Posted tagged ‘investment’

Build an Investment Bank: Technology

July 17, 2008

(As the first in this series, I’m trying to use construction terms to “build” our investment bank… we’ll see if it adds or detracts.)

The Foundation

As we begin our journey to build our very own investment bank, I’m going to make a few statements that people “in the know” will find both surprising and, in hindsight, very obvious. The topic, as the title states, is technology. Now, here are the statements:

  1. A major contributing factor to the way banks did business, especially in the businesses that contributed the most to banks’ current  problems, was their lack of technology.
  2. Credit default swaps, in all their glory, had most of their issues rooted in technological inadequacies at various institutions.
  3. A large portion of the cost structures at investment banks are due to a lack of technological heft.

I know, these seem outrageous. However, as anyone who has worked at a few different firms will tell you, there is a massive difference between a firm with good technology and bad technology. Let me tell you a simple anecdote: When very senior executives at a firm called down to the managers in charge of securitized products, they asked for the current marks and a summary of the various exposures “on the books.” It took about ten people three days to cull through all the various positions, put marks on them, model them, and put a concrete value on them. There wasn’t time to break down exposures by anything but the most trivial categories. Now, why this end product was acceptable is a different issue, but it should be clear that an effort of this magnitude shouldn’t be necessary to answer questions so totally basic in the context of running a multi-billion-dollar (although now with fewer billions) financial institution. A corollary: If it takes you several days to enumerate the positions your area has, you don’t know what it is yourself.

Now, when I speak of technology, I’m really speaking of the specialized systems and solutions used to tackle business issues, and not really the “desktop support” kind of technology. The systems that manage risk and positions, handle accounting, maintain an integrated analytics platform, deliver research and other products internally and externally, manage the human resource functions of the firm, and otherwise grease the wheels of capitalism.

The Blueprint

Our technology plan will have a few different components…

Structural Frame 1: Whether our theoretical investment bank is a startup or an established entity, the technology at the core will be home grown.

Structural Notes: Hiring consultants to stitch together purchased solutions and legacy systems is unacceptable. Technology, in order to be most effective, needs to be responsive. When a trading desk needs to run its business, and the system provided is insufficient, then it’s an unacceptable solution, and things will be done manually. Remember synthetic CDOs? Remember the ABX and credit default swaps on sub-prime bonds? Would it surprise you to know that at many major investment banks there was a manual component involved with every single contract and trade? The systems weren’t able to handle these instruments, and these businesses scaled up at a rate that was untenable. Also, there were no analytics available for these products. Businesses bought third party solutions for modeling and analytics, but those didn’t integrate or scale, so all the marks and risk numbers used to compute capital needs and P&L were merely estimates as these businesses were growing the most.

Let that sink in. Is it any wonder the senior managers didn’t know, before it was too late, what the actual exposures were? Had these firms built an integrated set of systems instead of buying a patchwork of specialized programs to solve the most current problem, these issues would not have been nearly as bad. I won’t even tell, in detail, the story about how, years ago, the system for trading credit default swaps at one bank was so difficult to use that they only created one identifier for GM and GMAC, not distinguishing between the two at all. But, when they were both on the brink of being downgraded to junk, but GMAC was de-coupled from GM, I wonder what kind of fun it was to rummage through 5- to 8-year-old confirms trying to match thousands and thousands of trades with the exact entity? Costly? Absolutely. Avoidable? Double absolutely.

On another note, an investment bank need not be innovative, but if it isn’t, then it should be able to mimic innovations quickly. Reporting to management, having an accurate record of transactions and various changes to the firm’s balance sheet, the ability to run various analyses on various products, and other, more basic, reporting functions (not even mentioning compliance and regulatory functionality) are all things that should be implementable once something new hits, and the only way to make these kinds of incremental changes is to build, not buy. A business as complex as an investment bank shouldn’t be reliant on outside parties to build software vital to their business–both from a cost standpoint and from a delay-until-completion standpoint. Further, the procurement process takes months!

Structural Frame 2: The technology part of the organization will not be a monolithic standalone bureaucracy.

Structural Notes: Simply put, technology (the people or business unit) needs to be vested in the process of making a business more profitable. Rather than taking on the normal support role mentality of, “If I say ‘yes’ then I might be wrong and held accountable, so I will say ‘no.'” The best way to do this is to not have technology be its own portion of the organization. Allowing technology to have a seperate seat at the table–or, worse, report into some catchall support person–only contributes to creating a centralized process for technology decisions. Centralizing technology decisions for many businesses with different needs creates unnecessary layering and wedges a huge management structure between the people doing the actual work and the people who are using the product and paying for it.

The final plan, I believe, would be to have as many technology people as possible integrated into the physical workspace of the people that utilize their work. Have investment banking developers sitting amongst investment bankers. Have the developers that build trading applications sitting with traders. The reporting structure should be a matrix of sorts–senior technology managers should report into a business whose technology needs are distinct from other businesses (atomic, perhaps is a better word) as well as a more senior technology person. In essence, people working in technology would be ingrained with the thought that they are there to help–the business unit would be setup as the client and the technology super-structure would be more for managing the processes. Obviously when the business is viewed as the client, technology managers are incentivized to get the businesses what they want, and when the people (both doing the work and in charge of liaising with the clients/business) are integrated (and can see the working environment of their clients and usage of their products) a lot of inefficiency and “lost in translation” moments are avoided. Senior managers really need to think of their business as including technology instead of interacting with it. This is highly important and is much more likely with a structure like I’ve proposed. Also, the closeness will just yield some more technologically savvy people and even encourage people to move between the two “worlds.”

Structural Frame 3: The people who are hired for technology roles will be of a high caliber and will be under a compensation regime and in an environment that sets big technology companies to shame.

Structural Notes: This shouldn’t be a hard line of reasoning to follow, but in general the difference between firms that “get it” and firms that don’t is how they recruit. Having an engineering background, I was recruited for I.T. from a very good school for that sort of thing by a few banks. Those banks have a high correlation to both still being around and surviving the mortgage mess with the smallest scathing in their peer group. I know several people who have told me that some other firms, one that haven’t been so lucky, have absolutely ridiculous and incredibly stupid policies for recruiting technology people. Most notably, one Manhattan firm recruits from local state schools almost exclusively–this is done so that the students they recruit can work part time during their senior year of college. No school in the top fifty or so participates. If one had to draw a grid, and rank various factors as to how important they are, the program I have just mentioned is the most ridiculous, stupid, and demonstrating a complete lack of critical thinking skills (or, for that matter, basic grasp of the business and reality) of the programs I have heard of or encountered. The people responsible for it have all moved on and the firm has suffered greatly from it’s underinvestment in technology.

So, to recruit good people you need a draw. To be honest, most graduates don’t fully grasp the concept of upside or career path–especially not ones in I.T. This makes it simple to get them, just offer a bigger number for the compensation in the first year. While this would work, it should be clear that this won’t help make them much more productive than the average technology drone in an investment bank. Giving technology employees a compensation structure that matches the businesses they are supporting is, in my view, a great solution. Obviously there would be more stability, but there should be a linking of incentives to the business and an interconnectedness in how they think about how technology and the problems facing the business. They should also have an incentive to be proactive and try to advocate solutions to problems they see instead of waiting for others to focus on them–this contributes greatly to becoming a nimble organization.

As for work environment, whenever possible, for groups not truly linked to a single business, like infrastructure groups and the web development team, my focus would be on building a start up-like atmosphere. The marginal cost of things like free coffee, free food, and some extra square footage for odd amenities is insignificant in relation to the quality of the work produced by the people snatched from places like Microsoft and Google versus a lower caliber of student culled from whatever lower-tier school(s) happens to be nearby. When you know your competition and what they offer that you do not, it’s very easy to compete: just offer what they offer. For things that aren’t as timely and linked to a knowing how a certain business runs, there is no problem in creating a lifestyle and work ethic that is free-form as long as it meets goals and needs of the firm. (Note: This isn’t my unique idea. A certain investment bank with a strong brand does this sort of thing already… but I did think of it before I knew that!)

Structural Frame 4: Technology, especially experimental or new technologies, should be used to try to create, or even drive, value.

Structural Notes: This is more a philosophy than an actual directive, but it’s important to taking a firm’s strategy on technology to the “next level.” There is a massive body of knowledge within a firm that is lost everyday due to a lack of effort. Usually the solution is to put humans somewhere and have them manually type in numbers or perform mundane tasks to get this working smoothly. Not in our investment bank! Let me furnish you with an example. The corporate bond market works in an unusual way: traders send around “runs” or lists of bonds with quotes of where they are willing to buy and sell bonds via Bloomberg’s messaging system–they are generally free form text. Why do they do it this way? It’s quick and easy. The firm I worked at didn’t make any effort to collect these pricing levels and store them somewhere. However, for publishing strategy reports, helping the desk find trade ideas based on historical relationships, calculating risk metrics, and any other number of things, this data would have been vital. Technology can easily help to store, warehouse, and serve these sorts of datasets (readily available from the market but unstructured) and help the organization as a whole improve its efficiency. This is just one example, but it serves to illustrate a point that is extremely common in an investment bank–lots of things require information that no one keeps but was readily available. Technology can drive value for lots of internal things by helping to solve problems like this. And, honestly, there are too many things that are out of one’s control not to have an organized and structured solution to the simple things that can be fixed.

Another note on technology, however, is that as the Web innovates social behaviors and collaboration those technologies should be actively examined as potential solutions to problems an investment bank would face. For example, lots and lots of information is needed when talking to a client. Getting good market “color” that everyone can see, and that is available, consistent, and easy to find is important. Perhaps a series of blogs could be used to ensure the delivery of this content is made as efficient as possible. One way I added value at my firm was by knowing as many people as possible. When liquidity started becoming an issue, the people I spoke to on the desk that funded banks in the LIBOR-based funding market explained what was the situation and we were able to assess if we thought this warranted a change in our positions or business in general. If that desk had a blog where they posted color throughout the day and the firm had an easy way to deliver this information to all of its employees, perhaps this could have helped people develop a more specific view on the market and notice some irregularities leading to the current crisis. Could Wikis be used effectively? I’m sure that they could. If it was institutionalized to have an up-to-date knowledge base within the firm, and it was made a priority to keep those things updated, nuances and details on complex transactions could be documented. People could avoid falling into the same traps or having to research the same issues other already have. These are just a few examples of how new technology innovations can be used to create value where it would otherwise be impossible.

Structural Frame 5: Every employee should be very comfortable with technology and make a large effort to integrate it into their work.

Structural Notes: I hate to sound like a snob, but in general, if you can’t figure out things like email and basic spreadsheets, you don’t have a lot of room left to grow. People should learn new technologies as they are available and make an effort to work more effectively. If this isn’t a priority of almost everyone in the firm, then building new systems and integrating things into their daily “workflow” is useless. Part of pushing the envelope on how new things are used means that people will have to learn how to use them. I’ve seen too many people, uncomfortable with a new system, resort to keeping their risk positions and other vital data the firm should know in a spreadsheet. Unacceptable. Now, not everyone has to “ooohhh” and “aaahhhh” over new features and technological platforms, but everyone should be asking themselves how they can use some new technology product to make more money, pitch more transactions, better monitor the firm’s risk, develop a better strategy for investing, or whatever their job entails. I don’t think this is hard, but I do think it’s important. And, with technology employees sitting with business people and understanding how they work day-to-day, the resources to figure out these sorts of things will be much more readily available than at most other firms. (See how the “structural frames” all interplay?)

The Final Inspection

As one can see, I value the little things that help people get 10-15% more productivity out of their daily routine–that’s the edge most firm’s need to excel in what they are focusing on. However, most firms poorly thought out systems and infrastructure issues, especially when it comes to technology, adds a hugely cost-ineffective layer of one-fix-at-a-time solutions that have added up. Why have a system where traders can input their own trades as they do them? Give them a paper record and hire a person, with full benefits and being paid an amount commensurate with living in New York City, to type them in. Oh, and now that the business has grown to three times to trading volume in six months, let’s hire four more people. Why have a system that allows a capital markets person to view real-time quotes in their sector or updates those quotes into a spreadsheet or presentation? Just have a bunch of analysts do it by hand. Why would you want a system that can model securitizations and CDOs and run the numbers effectively? We can have someone do it in a spreadsheet, that’s “close enough.” Although it doesn’t capture the nuanced risk factors, I’m sure defaults will never get high enough to worry about. These are the kind of solutions that, from the start, one should be thinking about. From the first instant it’s possible to fix these, they should be fixed. I think the five parts of the framework I’ve laid out will make a good plan to follow when building the technology part of our investment bank!

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Build an Investment Bank: Introduction

July 7, 2008

As I hinted before, I have been thinking about this for a while. This series is going to be about taking some discrete pieces of what makes a modern day investment bank, making a choice about how that part would be setup under DJT’s tyrannical rule, and stating the case for setting things up that way. Here are some example topics:

  • Risk management and organization surrounding risk management
  • Business mixes and core competencies
  • Management structure and other nuances of configuring management roles
  • Proprietary trading / risk taking
  • Technology
  • Operations and support roles
  • Ownership / corporate structure and other things (owned by a bank or not, for example)
  • Deciding on what, if any, presence in consumer markets should exist
  • Compensation
  • Culture and approach to H.R. and other people issues
  • Reviews and performance management
  • Anything else that comes to mind

I think that feedback on other areas or how to group these would be interesting to receive. The first one of these issues I think should be tackled is technology. It’s a topic I have thought a lot about and is extremely important in figuring out how day-to-day operations occur. I hope to have this up shortly. I have lots of skeletons of these entries written about, and more thoughts, so hopefully this series will have a lot of meat to it soon.

More Bear! (Part One)

May 28, 2008

Well, today begins the three part story of Bear Stearns, as told by the WSJ. Deal Journal has a great summary post … A few thoughts:

1. It struck me that Bear wasn’t able to see the forst through the trees when it came to it’s strategy, specifically demonstrated with the “Chaos” trade. When one thinks about how these sorts of things can play out, especially in unprecedented times, how the decision to unwind these trades came about makes perfect sense. Someone puts on a unique trade and management asks them to justify it. Well, there’s a slide with four or five bullet points explaining why this trade should work (mostly qualitative/anecdotal). Also, there there’s a chart presented that shows a pretty bad history for the trade if it had been put on in the past. Indeed we can examine Mr. Schwartz’s history with the trade to see this:

For some of the assets, the market was frozen, Mr. Schwartz reasoned, so selling was out of the question. On others, he had mixed feelings. He didn’t want to unload tens of billions of dollars worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.

The [hedge, called “the Chaos trade”] was a deeply pessimistic bet — essentially a method for making money if the mortgage and financial markets cratered. The traders bet that the ABX, a family of indexes made up of securities backed by subprime mortgages, would fall. They made similar moves on indexes tracking securities backed by commercial mortgages. Finally, they placed a series of bets that the stocks of major financial companies with exposure to mortgages … would decrease in value as well.

Faced with the fierce divide among his top executives, Mr. Schwartz, who was generally supportive of the chaos trade, decided to abandon it. He wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed. Frustrated, Mr. Marano ordered the trades undone.

(emphasis mine).

Now, everything until the last part follows naturally. The last part (matching your hedges to your positions one-to-one) is fine, until you realize that it’s impossible to do this in a liquidity-challenged market. Also, with a massive re-pricing of risk, due to liquidity constraints, one should take a broader view. The CDO market drove demand in securitized products generally and mortgages specifically. Inventories in loans and bonds were sitting on firm’s balance sheets while credit concerns were coming to fruition. So, firms can’t sell risky products, which are losing value from a fundamental re-pricing, and, also, the lack of buying (overall liquidity) is causing a further, more broad technical re-pricing. That is the subtle point from above–why bet on “financial markets cratering” if you own mortgages and call that a hedge? Well, given the widespread ownership of these products, their credit impairment caused widespread credit concerns. With credit worthiness in doubt, liquidity became scarce. Scarce liquidity means less available money to buy these products, and leads to a technical problem with markets and drives prices lower (lower demand … easy, right?). Clearly this requires a deeper understanding of how interconnected markets are and exactly how they work together–potentially a leap of faith or a layer of complexity a firm wasn’t willing to bet on.

There was, however, evidence markets were behaving this way. Spread product was moving in lock step (directionally). LCDX (index of loans, generally made to high yield companies) was moving wider, corporate bonds had a secular widening, and mortgage product was impossible to trade, commanding a larger and larger liquidity premium… Also, LIBOR was rising and banks were finding it harder and harder to borrow. But, instead of using relatively liquid indices and stocks to bet on these “second order” effects, Mr. Schwartz started asking for specific bets that offset highly illiquid positions. Good luck. To ask for relevant hedges is logical, follows from first principles, seems safer, and wasn’t executable–easy for risk managers and executives to demand and impossible to do, leaving the problems unsolved. Keep in mind, too, that the stock market hedges could easily be unwound in the event they failed to be correlated to the loans they were hedging. Would the “specific” hedges that would, themselves, be highly illiquid? No chance. CMBX and ABX have been known to trade in markets that are 5-10 points, or percentage of notional value, and that’s for small size (5-10 million dollars). To hedge the size here … well, I can’t imagine the costs.

Just to review: They had toxic positions, hedged them, and then removed the hedges, but (from what I can tell) didn’t sell the positions (while trying to one-to-one hedge the). There’s something to be said for taking the hit you know about today instead of trying to call a bottom.

2. Regulators were having calls, as regular as daily, with Bear. From the article:

Bear Stearns’s … risk officers were meeting in the sixth-floor executive offices with staffers from the Securities and Exchange Commission. The regulators had traveled from Washington to make sure Bear Stearns had access to the day-to-day loans it needed to fund its trading operation. After scrutinizing the firm’s $400 billion balance sheet well into the afternoon, the regulators agreed to reconvene with Bear Stearns managers for daily briefings until the market crisis passed.

Now, uness Bear is different from ever other financial institution, when it’s regulators come knocking it’s unusual–everyone walks more straight and takes much more care when dealing with them. The reason is simple: there’s nothing to be gained when a regulator is pleased, the best thing that can come from making regulators happy is avoiding the situation where said regulators are unhappy and consequences arise. I wonder if, ever, in the history of Bear, regulators called in to check on their situation daily. This should have been a major warning sign and left employees involved extremely uncomfortable as it was going on.

3. Many sophisticated investors walked away from a deal with Bear.

  • KKR walked away, and we never learn what their concerns were (Bear was focused on not crossing clients)
  • Allianz SE’s Pacific Investment Management Co. (PIMCO) had discussions with Bear that “fell apart”
  • Fortress discussed a merger with Bear (sounds similar to what I wrote about recently) that never went anywhere

Now, J.C. Flowers walked away because both sides had issues, so I don’t count them. Similarly, I don’t count the hiring of Lazard, and that effort failing to bearing fruit. I’m not sure why each of these potential transactions fizzled, but certainly it seems like a pattern that one can read into.

4. Two institutions with a major financial stake in Bear’s viability expressed concerns. One of these, PIMCO, unless I’m missing something glaring, had been in talks to acquire a stake in Bear and declined (second bullet point above). Maybe they knew something the rest of us didn’t, from their earlier talks and whatever due diligence they had performed? It would make sense, but would probably also be illegal. More likely? PIMCO was focused on Bear and extrapolated to the current market conditions. Perhaps, also, some unease exuded from the senior PIMCO ranks…

On a side note, what’s with the illustrations? Maybe this is going to be a chapter or section of a book? It reads that way almost… Newscorp swooping in to add a fresh (and awkward) feel to the WSJ? It was distracting to say the least. Of course Dealbreaker goes (almost scarily) deeper with this observation (as is their charge), and they have some amusing thoughts.

I can’t wait for part two!