Tuesday, May 08, 2007

Pricing a Wall Street Marriage

Ha, ha. One of the funniest things I've read in a while. Thanks to a quant correspondent for this.

I think it's clear ML only vaguely understands the calculation. But I suppose his point is really to expose the thought process ;-)

New terminology and statistic: BT = "Big Time" = career earnings of $25M, with 4% chance of getting there. Anyone care to refine these numbers?

(BT/25 x MPR) -- Pricing a Wall Street Marriage: Michael Lewis
2007-05-08 00:08 (New York)

     May 8 (Bloomberg) -- A few months ago, Bloomberg News reporter Caroline Byrne chronicled a British divorce court's chilling new open-handedness with the ex-wives of rich businessmen.

     A hedge-fund manager named Alan Miller was forced to shell out $10 million for a childless marriage that lasted less than three years; advertising executive Martin Sorrell paid roughly $60 million for losing the affections of his wife. The most recent House of Lords decision had gone so far as to imply that the women were entitled to half of all of the man's future earnings, in perpetuity.

     This news riveted Wall Street Man -- at any rate, it was the most read of any story that week by Bloomberg terminal users. And no wonder: A handful of British judges, far removed from the markets, were orchestrating a financial catastrophe, the losses from which threatened to dwarf those suffered in the Crash of '87, or any three giant hedge-fund collapses combined.

     No longer was it merely the house and the children at stake; it was the BONUS. You could almost hear the thud of 100 British investment bankers shelving their plans to alienate their wives even further.

     Then, a few weeks ago, came a second story by Ms. Byrne -- also the most read by Bloomberg users on that day: A London High Court had ruled that a banker who was ordered to give his ex- wife half of his accumulated wealth ($53 million) was allowed to keep all of his future bonuses. But, as the story explained, only a fool would find mercy in this one decision. British law remains messy: There is still no clear rule, just a bunch of contradictory precedents that, taken together, suggest there's never been a better time to divorce a London hedge-fund manager.

                        `Don't Get Married'

     The situation for rich men has grown so dire that a U.K. divorce lawyer named Jeremy Levison now tells his clients: ``Don't get married. If you must, make sure your other half is as rich as you.''

     British law has now put a fine point on a question that has been hovering over Wall Street for a long time now, and grown more interesting with each tic upward in hedge-fund pay: Why does Wall Street Man get married at all? He cares a great deal about money, obviously, as he spends so much of his life getting it. His chosen career makes him more likely than most to amass a fantastic fortune. The long-running miracle in the financial markets now puts him in line to make not just millions but hundreds of millions.

     And if he does get rich it is because, in theory, he has a special gift for shrewdly assessing the odds of financial transactions. Yet at some point he -- and it's typically ``he'' though on very rare occasions it's a ``she'' -- blithely ignores the odds of this potentially disastrous deal: Why?

                         Through the Roof

     Put another way: The expected benefits of marriage to a young Wall Street male haven't obviously improved but the expected costs to him are going through the roof. Worse, the very act of making a fortune on Wall Street probably only increases the chances of losing a wife.

     Pay an investment banker who seriously dislikes his wife half a million dollars and he may be a bit more tempted than usual to put his marriage at risk, but he'll still think a few times before leaving it. Pay a hedge-fund manager who has even the first doubts about his wife $100 million and he'll set a land-speed record heading for the exit, only to find that he's been driving on a toll road and the lady at the booth plans to charge him half of his net worth, and take away his Maybach in the bargain. Why doesn't he just take the freeway?

                            Call Option

     Of course, it's possible that Wall Street Man isn't nearly as shrewd and calculating in his private life as he is in his professional one. It's possible that, just like ordinary folk, he forgets his narrow financial interests when he falls in love, and only later, when he falls out, appreciates the value of what he has sold: a call option on half of whatever financial fortune he's made. (Obtaining in the bargain, a put option on his soft, aging, hairy body.)

     But I was curious if there might not be a more plausible explanation why so many young men who set out so single-mindedly to become rich on Wall Street ignore the British divorce lawyer's sage advice. To find it I called a man who now runs a very successful hedge fund, and who, before he set off on his own, had a very successful career pricing complex securities for big Wall Street firms. He was a quant with horse sense -- just the sort of person the market would turn to if they wanted to put a price on something that seemed unpriceable.

                            $25 Million

     I asked this man to value a new security: a call option on half the expected earnings of a Wall Street trader or investment banker. Not of a banker or trader who already has made huge sums of money, but a banker or trader who is just launching his career, with dollar signs in his eyes. What, in effect, would a smart hedge-fund manager pay to marry a first-year associate at Goldman Sachs Group Inc.?

     Because this hedge-fund manager knew especially well the fancy end of Wall Street, his assumptions were as interesting as his analysis. He began with a back-of-the-envelope calculation of the present value of the expected future earnings of a banker who made it Big Time, or BT: $25 million was about the right number, he guessed.

     He then further assumed -- again, drawing on his experience of many years watching young men trying to get really, really rich -- that about one in 25 who start out in Wall Street jobs actually make the BT. He then calculated something he called the Market Price of Risk, or MPR, which he described as ``an adjustment that makes risky propositions just as attractive as other investments in the world.''

                        Formula for Truth

     He felt reasonably sure -- here he drew some analogy to pricing of options on catastrophe bonds -- that in this case the MPR should range from 0.5 to 0.75.

     He conceded that he'd fudged quite a bit. He completely ignored the value of the intermediate cases -- the guys who didn't make the BT but still amassed several million dollars. His goal was not smart-bomb accuracy but to land in the general vicinity of truth.

     When he was finished he had a formula: (BT/25 x MPR). And when you plugged into it all his assumptions about risk, likelihood of making the Big Time, etc., that formula yielded a number. But that number had to be divided by two, as the divorcing wife/ex-wife would be given at most a half share. ``In a reasonably competitive market for marriages to junior bankers,'' he concluded, ``you might expect to see $187,500 to $375,000 being invested toward getting a junior banker to the altar.'' And then he realized: ``I didn't even take taxes into account.''

                         Who Got Stiffed?

     People will quibble with his calculation. Valuation models will no doubt improve, if this market ever gets going. But the hedge-fund quant's number does raise an interesting possibility: that all these newly rich hedge-fund managers who now find themselves paying tens of millions of dollars to their ex-wives had a pretty clear idea, when they got married, of the value of what they were selling. And it wasn't that high.    

 It's not the Wall Street traders who failed to run the numbers and, as a result, got stiffed in the deal. It's the women who married them.


Anonymous said...

If I were a young woman engaged to a wall street a-hole who hadn't made BT yet, those odds would give me pause.

In a related note, I once read an article claiming that women in the San Francisco bay area tend to hold off on getting married longer, because the potential rewards of finding the right spouse were so much higher.

Anonymous said...

2006 Wall Street Bonus Survey


daniel said...

Options are about as confusing as marriage itself. I found an article that can be somewhat of a marriage consoler of sorts.

Understanding Options

This WILL open your eyes....Cheers!

Josue said...

I like to talk about issues related to marriage, some time ago when I was in college studying psychology conducted a study called before marriage, where we found the main problems for which divorces happen ...

beforemarriage said...

He was a want with horse sense -- just the sort of person the market would turn to if they wanted to put a price on something that seemed unpronounceable.

before marriage said...

What, in effect, would a smart hedge-fund manager pay to marry a first-year associate at Goldman Sachs Group Inc.?

Blog Archive