The end of the BSD.

Commentary about business and finance.
Sept. 25 2008 6:18 PM

The End of the BSD

A Wall Street icon falls.

Read more about Wall Street's ongoing crisis. 

Illustration by Charlie Powell. Click image to expand.

In New York, happiest among the financial alpha males is the big swinging dick. The term entered the lingua franca via Michael Lewis' Liar's Poker. (Relevant quote: "If he could make millions of dollars come out of those phones, he became that most revered of all species: a Big Swinging Dick.") BSDs are the perennial winners of the game of conspicuous earnings (giant bonuses), conspicuous consumption (giant co-ops and summer homes), and conspicuous philanthropy (giant plaques on public edifices). In recent years, with the explosion of wealth triggered by the credit and housing boom, a large number of BSDs were minted by the Holy Trinity: hedge funds, private equity, and investment banking.

Players in these arenas had clearly succeeded in the most difficult and competitive of environments. But these industries were all easy-money businesses—great, sexy, and wonderful to be in when credit is plentiful and cheap but considerably tougher when the lending climate turns nasty. The dirty little secret of the late boom? Many of the people who succeeded most flagrantly did so not because they were great at figuring out ways to make huge amounts of money. Rather, they scored because they were great at figuring out ways to make small amounts of money and then magnified their returns through the massive use of debt. But now the credit crunch and a new market and regulatory climate are turning BSDs into NSBSDs (not such big swinging dicks).

Hedge funds thrived on the use of debt. Find a stock that's doing well in a bull market, borrow money to buy it, reap outsized returns when it rises, and keep 20 percent of the returns. Investment banks eager for stock-trading commissions were keen to provide the liquidity. Today, not so much. Hedge funds were willing to use leverage in part because they hedged; they sold stocks short to protect themselves from being wiped out if the market moved down. But as part of an effort to protect the CEOs of financial institutions from their fellow BSDs at hedge funds, the Securities and Exchange Commission this week issued an order banning the short selling of several hundred financial stocks. As a result, many hedge funds are pulling in their horns and running for safety. As the Financial Times reported Thursday: "Citigroup estimates that hedge funds have now placed $600bn in cash, and that $100bn of this is held in money market funds." The BSDs are investing like grannies who survived the Great Depression. Riding out the storm by parking assets in cash is a smart strategy for a hedge fund that has already scored big gains for the year. But most hedge funds haven't. Earlier this week, it was reported that, globally speaking, only one in 10 hedge funds is earning performance fees—i.e., the 20 percent of the fund's gains that the managers keep as compensation. Performance fees are what make hedgies BSDs. (What's 20 percent of nothing? Zero.) Fortress Investment Group, one of the few publicly held hedge funds, just canceled its dividend for the third quarter.

Private equity firms, which have a compensation structure similar to that of hedge funds, have also seen their returns wilt. During the boom, private equity firms could rack up big gains by buying a company with little or no money down, and then having the company issue debt to pay the new owners a healthy dividend. (They called it investing.) Or they could profit by selling it to other private equity firms or by selling shares to the public. Just as homebuyers now must make larger down payments, private equity firms in the post-credit-boom era have to pony up more cash to buy firms. Issuing bonds to pay dividends is passé, and the market for IPOs is limp. The slim list of recent IPOs is heavy on Asian firms. The upshot: Private equity firms are having difficulty consummating exit transactions. In the second quarter, Blackstone reported that performance fees were actually negative, compared with $453 million in the second quarter of 2007.

Investment banks have suffered a triple whammy. Many of the biggest of the BSDs, like former Lehman Bros. CEO Richard Fuld and former Bear Stearns CEO Jimmy Cayne, have seen their massive fortunes evaporate as their stocks plummeted. Thousands of lower-level BSDs have suffered alongside them. (Check out Gabriel Sherman's New York piece on the lament of a former Lehman Bros. $3 million man.) And there's not much hope for the near future. Investment banks funded themselves through the capital markets, which meant they could rack up as much leverage as the market would permit—up to 25 or 30 times the amount of capital. Higher leverage means greater returns when you have a good idea and the climate is forgiving (viz. 2002-06). But it's a killer when the weather turns nasty (viz. 2008). At some investment banks, bonuses this year will be slim to nonexistent. Earlier this week, Goldman Sachs and Morgan Stanley, seeking more stability, received permission to transform themselves into commercial banks. They can now accept deposits and enjoy regular access to credit from the Federal Reserve. In return, they'll have to submit to more regulation and use much less debt in their operations. For decades, investment bankers looked down on commercial bankers—with their shorter hours and lower profits and salaries—as nerds, putt-putting along in Oldsmobiles while the I-bankers drove Ferraris. But now investment banks will have to operate less like hedge funds and more like the First National Bank of Podunk, with commensurate changes in compensation.

Among investment banks, Goldman Sachs was the ultimate big swinging dick, the firm that could do no wrong, that was more profitable than anybody else, that was just better. But this week, Goldman, needing cash, turned to Warren Buffett, the biggest of the BSDs. He agreed to help but extracted pretty onerous terms: 10 percent annual interest rate plus an equity kicker. In other words, Goldman is paying a double-digit interest rate and giving up a piece of the house in exchange for a measly few billion dollars. Goldman Sachs CEO Lloyd Blankfein, lord of the BSDs, is now a subprime borrower.

Daniel Gross is a longtime Slate contributor. His most recent book is Better, Stronger, Faster. Follow him on Twitter.