This week, David Einhorn has been all over the news. We covered the news, but thought some of his old speeches/ideas before he was super famous would be of interest to readers. We found some material from 2007/08. If you have anything earlier we would LOVE to see it send us a tip. Here is the first one, a speech Einhorn made in 20008. We will be posting more. sign up for our free newsletter to ensure you do not miss any.
David Einhorn, “Private Profits and Socialized Risk”
Grant’s Spring Investment Conference
April 8, 2008
A few weeks ago the financial world was presented with the imminent failure of a publicly traded entity called Carlyle Capital Corporation. You see, it had leveraged itself more than thirty to one. The press scoffed about what kind of insanity this was. Who in their right mind would take on such leverage?
The fact was that the Carlyle portfolio consisted of government agency securities. Historically, after treasuries these have been among the safest securities around. Carlyle’s strategy was to take relatively safe securities that generate small returns and through the magic of leverage create medium returns. Given the historical safety of the instruments, Carlyle and its lenders judged thirty times leverage to be appropriate. One could look at the backward-looking volatility and come to the same conclusion. Of course, the world changed, and the models didn’t work. Carlyle’s investors lost most of their investment and the world, with normal 20-20 hindsight, has learned that investment companies with thirty times leverage are not safe.
It didn’t take long for investors to realize that the big investment banks sport similar leverage. In fact, the banks count things such as preferred stock and subordinated debt as equity for calculating leverage ratios. If those are excluded, the leverage to common equity is even higher than thirty times.
And I’ll tell you a little secret: These levered balance sheets hold some things that are dicier than government agency securities. They hold inventories of common stocks and bonds. They also have various loans that they hope to securitize. They have pieces of structured finance transactions. They have derivative exposures of staggering notional amounts and related counter-party risk. They have real estate. They have private equity. The investment banks claim that they are in the “moving” business rather than the “storage” business, but the very nature of some of the holdings suggests that this is not true. And they hold this stuff on tremendously levered balance sheets.
The first question to ask is, how did this happen? The answer is that the investment banks out maneuvered the watchdogs, as I will explain in detail in a moment. As a result, with no one watching, the managements of the investment banks did exactly what they were incentivized to do: maximize employee compensation. Investment banks pay out 50% of revenues as compensation. So, more leverage means more revenues, which means more compensation. In good times, once they pay out the compensation, overhead and taxes, only a fraction of the incremental revenues fall to the bottom line for shareholders. Shareholders get just enough so that the returns on equity are decent.
Considering the franchise value, the non-risk fee generating capabilities of the banks, and the levered investment result, in the good times the returns on equity should not be decent, they should be extraordinary. But they are not, because so much of the revenue goes to compensation. The banks have also done a wonderful job at public relations.
Everyone knows about the 20% incentive fees in the hedge fund and private equity industry. Nobody talks about the investment banks’ 50% structures, which have no highwater mark and actually are exceeded in difficult times in order to retain talent.
The second question is how do the investment banks justify such thin capitalization ratios? And the answer is, in part, by relying on flawed risk models, most notably Value-at-Risk or “VaR.” Value-at-Risk is an interesting concept. The idea is to tell how much a portfolio stands to make or lose 95% of the days or 99% of the days or what have you. Of course, if you are a risk manager, you should not be particularly concerned how much is at risk 95 or 99% of the time.