Why Goldman
Always Wins
by Megan McArdle
of the Atlantic magazine
IN THE SUMMER
of 2000, David Poor, a direct descendant of a founder of Standard & Poor’s,
flew me to his family’s Nantucket home on a private jet.
I am sure he
will not remember having done so. At the time, he was the head of Merrill
Lynch’s technology investment-banking group, and I was a summer associate
serving out my internship in his department. The only time I got more than
a glimpse of him was during that Nantucket weekend, when we larval M.B.A.s
tried to impress the boss with the panache with which we donned ugly chintz
sundresses or crisp new Nantucket Reds. Bunked at his mother’s “cottage”
with the few other women in the group, I spent the weekend gingerly sipping
gin-and-tonics and trying to fade into the couch.
Weeks after
this WASPish ordeal, I remained puzzled by it. Why were David Poor, and presumably
Merrill Lynch, spending so much money on us? We were all fine Americans, I
am sure, and attended top business schools. But that summer, and every summer,
tens of thousands of young M.B.A.s would have slaved away happily in Merrill
Lynch’s beige corridors without being wined and dined. If Merrill had
lost a few of us to JP Morgan or Goldman Sachs, we could have been effortlessly
replaced. Yet the company was not only treating us to trips and fancy dinners,
but also paying us $25,000 for 10 weeks of work.
I use the word
work somewhat loosely. My summer-associate class had been flown in for orientation
the previous spring, only to spend the day in the lobby of the training room,
watching the NASDAQ plunge 300 points. By the time we reported for duty in
mid-June, the tech-heavy index had lost about 1,300 points from its March
peak of 5,132. Before the crash, eager recruiters had told us that Merrill
Lynch’s bankers would be okay no matter what; in the bull market, they
had done initial public offerings, or IPOs, and in a bear market, they would
do mergers and acquisitions and stock repurchases instead. This prognosis
turned out to be as delusional as the Pets.com prospectus. The office was
a well-upholstered tomb. We spent most of our days — and nights —
performing a kind of kabuki, pretending to do work for bosses who must have
known that they had no work for us to do. Yet still the dinners, the trips,
and the lavish paychecks continued.
Why? The question
was resolved for me during an August cocktail hour at P. J. Clarke’s,
the financial district’s version of a meat market. There another associate
pointed out, a trifle owlishly, the explanation: “Seven percent.”
That was where
a new analysis had pegged the average “gross spread,” or fees, on
an IPO, which was the only kind of live deal I had worked that summer. To
be sure, Merrill Lynch was splitting those fees with other banks. But when
offerings ran into the hundreds of millions of dollars, as they easily did,
a few percent was a lot of money. Sure, a competent bookkeeper or legal secretary
could have done most of our work. But in the banks’ fees, our salaries
were a rounding error.
Still, why not
compete down our salaries, if they could? I’m sure that if David Poor
and his fellow managers had hired M.B.A.s from Georgetown and Notre Dame instead
of Harvard and Chicago, they could have found something to do with the money
saved.
These days,
that question seems more pertinent, and more mysterious, than ever. With laid-off
bankers flooding the job market, you would think that salaries in finance
at long last would come down. But even a coven of angry Congress members seems
to have had only a limited effect on what the financial industry is willing
to pay its employees. Hearings and diatribes have succeeded merely in forcing
firms to pay more compensation as salaries rather than as bonuses — as
if the main issue with lavish paydays at bailed-out banks were the timing
of the checks.
To understand
why banker pay seems so persistently outlandish, consider another industry
that skims off the top of a vast well of cash: the business of making movie
trailers.
Unless you’re
deaf, or have been living in an ashram for the past four decades, you’ve
heard the voice of Don LaFontaine, known in the trailer industry as “the
voice of God.” LaFontaine’s gravelly baritone popularized the phrase
In a world where … and seduced us into movie after movie, from Dr. Strangelove
to The Simpsons Movie. When he died last year, at the age of 68, one obituary
reported that at his peak, LaFontaine was making $30 million a year voicing
trailers and commercials.
That’s
quite a wage, especially when you break it down to an hourly rate. Over a
long career, LaFontaine voiced more than 5,000 trailers and hundreds of thousands
of commercial spots. But top voice-over artists frequently work out of their
homes and record the spots, which usually run about two minutes, in no more
than five takes. It’s one thing to pay Tom Cruise $25 million per movie;
he makes perhaps one movie a year, to which he brings his built-in fan base.
But no guy asks a date if she’d like to go see the new Don LaFontaine
trailer.
Nonetheless,
trailers have grown into a nearly $100 million industry, whose companies continue
to give work to a coterie of well-paid veterans, rather than bidding jobs
out to the legions of starving actors haunting the streets of L.A. And if
you look at the economics of the movie industry, this behavior starts to make
sense.
Don LaFontaine’s
40-year career began as the old Hollywood studio system breathed its last.
The forces that killed the studio cartel also smashed the monopoly of the
National Screen Service, which had produced virtually every movie trailer
for more than 40 years. In its wake, independent firms began competing for
the lucrative business, gradually supplanting those stilted spots you see
on Turner Classic Movies, where Bob Hope appears on the screen to tell you
how great his next picture is.
Over the years,
changes in the movie business conspired to make trailers and television ads
more and more important. First TV, then VHS, and finally DVD reduced the number
of times people went to see a movie in a theater. As a small child, I saw
Star Wars something like 17 times on its first run. But I’m hard-pressed
to name a single movie I’ve seen twice in theaters since graduating from
college.
Star Wars grossed
$1.5 million the first weekend it opened, in late May of 1977, and peaked
at $7.7 million the first weekend of September. By early December, it was
still earning more than a million a week. These days, it would already have
been out on DVD by then.
Because of piracy
and a highly competitive DVD market, films no longer have much time to build
an audience. They need to roar out of the gate, rake in piles of money for
a few weeks, and then retire to finish out the modern movie life cycle of
international releases, cable premieres, and DVD box sets. So the ads and
trailers need to drive novelty-hungry teenagers, the movie industry’s
ripest target audience, out to the theaters in droves. Heavy investment in
top-notch promotion may be why people like me call trailers their favorite
part of the movies. Even when studios don’t make a profit at the domestic
box office—as happens all too frequently—big box office helps to
sell the movie in foreign markets.
When a studio
spends tens of millions of dollars producing a film, and further tens of millions
advertising it, cheaping out on a voice-over makes no sense. You could pay
a Don LaFontaine successor $300,000 a spot and still eat up just a tiny percentage
of the film’s overall budget. A bad voice-over would cost you far more
than you could hope to save. When you have only one chance to get it right,
you tend to open up your wallet and pray. So one-shot deals are very, very
expensive — a logic that prevails with weddings, funerals, and college
diplomas.
That same logic
explains why clients have been willing to pay investment banks lavish fees
to do IPOs — and secondary offerings, and bond underwriting, and M&A,
and advisory work. The mystery of investment-banking fees is often framed
as a matter of banks rooking naive managers, or managers selling out their
shareholders in return for a space on Merrill Lynch’s private jet. But
the venture capitalists behind many of the IPOs aren’t neophytes at the
mercy of big-city bankers; both they and the firm’s managers depend on
a strong IPO, and a liquid aftermarket, to allow them to get some of their
money back out of the company. If they’re tolerating such large fees,
there must be a reason.
When the boutique
firm WR Hambrecht + Co persuaded Google to use an auction process for its
2004 IPO, there was a lot of talk about the end of traditional investment
banking. Five years later, however, firms like Goldman Sachs are as dominant
as ever, and auctions are rare. Google could rely on its own brand to sell
the stock and create a deep secondary market in which its employees could
exercise their stock options. But most companies need a little more help.
Although Goldman Sachs may not be a bargain, if you’re undertaking a
one-shot deal, you may want to pay more to hear the one thing a hungry upstart
can’t tell you: that the company knows how to handle an offering of size
and complexity, because it’s done so a bunch of times before.
Of course, underwriting
IPOs isn’t the only place where financial firms, or financial workers,
make their money. But the logic of the one-shot deal applies to the payment
of traders and many others. A moment of reckoning will come when the deal
either goes well, or does not; that moment is very hard to anticipate; and
if things go wrong, they can be very hard to fix. In those cases, even weak
signals of ability — like, say, an M.B.A. from a top school — command
huge premiums.
I didn’t
get a permanent offer from Merrill Lynch at the end of the summer; both the
firm and I recognized early on that I had no inner investment banker struggling
to get out. (Even in one-shot deals, a weak signal gets you only so far.)
Most of my classmates who did, toiled for a year or two and then were laid
off, or they left for a job that would allow them to occasionally see the
sun.
But the ones
who stayed in the financial industry have earned ever-huger sums, helping
to fuel another congressional obsession: America’s rising income inequality.
A growing body of evidence suggests that our grossly inflated financial sector
accounts for a substantial portion of the widening gap between rich and poor
over the past two decades. Even for someone as basically libertarian as I
am, that’s troubling. Financial markets are an extremely valuable contributor
to the economy. But they are not so valuable that they should have soaked
up most of the income growth of the past few decades.
As this article
went to press, Goldman Sachs had just announced record profits, and rumors
abounded of another banner year for banker pay. How much longer can this go
on? Every time another banker bonus is announced, Congress screams, and its
staffers look for some quasi-legal way of capping financial salaries. But
a recent paper by the economists Thomas Philippon and Ariell Reshef suggests
that when deregulation allows for a complex financial sector, particularly
in the arenas of IPOs and credit risk, the wages of financial workers will
remain severely inflated relative to workers in the rest of the economy.
Is it worth
tamping down complexity and risk to limit banker pay? Right now, the answer
seems obvious. But the tech and credit bubbles created as well as destroyed:
assuming that we manage to skirt an outright depression, we won’t necessarily
be better off in five or 10 years if we try to chase all the excess returns
out of the financial sector.
Unfortunately,
regulation itself is a one-shot deal — we won’t know until long
afterward whether we’ve done it right. Maybe Uncle Sam should spend less
time worrying about banker pay, and more time wooing prospective regulators
with fancy trips on private jets.
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