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Friday, October 27, 2006

Interview With Roger Ehrenberg, Former CEO of Deutsche Bank Advisors and Managing Director at Citigroup

By Yaser Anwar, CSC of Equity Investment Ideas

It used to be that investment bankers generated a majority of the revenue at the banks & brokerage houses, but ever since the collapse of the Tech bubble in 2000, we have seen a shift to trading desks generating majority of the revenue versus the investment banking division.

To talk about this shift and other industry related topics such as; Derivatives, Risk Controls & Hedge Funds, I conducted an interview with Roger Ehrenberg, former CEO of Deutsche Bank Advisors, wholly-owned subsidiary of Deutsche Bank, and Managing Director at Citigroup.

Roger led a 130-person team that managed over $6 billion in capital through a twenty-strategy hedge fund platform with offices in New York, London and Hong Kong. Strategies deployed included managed futures, statistical arbitrage, merger arbitrage, event, fundamental long/short, systematic long/short, relative value, special situations, convertible arbitrage, foreign exchange and credit.

Roger currently runs Monitor 110, which aims to aid institutional investors generate alpha through the myriad of information available on the internet in a time-sensitive & tickerized manner.

Wall Street Talk with Yaser Anwar

Guest: Roger Ehrenberg, President and Chief Operating Officer, Monitor 110, Inc.

1) Y: How do you explain this shift in revenue generation?

R: Three principal reasons: (1) most banks have excess capital that can be deployed; (2) trading, order management and risk management technologies have evolved to the point where they can scale; and (3) firms adapted to the shrinking equity calendar by re-purposing traders from customer flow towards proprietary trading.

2) Y: In your opinion, what portion of it was related to the demise of the Tech bubble & the boom in commodity markets followed by the stock market?

R: I wouldn’t limit the boom in proprietary trading to commodities. I think if I was to put percentages by the three reasons listed above they would be 30% excess capital, 20% improved technologies and 50% need to find other ways to generate returns.

3) Follow-up Q: Would we have to see another bubble, similar to the Tech bubble in 2000, for investment bankers to take the lead?

R: I don’t think so, I think the Banking vs. Trading revenue split is a cyclical phenomenon, and that the next big boom in Banking revenues will arise from the tons of restructuring business to be had after some of these highly leveraged private equity-driven deals fail.

4) Y: When markets go sour, traders can still generate alpha by going short, where as investment bankers aren't so fortunate, since an economic downturn constraints M&A activity, would you agree? If not, please explain.

R: While an economic downturn may dampen M&A activity, it can turbocharge restructuring activity. Further, running a short book is very, very difficult, made particularly so by the fact that down markets don’t move straight down. Traders can still get carried out during a secular bear market being short as sudden, violent rallies can force massive short covering that only drives near-term share prices even higher. It makes for an ugly, ugly picture.

5) Y: Even though trading desks account for majority of the revenue, the average trader still makes a lot less than an average investment banker, why this discrepancy when traders generate more revenue than investment bankers?

R: I don’t think this is a game of averages. Rock star traders make way more money than rock star bankers at Wall Street firms, much less hedge funds. I would argue that investment banking is actually “flatter” by its nature than trading, since it is possible to be a competent banker but not a star (and collect a healthy but not stratospheric paycheck) while this is really impossible in trading (merely competent traders don’t last long – they can lose you money fast).

6) Y: Recently you commented on Credit Suisse's $120 million loss on derivatives, "Sometimes risky bets pay off. Sometimes they don't." Do you think risk controls were not followed closely enough to limit the loss?

R: This is neither a judgment myself nor anyone can make from the outside. As I stated, this loss is certainly within the expected range of outcomes for a firm the scale of a CS. Whether or not the magnitude of the loss was due to poor risk management is impossible to know without more facts.

7) Follow up Q- You headed Deutsche Bank's Global Strategic Equity Transactions Group which won Institutional Investor magazine’s “Derivatives Deal of the Year” award in 2000. Could you briefly talk about the risk controls in place to avoid CS like calamities?

R: I wouldn’t call the CS loss a calamity. I would call it an undesired outcome. All firms have very strict risk guidelines for their proprietary trading operations, as well as for the “back books” run by those in the customer-driven flow trading businesses. In my experience large losses either arise from a conscious decision to push risk limits, or a gapping market which causes steep losses for those on the wrong side. In either case, these possible outcomes are modeled and reflected in the risk budget for these businesses, so in the absence of fraud or a rogue trader losses on the order of the one sustained by CS should happen every so often. We’ve all got to calm down about this. Either trade risk and acknowledge the risks or get out of the business. It’s that simple.

8) Y: On Sep. 20th 06 your blog, Information Arbitrage, you addressed the Amaranth situation & said; "Even increasingly sophisticated risk management systems and processes are insufficient to stop this behavior (Proprietary traders making inappropriate risk-reward gambles since it's the "house's money") from happening from time to time." As someone who managed a 130-person team with $6 billion in capital at DB Advisors LLC, What else needs to be done?

R: Senior Management taking responsibility. In the case of Amaranth it wasn’t a rogue trader that caused the losses, it was an institutional breakdown at the highest levels of the firm that allowed a risk position of that scale to live on for months. Instances of rogue traders will always happen, and the improving real-time risk monitoring of trading desks’ exposures help to mitigate the likelihood of its occurrence. But this is not what happened with Amaranth. It was just terribly poor risk management and decision-making on the part of those running the firm.

9) Y: What computers did to typewriters, ATMs did to tellers and Andy Kessler thinks will do to doctors, in his latest book 'The End of Medicine'. Will Automated Quantative Strategies do the same to Fund Managers?

R: No. I am a big proponent of quantitative trading strategies, and believe there is significant alpha to be captured via top-performing statistical arbitrage programs. That said, what will evolve is a balance between quant traders and fundamental traders, since when too much capital flows into either arena returns are squashed and capital flows in the other direction. This is the nature of diversification and optimizing the use of capital across the investment landscape.

10) Y: You recently talked about pension funds being a train wreck on your blog- Would you be for or against regulation to prevent another Orange County like incident?

R: While I am generally in the camp of market-driven regulation, I really think that pension funds can give rise to externalities due to the breadth and lack of sophistication of their constituencies. Time and time again, pension funds do stupid things with other people’s money. It is both irritating and represents a colossal breach of fiduciary duty. There probably should be some standards relating to “expertise,” similar to a retail investors’ requirement to have certain levels of experience and net worth in order to trade more complex (or naked) option strategies. Otherwise, pension funds should be compelled to use fund-of-funds or other skilled allocators to construct their portfolios. Because some, when left to their own devices, make very poor decisions. And if it just impacted the pension fund manager that would be one thing. But it effects potentially thousands of people, which makes the current model unacceptable.

11) Y: Amaranth Advisors, the most recent hedge fund blow-up, had a 3-year lockup period. Should there be a rule to supersede such lockup periods, when funds move away from their initial strategies and risk controls?

Note to readers: In Amaranth's case the fund was supposed to be a "multi-strategy" fund but due to lack of diligence and management oversight they placed 50% of their assets in natural gas trades, which led to their demise.

R: No. Amaranth abided by its fund document, I believe. What they may have done is misrepresent the steps they were taking to mitigate risk while raising money. None of this has to do with their document. If investors don’t want to be subject to a 3 year lock-up then don’t invest in funds with 3 year lock-ups. If investors don’t want a fund to have the ability to put 50% of its capital in natural gas, then don’t invest in such a fund. Investors in Amaranth are culpable as well, and should look at themselves in the mirror before making another investment in a fund with a loose document and a long lock-up.

12) Y: It is my understanding that you’re quite happy with how Christopher Cox is running the SEC. What are the necessary steps the SEC needs to take to ensure investor safety when it comes to hedge funds- Increase the net-worth limit, requirements of greater transparency and/or a self-regulating hedge fund body?

R: I think Commissioner Cox has done a solid job to date. I think the crux of the work that needs to be done relates to the definition of “accredited investor.” One of those commenting on my blog, Jack Doueck of Stillwater Capital, made the point that the rules are not designed to see if an investor can sustain a loss but to serve as a measure of one’s sophistication. He is right. And I don’t think the rules are sufficient in today’s day and age to weed out the unsophisticated from the lot. And this is bad. Otherwise, I think the self-regulatory system, coupled with the SEC’s ability to investigate issues whenever they feel there is a problem and the federal bank and broker/dealer regulations covering prime brokers are sufficient to maintain a safe and orderly market.

13) Y: Hedge funds have an inherent incentive to take on huge risks in hopes of huge payoffs; the compensation structure is designed that way, since hedge fund managers have practically nothing to lose in the event their bets go sour. Add to this the fact that few hedge funds have been able to generate returns that justify their pay. Hence you may ask yourself- why play the hedge fund game at all?

R: The hedge fund game, as you say, is a good game if you know what you are doing and a potentially fatal game if you don’t. There is no question that hedge fund returns exhibit negative skewness, akin to a manager selling optionality in the hopes of not getting hit in order to enhance returns, but then having a long tail of negative outcomes when some of this does, in fact, come to pass. That said, excellent managers can allocate capital wisely, build deep benches of talent, generate returns that are less correlated than vanilla asset classes and generate true alpha. The problem is figuring out which managers will outperform. This is why, in the absence of immense in-house sophistication, hedge fund investors should use seasoned fund-of-funds (that are not too diversified) or advisors to construct solid portfolios. Or, alternatively, don’t invest in the asset class at all. There is no harm in acknowledging a lack of expertise in hedge funds and avoiding investment; attractive diversified portfolios don’t necessarily require them. The real harm comes when investors pretend they have expertise in an area that they don’t, potentially hurting themselves and others in the process.

13) Y: You seem to enjoy blogging and after 17 years in M&A, Derivatives and Trading, when can we expect “The Memoir of Roger Ehrenberg” published?

R: When I do something that is worthy of a memoir. I’ve got a ways to go, my friend.

Y: Thank you very much for your time & insights Mr. Ehrenberg. Good luck with Monitor110 and your other ventures.

R: And best to you as well, Yaser.

For more information on Roger Ehrenberg and/or Monitor 110, visit his blog Information Arbitrage and Monitor 110’s corporate website, respectively.

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