Thursday, October 4, 2007

A Tale of Two Cities: New York and Detroit (Wall Street Competitiveness)

A Tale of Two Cities: New York and Detroit (revised)

The other day I wrote about the recent UAW/GM contract negotiations, and some commentary about the outcome. The bottom line of my piece is that US autoworkers are being forced down the standard of living scale by a shift in power from labor to business, and the main argument used to support this shift is competition from the global economy. Whether this is actually the case remains unclear, but it is certainly the reason given by business and the media in general for the decline in US manufacturing job compensation in Detroit. (For more on that see my post.)

I was reading an article in The WSJ Online edition today regarding Sen. Jeff Sessions promotion of a bill favoring financial institutions over accepted intellectual property rights, and I was struck by the way the rules are changed when the “victim” is an industry with very strong ties to the rule makers. (Of course, we all know there was gambling at Rick’s, but at least it was in the back room.)

Being interested in this example of the imbalance of power, I began to poke around a little, and came upon a recent report published by The Senate Republican Policy Committee which can be found at . The report (the “Senate Report”) is entitled Excesses Threaten U.S. Competitiveness, When Excess Damages Success: Have Litigation, Taxation, and Regulation Gone Too Far? This report, dated June 19, 2007 explains that US banks (Wall Street) are losing competitiveness to foreign markets. The conclusion of this report is:

"The declining competitiveness of the United States’ capital markets may be a canary in the coal mine of a much deeper problem. The trends of excessive regulation, litigation, and taxation in our capital markets are being replicated in other parts of our economy. Unless Congress, the Administration, and the business community create a clear and unified blueprint for maintaining our nation’s competitiveness, capital and jobs will continue to move overseas."

One of the major resources relied on for this finding is a report (the “McKinsey Report”) generated by McKinsey & Company for Mayor Blumburg of New York and United States Senator Charles Schumer entitled Sustaining New York’s and the US’ Global Financial Services Leadership which can be found at . Citing this report, the Senate Report states that

Regulatory and litigation burdens are two major drivers of declining
competitiveness for capital markets.

In a large survey of industry leaders, McKinsey & Company, a premier management consulting firm, found that about two-fifths of CEOs surveyed expected that New York City—and by extension the United States—would become less attractive as a place to do business. McKinsey found that what clearly dominated these views were fears that two factors would not be present: 1) a fair and predictable legal environment and 2) a strong but responsive regulatory environment.”

In other words, the problems causing New York banks to lose market share are taxes, the lawyers bringing too many frivolous lawsuits against companies in the US, and over-regulation of US companies. This is causing companies to go overseas and sell their stock in foreign markets. Now, to be fair, there is some merit to these claims, and I am all for rationalizing our regulatory systems. There is a price to be paid, however, for transparency and safety and I do not believe we should go too far. (This is the stuff of a future blog piece.) All of this got me thinking about the competitiveness issue for investment banks. Being a former analyst and having just written a piece regarding global competition, the first question that came to mind was how much of this competitive loss is being caused by these factors as compared to good old competition from lower cost global competitors?

Well, I reviewed the McKinsey Report (though I will admit I did not read all 142 pages of it in its entirety), and was startled at what I did not find. What I did not find in all of the 142 pages of the McKinsey Report was a material discussion of the impact of lower fees charged by banks in other countries having an impact on the competitiveness of New York banks. Not to digress, but how can one of the premier consulting firms on the face of the Earth, engaged by The City of New York and the United States Congress, produce a report that purports to study why US Banks are losing competitiveness to banks overseas not consider the prices being charged by overseas competitors? Either the researchers were instructed to report only on select issues, or the research is completely flawed. You be the judge. Here is what they had to say about the fees:

“Another explanation put forward by some commentators as to why international issuers are staying away from US equity markets is the fact that the underwriting fees charged by investment banks are significantly higher for US listings than in competing markets. One study reveals that underwriting fees for non-domestic listings were 5.6 percent and 7.0 percent on the NYSE and NASDAQ, respectively, compared with just 3.5 percent on London’s man market. But while such figures may seem significant when looked at in isolation, their importance relative to the overall value of an IPO s fairly low, and easily outweighed by the benefits of a more liquid market and superior execution. Surveys conducted for this report corroborate this thesis: when asked to rate the importance of underwriting fees in the overall process of listing a company on the public equity markets, survey respondents ranked underwriting fees last among seven factors, with just 4 percent judging the issue ‘very important.’” (See pg 49 of the McKinsey Report.) (Note that they did not site the LSE Report discussed below here, as that would show a larger fee discrepancy.) Who are these respondents who deem it not important that the fees charged are almost double? “… a McKinsey team personally interviewed more than 50 financial services industry CEOs and business leaders. The team also captured the views of more than 30 other leading financial services CEOs through a survey and those of more than 75 additional global financial services senior executives through a separate on-line survey.” (See McKinsey Report pg 8.) So the people who say the vast differential in the fee is not important are the very people running these businesses and charging these fees. Sounds conclusive to me.

As it turns out there has been a study that identifies the fee differentials between international markets for investment banking services. I found it in a footnote to the McKinsey Report (so they looked at this report). You can find the report (the “LSE Report”), published by The London Stock Exchange, here .

The LSE Report finds "Gross spreads of IPOs on the US exchanges are found to be highest, averaging 6.5% for the NYSE sample and 7% for Nasdaq IPOs. In comparison, median spreads of IPOs on the LSE’s Main Market are 3.25% and those on AIM somewhat higher at 4%. Thus, there is a cost saving of three percentage points for a UK transaction compared with a US transaction." (See pg 18 of the LSE Report.) How much is 3%? Well, for the over $4 billion Blackstone initial public offering, that would be at least (.03X4,000,000,000) $120 million! That's just the excess of US over other markets. How does this compare to the first year’s cost of compliance with Sarbanes-Oxley? That cost is estimated at $4.4 million according to a 2005 survey cited in the LSE Report (LSE Report pg. 33).

So let’s review. The fee charged is by far the largest component of the cost of issuance in the US, and fees in the US are by far the largest among international competitors. This fee differential is not, however, why US banks are losing competitiveness. The reason is the cost of these darn law suits and regulations that companies in the US must put up with. That’s the New York tale. The Detroit tale? US workers at GM, Ford, and Chrysler must reduce their standard of living because we cannot compete with lower cost labor from foreign competitors. My conclusion? Perhaps Wall Street should lower the standard of living of its employees so that it can better compete with the foreign competition just like those on main street in Detroit are doing. Otherwise, stop spending my tax dollars on stupid reports that ignore the most obvious issues. Now don’t get me wrong. I am all for US competitiveness. We need to continue to study our competitiveness and actions we should take to ensure our future. I, however, would prefer to do so with full information applied across all of the US constituents rather than targeted reports used to influence the rule making process for the benefit of those in power (which is my interpretation of the McKinsey Report).

PS – if you think the higher fees charged by the New York banks has to do with the cost of living in New York, forget it. The studies show that is not the case.

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dd said...

I'm not sure what your point is here - you want US banks to lower their fees...? Well, as more business leaves the country, the laws of economics dictates that they will need lower their own fees or face a death spiral if they start to try to compensate for the loss of business. That's the nature of the competitive environment. However, these fees are assessed by the investment banks mostly on equity offerings. I'm not quite clear how, lets say a 5% cut on the returns from a public offering effects the underlying company and economy for that matter. However, for debt offerings it does indeed increase the effective interest rate - however, I believe debt offerings have a substantially reduced fee rate in comparison to IPOs. I'm not sure why you harped on the Newsweek blog regarding the aforementioned fee issue as their topic for discussion was how the fed's interest rate cut is not the remedy for the mortgage turmoil - it's tantamount to giving a cancer patient some aspirin and sending him on his way.

Reducing the fed rate has a major side effect that's not receiving enough attention in my mind. Our greenback is taking a major hit on the foreign exchanges. We all know that Bernanke is a money printer. I think what you may have missed yourself is a more important question - what are the effects of the continued devaluation in US currency is going to have on our economy? Positive short term effects are known - it's a boon to US manufacturers - especially capital goods (Boeing). However, I believe these interest rate measures have severe long term consequences which we will have to eventually face. I mean, for god sake, it's embarrassing that the Canadian Dollar has reached parity with the US. It's actually now even more expensive. The Euro is ridiculously expensive now. European banks who've invested in US debt have also taken a hit as a result (ex. Northern Rock - US firms bought them out since the underlying assets are based in their own currency). Perhaps the major, long term effects of the devluation wont surface during this Presidency - And frankly, I think Mr. Bernanke is doing Pres. Bush a huge favor, but it definitely wont bode well for his own legacy. I hate to be the harbinger, but I think that the US' currency woes may spiral into a greater economic crisis similar to that of Asia's in the late 90s.

Anyway, just my 1.95 Canadian cents.


PS - On a side note, with regards to the McKenzie report, as a consultant at a mid size consulting firm myself (albeit, not top tier) I've never found their work (MacKenzie) to be impressive nor the least bit useful. We've been hired to clean up reports and studies that they've done on several occasions. Yet major companies still hire them for their name recognition.

Palermo's Blog said...

DD: Thank for your comment. The reason I ended up linking to that article is that it was the only way I could find to get to Dan Gross, the author of the NYT article in question. I tried emailing him at Newsweek, looking him up on their website, through the NYT, and via a general web search, but came up empty. The emails I sent came back undeliverable, and there was no place to make any comment. If you are interested, you can see Mr. Gross's interview on CNBC here: . Note his discussion of fees that does not appear in his article. His article can be found here: . I am genuinly curious about this but have been frustrated in my attempts to contact him directly.