be as lucrative, but in many cases the hours won't be as punishing.”

Cornell Professor Victoria Averbukh, director of Cornell Financial Engineering Manhattan (CFEM), says that “[a]cross the financial industry, one theme has emerged more clearly than any other: a dire need for vigilant management of market risk.”

Recently the Wall Street Journal reported results of conversations with headhunters and bankers on “what the next good jobs are” for those leaving Wall Street. First, they report that investment bankers are keen on becoming executives at public companies, partly because the pay is good and partly because CEO and CFO positions give them the opportunity to be in charge. Another option is distressed investing where, after almost two years of low liquidity and few deals, insiders believe that “when the dam breaks…it will be massive.” Wall Streeters are also moving to small trading shops, where “merger advice is booming for many small boutiques that have nothing to do with markets” and where there is a “boom in the trading of commodity businesses, foreign currencies and government bonds, something that is bolstering smaller sales-and-trading operations like Libertas and Cantor Fitzgerald.” According to the WSJ, these “firms have higher profit margins than …the big Wall Street banks because their costs are lower.” And, finally, bankers who’ve left Wall Street or who have been let go are finding it easy to get interviews at the SEC, and are also eager to join start-up firms.

Entrepreneurs: Energy, Infrastructure, and the New President
One sector that will likely attract the most successful investors and entrepreneurs is alternative energy. Ted Nordhaus and Michael Shellenberger of American Environics report that the “prospects for serious public investment in our energy economy and infrastructure are better than they have been in a generation.” And while the financial crisis might force postponement of some planned investments in this area, President Obama sees energy as integral to economic recovery, as he explained in a Time magazine interview in October: “The biggest problem with our energy policy has been to lurch from crisis to trance . . . finding a new driver [to replace consumer spending and credit] of our economy is going to be critical…there is no better potential driver that pervades all aspects of our economy than a new energy economy.” A first step was taken toward this planned investment in a new energy economy in February, when the recovery legislation passed containing a “total amount of clean-energy spending . . . [ranging] between $50 billion and $140 billion, depending on how one counts the patchwork of direct public spending and private-sector initiatives.”

Regarding investment in energy, the executive search firm A.E. Feldman “says right now opportunities are opening up for investment professionals with expertise in energy and alternative technologies. The firm reports that right now across the country, the wealth of individuals and institutional investors getting involved in the energy and clean technology sector is enormously high. A growing number of law firms with close ties to the VC community and strong IP practices have jumped onto the green energy bandwagon. The firm also notes that legal jobs are opening up as firms build practice groups that target the clean tech sector.” Obama’s policy proposals favor renewable energy technologies—wind, solar, and geothermal—according to CNET. Some experts maintain that renewable energy conversion cannot be brought to scale without national-level efforts and it remains to be seen how the “green economy” initiative will play out, but this is an area to watch closely.

Hedge Funds
Hedge funds give very wealthy investors the opportunity to make more money on their investments than they could in a more regulated type of fund. They also present hedge fund managers with an opportunity to make more money than they could working for a firm subject to stricter regulations on fee structures. But hedge funds have taken a hit like everyone else. Alan Johnson of Johnson Associates, Inc. estimates that compensation at hedge funds will be about half that of the record levels of 2007. Alpha Magazine reports that “[a]verage pay at hedge funds was $774,000 in 2008, down from $940,000 a year earlier,” while Johnson says that figure is low. A recent Bloomberg article reports that “[a]bout 70 percent of the industry’s 6,800 so-called single-manager funds lost money in 2008 with the average fund dropping 19 percent . . . [t]hat means that most clients don’t have to pay performance fees—generally 20 percent of profits—until the losses are made up.” The article also reports that “[t]o recover losses from 2008 and resume charging performance fees, managers will have to post gains of 23 percent,” which the author estimates will take more than two years.

Keeping an eye on where successful hedge funds are investing can provide clues to which industry sectors and which companies are successful. One method for doing that is to monitor the SEC filings of a group of money-making hedge funds to see where these funds invest using the website http://www.j3sg.com/.

SNAP SHOTS OF WINNING INDUSTRIES
 IPOs
From November 2007 through November 2008, 105 companies went public. By November 2008, only 11 are trading above their initial offering price. The companies that went public during that year that were trading above their initial public offering price in November are mostly health care and medical supply companies (4 of 11), and also include child care and education (2), electronic payment (VISA) and telecommunications services (2), an industrial machinery and equipment distribution firm, a waste management firm, and an investment firm. This is a small sample but shows clearly the difficulty the economy is in right now. There have been only two IPOs filed and priced since November 2008, and both—Grand Canyon Education and Mead Johnson Nutrition—are trading above their initial offering price. Of IPOs issued in the last year, two others—CardioNet and Visa—are trading above their initial offering price. Clearly it is too soon to use the IPO market to gauge where the economy might be growing.

S&P 500
As for well-established public companies, the only firms in the Standard and Poor’s 500 that saw their stock rise in 2008—a mere eleven in all— include Family Dollar Tree, Rohm and Haas (plastic and rubber), UST, Barr Pharmaceuticals, Amgen, General Mills, Wal-Mart, Southwestern Energy, Celgene, Apollo Group (runs University of Phoenix), and Kroger.

Robert Froehlich, chief investment strategist for DWS Securities, the retail arm of Deutsche Bank, advises an investment strategy for 2009 he calls R.F.D.C.: Retailer's (Discount), Food, Drugs and Chemicals. “People will still shop, people will still eat, people will still pay for health care and cheap oil is profitable for chemical firms. But they aren't paying top dollar for this stuff if they can avoid it.”

WHO IS GENEROUS?
Bank of America released the results of a survey of high net-worth philanthropy in December 2007 called “Portraits of Donors.” The study revealed that entrepreneurs in 2005 gave more than double the amount to charitable causes than those whose wealth came from inheritance, the second highest givers. Entrepreneurs also gave more to educational organizations than their wealthy peers. In 2005 almost one quarter of entrepreneurs’ giving went to education. Entrepreneurs also “gave more on average to environmental and international groups than their peers.”

Another study of philanthropy by Northern Trust in 2007, “Wealth in America,” revealed that “Generation-X millionaires (aged 28 to 42) gave an average of $20,000 to worthy causes in 2006, double the size of giving by their parents and grandparents.” Though this study does not report on what proportion of young donors’ giving went to higher education versus other causes in 2006, it suggests that a more intensive focus on this younger generation of prospective donors could pay off.

The Bill and Melinda Gates Foundation co-funded a study of wealthy Americans, called “The Joys and Dilemmas of Wealth,” which is being conducted by Boston College’s Center on Wealth and Philanthropy. The results, scheduled for release in 2009, could shed more light on the philanthropic behavior of high net-worth households.

Thanks to Allen Ward, Research Administrative Assistant, Cornell University, for research help.