Wall Street Still Doesn't Get It

By: Reggie Middleton | Wed, Apr 16, 2008
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From WSJ.com:

Some 10 months after the mortgage hurricane made landfall, Merrill Lynch & Co. is still trying to dig out.

On Thursday Merrill will report $6 billion to $8 billion in new write-downs, according to a person familiar with the matter. The latest would bring its total since October to more than $30 billion and mean that Merrill reports a third straight quarterly net loss, the longest losing streak in its 94-year history.

New chief executive John Thain has said that, having recently raised $12.8 billion in fresh capital, Merrill won't need to seek more in the foreseeable future. Mr. Thain has increased the importance of weekly risk-management meetings by requiring the heads of trading businesses to attend and by having the top risk managers report directly to him. Since taking over in December, he also has reduced executives' incentive to swing for the fences by tying more of their pay to the firm's overall results and less to how businesses do individually.

Yet as of year end, Merrill still appeared to be taking large risks. Its "leverage ratio" -- how many times assets exceed equity -- stood at 31.9 to 1, higher than most other Wall Street firms. Heavy borrowing like this magnifies both profits and losses.

This does not solve the problem, it just incentivizes star employees to jump ship when they overperform yet have their bonuses dragged down by those that don't. What you need to do is give them what they want. If everybody wants mini-fiefdoms, then they get it - all of it. Producers, bankers and traders should be individually responsible for risk AND reward. Currently, they get paid only for the rewards they produce, and the shareholder gets stuck holding the bag of risk - with most of the reward stripped out in the form of overly generous compensation.

In my entrepenerial financial pursuits, not only do I not have a regular and reliable salary, but I am fully responsible for risk and reward. Although I still take significant risks for a living, they are in no way (and never will be) outsized in relation to the commensurate reward. As a matter of fact, I won't even take a risk if the reward doesn't outstrip the risk. The risks that I take may seem large to the untrained eye, but they are actually small when taking the whole pie into consideration. The extreme volalitility that I faced head on with large directional bets are an example of such. I was short certain sectors of the market, and as volatility spiked, trash companies rallied hard and short covering ramped up I sold shorts and/or bought puts into these rallies. This resulted in my account showing much more volatility than the broad market averages and mutual or hedge fund indices, but at the end of the day the resultant profit easily outstrips all indices and averages by several multiples - even according to all of applicable risk adjusted measures. A quick perusal of my blog should confirm this in an indirect way.

I am able to discpline myself in the gorging of volatility and market risk because I am responsible for my own losses and have no one to lay them off on. If the bankers, traders, and sales persons of Wall Street had the same responsibilities, I am sure the genius in them will be able to produce similar results. If you read the entire article linked above, it appears to be spotted with many "managers" who were not compensated with risk adjusted return, just with return. Thus they pushed for imprudent risks. This is not the way to do it. Be entrepenurial.

Hey, Merrill, this individual investor is available for consulting if you need him.

 


 

Reggie Middleton

Author: Reggie Middleton

Reggie Middleton
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Reggie Middleton

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Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

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