We're staying about 200 yards down the Royal Mile from Adam Smith's new statue, unveiled 4 July 2008, and about 400 yards up from his gravesite in the Canondale Kirk yard.  The statue is bronze, 10' tall, and prominently situated in front of St. Giles church, Behind him is a plough, said to symbolize the impact of his thinking on the eclipse of agrarian economies, and to his right is a beehive, symbolizing, of course, the invisible hand of unguided individual effort creating without a centralized authority something greater than the sum of the individuals alone.

In other words, we need some new ideas, or at least one.

I actually have a nominee.

I credit the reliable David Warsh of Economic Principals for first bringing this to my attention. The essential concept is simple: Every debtor/creditor transaction involves the negotiation of two critical terms, but economic literature has focused on only one: The interest rate.

That is to say, as far as macroeconomics is concerned, the Fed's key job in terms of maintaining relative equilibrium is to focus on interest rates. But the other key variable we've ignored is that of collateral. Or, stated differently, leverage. How much collateral is the debtor putting up? How much leverage are they relying upon?

For this insight, in turn, Warsh credits John Geanakoplos, a professor of economics at Yale since 1994. (Interestingly for our purposes, Geanakoplos also served 5 years in the early 1990's as Managing Director and Head of Fixed Income Research at Kidder, Peabody, which, until it flamed out in the wake of the Joseph Jett scandal was an innovative firm, particularly in the greenfield territory of CMO's.)

Here's the gist of the theory (emphasis mine):

For at least a century, economists have been accustomed to thinking of the interest rate as the most important variable in the economy - lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands - alternatively, margin requirements, loan-to-value ratios, leverage rates or "gearing" - become much more important.

Everybody knows that when interest rates go down, prices rise. Less widely recognized is that when margin requirements go down - say, the down payment on a house - prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low. This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.

Central banks, therefore, should rethink their priorities. The Fed should learn to manage system-wide leverage, reining in on it in ebullient times and propping it up in anxious times, in order to prevent the worst outcomes. Leverage cycles happen not because people are stupid, or because they ignore danger signs. It's in the nature of competition to drive leverage to unsustainable levels, whereupon it collapses, with various effects.

I find this fascinating on several levels.

For one thing, it partially explains why the dot-com bubble didn't bring the entire global financial system to its knees. Stock margin requirements have always been essentially 50%, not zero money down. As well, of course, that was limited to one industry in (largely) one geographic territory, not the national housing market.

Second, it has potential implications for our professional judgment and behavior when we act for debtors and for creditors. I will leave you to be the conscience and the brains of your own professional conduct, but just a thought.

The key point is that in certain circumstances, it's the collateral terms and not the interest terms that assume overwhelming importance. If you want a memorable "hook" to understand this, look no further than The Merchant of Venice. Geanakoplos writes:

"Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral -a pound of flesh but not a drop of blood."

What, you should be asking by now, are the implications of this for getting out of our current predicament?

As hard as it may be to stomach, if you believe (as do I) that getting "underwater" homeowners to have a real stake in continuing to pay their mortgages, so as to staunch the bleeding of foreclosures, bank writeoffs, deteriorating or unguessable values of "toxic" or "legacy" CMO's and CDO's, and all the follow-on destruction that causes, we may need to swallow deeply and simply absorb big writedowns on those underwater mortgages in order to give the homeowners an incentive to keep paying.

Again, Geanakoplos has written about this:

Despite all the job losses and economic uncertainty, almost all owners with real equity in their homes, are finding a way to pay off their loans. It is those "underwater" on their mortgages -- with homes worth less than their loans -- who are defaulting, but who, given equity in their homes, will find a way to pay. They are not evil or irresponsible; they are defaulting because -- for anyone with an already compromised credit rating -- it is the economically prudent thing to do.

Isn't it against the interest of bondholders to have "cramdown" writedowns of the value of the collateral in the form of homes with underwater mortgages? In a perfect world, it would be, but we've traveled a long way from that perfect world. Consider:

For subprime and other non-prime loans, which account for more than half of all foreclosures, the best thing to do for the homeowners and for the bondholders is to write down principal far enough so that each homeowner will have equity in his house and thus an incentive to pay and not default again down the line. This is also best for taxpayers, who now effectively guarantee the securities linked to these mortgages because of the various deals we've made to support the banks.

For these non-prime mortgages, there is room to make generous principal reductions, without hurting bondholders and without spending a dime of taxpayer money, because the bond markets expect so little out of foreclosures. Typically, a homeowner fights off eviction for 18 months, making no mortgage or tax payments and no repairs. Abandoned homes are often stripped and vandalized. Foreclosure and reselling expenses are so high the subprime bond market trades now as if it expects only 25 percent back on a loan when there is a foreclosure.

As usual, a graphic can illustrate succinctly what a multitude of words cannot.

What this shows is the default percentage rate by month on the horizontal axis (0-2-4-6-8-10-12-14%) and the amount owed on all mortgages on a home divided by the current value of the home on the vertical axis, from 0% at the top to 100% where the green shaded field begins through 300% at the bottom.

The four different right-downward descending lines represent, from left to right, prime loans, ALT-A loans, option ARM loans, and subprime loans.

What's notable to me in eyeballing this is:

• In the white area, where homeowners have positive equity, defaults are relatively low, even for the lowest-quality loans.
• At above 25% equity (75% loan to value), defaults are not material.
• But at about 150% loan to value (50% underwater), defaults go up dramatically, at all levels of loan quality.
• This suggests that if writedowns could occur, giving deeply underwater homeowners equity of at least 25%, much of the national and global problem could be resolved by hardworking people getting back to work to save their homes. Not too much further bailout needed. At least so it suggests.

And again, lessons for us in all of this?

First of all, I hope it's simply been informative and eye-opening. The worst thing about all those liar loans may not have been the teaser interest rates but the no-downpayment scourge.

As I said earlier, your professional obligations, as you interpret them in your mind and your soul, will dictate the extent to which you will participate in negotiating and drafting highly-leveraged transactions in future. As a capitalist at heart, I imagine--with rueful confidence--that you will, by and large, negotiate and draft transactions with every last ounce of leverage your clients can negotiate. It is advisedly the Fed's role, and not yours, to regulate the extension of credit in our economy. But you are not thereby exempted from telling your clients, in the immortal words, that "they're a damned fool and they oughtn't do it."

If you're in a position of leadership in your firm, this would be the most opportune of times to re-examine your firm's capital structure. What level of commitment are people in for? Are you over-leveraged, as a firm? What's the level of "equity" that your partners feel you have in your firm?

This is not only financial equity, of course. But you know that.

Update (15 April):

A reader preferring anonymity (but a regular correspondent) writes:

Great post today.  You made one assertion that is worth exploring.  You said that unlike the dot-com bubble (which was limited to one industry in (largely) one geographic territory), the housing crisis is national in scope.  I thought you might find the following map of interest.  According to these data, 32 counties account for more than half of all foreclosures.  Therefore, the current housing crisis really isn't national but instead is highly concentrated in a few discrete regions.

Therefore, not only is a mortgage bailout sub-optimal economically it is also a hidden income transfer from most of the country to a few counties (as well as an income transfer from responsible borrowers to less responsible borrowers).  

32 Counties Account for 50 Percent of Foreclosures

As someone who has all four feet planted squarely in the "responsible" camp—and whose primary residence is a Manhattan co-op, famously immune from speculative fever because of both the vigilance of co-op boards and the non-negotiable requirement of sizable down-payments and substantial post-closing liquidity—I am deeply sympathetic to our correspondent.  Reckless economic behavior is anathema to me even when I'm immune from collateral damage, and as a taxpayer, here I'm not immune.

But I'm also a pragmatist at heart; I think most Americans are.  So let me quote from the conclusion of Geanakoplos' original piece, which suggests very pragmatic reasons to throw expensive life-jackets at the underwater homeowners:

We know there are some who will be outraged at the idea that their neighbors might get a break, while they -- so much more responsible -- get nothing. To these outraged folks we say, you would benefit too. It is not just your home values and your neighborhoods that will deteriorate if you insist that your underwater neighbors not get relief; it is your tax dollars and that of your children that will be needed to make up for the plummeting value of those toxic assets held by banks, which we taxpayers now guarantee and may soon own outright. It is your job that will be at stake when your neighbors can no longer afford to buy goods and services, causing more companies to cut jobs. So you need to act responsibly again, for your own sake and for the welfare and future prosperity of the entire nation.

This type of cool, ratiocinated argument may come off as a bit too close for comfort to those who defended the AIG bonuses as a trivial amount of money in the larger scheme of things:  That is to say, probably true, but completely tone-deaf in terms of public outrage and more likely to inflame than to cool passions.  You have probably also heard the strained analogy that just because your neighbor smokes in bed doesn't mean you want to short-change the fire department. 

I honestly don't know how to respond to or rebut the "morally outrageous" argument since, as noted, I could easily be tempted to incline in that direction myself. 

The problem is that succumbing to that mildly vengeful instinct doesn't get us out of this.  And at the moment, I want out.  I want out bad. 

If anyone has a suggestion for what "out good" would look like, I'm all ears.  Barring that, I'll take out bad.

We're not going to solve this right now--and the reality is we'll only begin to create informed judgments when we have some perspective, years from now.

But I'd like to pull together a few perspectives at this juncture.

First of all, what can we learn from the past? Unfortunately, less than we think. As The American put it in "Our Epistemological Depression:"

History rarely repeats itself. There are some standard patterns in economic recessions, but major recessions are characterized by something novel. If only this were not the case: economists have devoted a great deal of attention to learning the lessons of the Great Depression that began in 1929, not least Ben Bernanke. As a result, we are unlikely to make the errors of monetary policy made by the Fed in that era (of tightening money when it should have been loosened); or the errors of fiscal policy made by the Treasury (such as raising taxes when they should have been lowered); or the errors of ideological tone made during the 1930s, when anticapitalist rhetoric frightened many potential investors from making new investments. In all of these respects, we have learned from the past.

Unfortunately, initial conditions are too different from case to case to simply apply some historical template that would permit us to fully understand what is currently happening, let alone how to deal with it. Instead of explaining why this recession (or depression) is just like the others, we should attend to what is new and especially problematic about the current downturn and why it may not respond to policies modeled on avoiding the errors of the past.

This is not a counsel of confidence. It suggests there's not so much we can learn from the past and that, by implication, we're flying relatively blind. That's not to say deny that by and large, this piece defends--as do I!--capitalism. Only consider its opening lines (emphasis original):

The history of socialism is the history of failure--and so is the history of capitalism, but in a different sense. For the history of socialism is one of fundamental failure, a failure to provide incentives and an inability to coordinate information about supply and effective demand. The history of capitalism, by contrast, is the history of dialectical failure: it is a history of the creation of new institutions and practices that may be successful, even transformative for a while, but which eventually prove dysfunctional, either because their intrinsic weaknesses become more evident over time or because of a change in external circumstances.

Opposing this counsel of faith in the long-run wisdom of capitalism is a piece written by a former chief economist of the International Monetary Fund, The Quiet Coup, from The Atlantic, which posits essentially that the US is "becoming a banana republic:"

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn't be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn't roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there's a deeper and more disturbing similarity: elite business interests--financiers, in the case of the U.S.--played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

This piece reaches its rhetorical apogee in "The great wealth that the financial sector created and concentrated gave bankers enormous political weight--a weight not seen in the U.S. since the era of J.P. Morgan (the man)." There are other counts to the indictment:

• Under "The Wall Street/Washington Corridor:" "Just as we have the world's most advanced economy, military, and technology, we also have its most advanced oligarchy. [...]
• The American financial industry gained political power by amassing a kind of cultural capital--a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors. [...]
• Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. [...]
• A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan's pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone.

You get the gist: The "oligarchs" of the financial services industry have thoroughly captured the mewling and subservient regulators, Cabinet officials, and Congressmen and Senators. If this is an accurate diagnosis, the solution follows inevitably:

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical--since we'll want to sell the banks quickly--they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

Fundamentally, this posits the economic meltdown as just desserts for the over-reaching of the priviliged few, who now need to be put brusquely in their place by force majeure.

Warrant you, I do not subscribe to this ideology or this explanatory device for a moment, but I have dwelt on it herein to bring attention to what a substantial stream of thought it is. The Atlantic, after all, is not exactly a fringe publication.

Having presented these two dueling explanations--the first that capitalism, the best of all possible worlds, is still subject to episodic paroxysms of dysfunction in the face of endogenous excesses or exogenous shocks, and the second that (democratic) capitalism, not necessarily the best of all worlds, is subject to capture by oligarchies to the supreme detriment of the commonweal--I'd like to present a third and, I believe, more informative, perspective: What if this recession is not the usual "income statement" recession but instead a "balance sheet" recession.

For suggesting this train of thought I'm indebted to Roger Altman, Chairman and CEO of Evercore Partners but perhaps better known as deputy Treasury secretary under President Clinton, who recently wrote in the FT that:

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out [...]

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. [...]

For households, net worth peaked in mid-2007 at $64,400bn but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big - especially when household debt reached 130 per cent of income in 2008..... Now that wealth effect has reversed with a vengeance. The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent.

Why do I emphasize this?

Recessions as described or dissected by Econ 101 are income-shock driven, not balance-sheet shock driven. Typically, rising inflation compels the Fed to tighten money and raise interest rates and the predictable slowdown follows as (a) business investment contracts because of higher funding costs (b) causing all the industries and suppliers associated with that investment to contract (c) laying off their workers and cutting their orders to their own suppliers (d) leading to further employment contraction (e) decreased consumer spending (f) decreased demand for business products and services, and so on until inflation is tamed and the Fed can ease off the brake and back onto the gas.

Alternatively, of course, a single sector can become a bubble unto itself (the dot-com boom or the S&L crash of the 1980's) or an exogenous shock (the OPEC price spike of the early 1970's) can prompt a recession, but the single-sector bubbles are typically self-contained and parochial in scope and the exogenous shock bring forth a plethora of innovation and plain old readjustments (turn down the thermostat and stock up on sweaters?) that hasten recovery.

This time is different.

This time everyone--households, small businesses, big busineses, banks, investment banks, and yes, law firms--has seen their net worth hosed. The problem with recovering wealth is that it takes so much longer than it does to recover income.

The famous arithmetic tautologies still hold, alas: If your portfolio drops by 20%, it takes a 25% gain to recover; if by 33%, a 50% gain; and if by 50%, a doubling.

By contrast, replacing "lost" income isn't all that simple, especially if, blessings upon you, you're unemployed in this environment. But once you are re-hired, the bleeding instantly stops. Not so easy and not so fast in terms of regaining lost wealth.

Aside from having had a tour d'horizon of how we might have gotten here, where does this leave us?

Actually, with some perspective.

Law firms are not, permit me to suggest, the worst industry to be in right now. Would you rather work for a large retail chain? A resort or hotel or entertainment complex? A bank? An investment bank? A hedge fund or private equity house? A magazine or newspaper publisher? An auto company?

If this is a "balance sheet recession," be grateful at least that, while no firm you work for and no industry you work in can bulletproof your 401(k) or the "mark to market" value of your home, the long-term prospects for your income are, I maintain, as bright or brighter than ever.

Chin up.

Here's what they found.

In summary, a "gloomy economic stasis has taken hold," and while the proportion of executives saying economic conditions have deteriorated has, at least, not increased this quarter, fewer than one-third expect an economic upturn this year.

As we've almost come to expect in these types of surveys, and amusingly, overall they remain confident about how their own companies are handling the crisis (still, over half expect profits to drop in the near term).

Some other interesting results of the study:

• There's no doubt whatsoever that trust in business has fallen: 85% have that view. And the culprit? The #1 response(56%) was: Financial firms' inability to comprehend risk and guard against its repercussions. For our purposes, what's more interesting is that after #2 (33%, "job losses," which is something of a non-response) was "executive compensation levels" (29%). Why do I mention this? Only because lawyers are seen as highly paid.
  
  
• Recovery will take time. 90% of these global executives say their own national economies "are in very poor shape" and "have declined since September 2008" but a similar number also agree conditions have not gotten worse since then.
  
  
• Some particularly revealing responses came in answer to questions about jobs and prices:
  • Compared to just three months ago, even more executives expect their workforces to shrink: 50% now vs. 42% in January, and only 38% expect them to stay the same size now vs. 45% in January.
  • The news on prices (can you say: Rates?) is equally telling: Projecting changes for the first half of 2009, only 12% see an increase, 25% see a decrease, and 54% see no change (9%, presumably in commodity businesses, don't know).
    
    
• There are very modest signs of a potential upturn in economic conditions. By and large, these executives are more hopeful than they were as recently as January:
  • When asked how they expect their country's economy to be in the first half of 2009, the results were:
    • January: 50% moderately worse, 7% moderately better
    • March: 41% moderately worse, 14% moderately better
      
      
• In terms of seeking new funds for new initiatives, while two-thirds of firms said they had sought no new funding, the change in the composition of what the other third that were seeking new funding planned to do with it was revealing:
  • Four months ago, 40% sought funding simply to increase available cash; now that's down to 30%
  • Four months ago, 32% sought it to pay for new initiatives; now that's up to 37%.
    
    
• A final, and suggestive, set of responses concerns differences between executives and managers who consider their firms to be "weathering the crisis well" (i.e., well-managed firms) and those at firms who say they have been hurt by the crisis because of poor management. What are firms deemed to be well-managed (by those who should know) doing differently than those poorly managed?
  • "Reducing operating costs:" Over three-quarters of well-managed firms but just more than half of poorly managed firms are doing this.
  • "Introducing new products/services to gain market share from weakened competitors:" Over one-third of good firms but just over one-quarter of bad firms.
  • "Increasing productivity:" Nearly 2 in 5 good firms, just over 1 in 4 bad firms.
  • "Leaving certain markets:" Only 8% of good firms, nearly one-quarter (23%) of bad firms.

What does this tell us, back here in LawFirm Land and out of McKinsey Land?

If trust in business at large has fallen, it perhaps cannot help but have spilled over into our world. Or, if as I do, you would prefer not to believe that, it nevertheless signals an opportunity to get closer than ever to your clients. Don't permit even a whiff of questioned trust to enter your relationships with your clients. Do you think (do they think?) that if there's nothing going on, there's nothing to talk about? Wrong, wrong, wrong. Reach out to them.

Second, if businesses are shedding jobs and prices are under pressure, surely we have known since at least September 2008 that the same is true of us. This is, at this point, very old news.

Third and most important, what is your firm actually doing in response to the crisis?

Here the McKinsey survey actually provides a bit of guidance, even if you're tempted to more realistically categorize it as confirmation of common sense. But the guidance would be:

• "Cut operating costs:" Engage in the dreadful substance, process, and experience of laying off lawyers and staff. And yes, associates today and partners tomorrow.
• "Increase productivity:" Partly by engaging in (a), above, but more creatively and more importantly by reallocating people to practice areas in greater relative demand. You object that it's hard to retrain people? I retort that it's only hard if those individuals who are about to be among the retrained find it hard themselves. And then you know who is onboard the train and who is not.
• "Leaving certain markets:" Here the message may be, if any of these are, more positive. Do not retrench. At least not if you're in markets you entered after due consideration, and not in a pell-mell rush to emulate a competitor or to plant a flag for ego's sake. If you are in a particular city for a fundamentally sound reason, aligned with your own internal firm strategy and your clients' long-term demands, do not retreat. We last saw this, may I remind you, in 2000 when everyone seemed to plunge into Northern California just about at the peak of the dot-com boom. Those who subsequently retreated were not there for the long haul, and should not have been there for the short.

Summing this up, I choose to put at least a skin-deep positive gloss on it.

We clearly don't know nearly as much as we'd like about what we're experiencing, but that doesn't mean we know nothing. We can take some obvious steps (costs, productivity, markets).

We can, also and imperatively, engage our partners, associates, and staff in the new firm-wide enterprise of shifting from a mindset of do-no-harm and steady-as-she-goes to one of:

• creativity,
• agility,
• flexibility,
• and suppleness.

Think different.

The Financial Times has an ongoing series, The Future of Capitalism (I haven't read it all, but "dubious" would seem to be the most apt one-word review so far),  Knowledge @ Wharton has "revisited" the question whether capitalism is working, and even the normally staid and circumpsect McKinsey Quarterly has The New Normal, positing that "the business landscape has changed fundamentally." 

Meanwhile, the redoubtable Economist has Greed--and fear: a special report on the future of finance (for a taste, try "Financial services are in ruins....") and I will commend to you again Amartya Sen's Capitalism beyond the crisis from The New York Review of Books.

I've written before--but it's worth reprising--that a smart friend of mine observed that today "people are reading too many newspapers and not enough history." So a quick bit of history (Wharton):

The April 21, 1980, cover of Time magazine carried the stark headline: "Is Capitalism Working?" The American economy was in crisis after years of stagflation. The story recounted the ills: Mortgage rates were 17%, business loans carried 20% interest rates and productivity had collapsed. The article quoted Robert Lekachman, a left-leaning City University of New York economist, as saying, "The central economic fact of our day is the declining vitality and élan of capitalism and capitalists." On the opposite side of the political spectrum, Chrysler Chairman Lee Iacocca was quoted as saying, "Free enterprise has gone to hell."

Is the doubt now being sown on the fertile fields of capitalism surprising? Not in the least.

For perspective, we've come off a tremendous 2-1/2 decade bull run favoring capitalism: The Reagan Revolution here, the Thacher Era in the UK, China and India opening up, the fall of the Berlin Wall and the spontaneous resurgence of beaten-down Eastern Europe, even the technology bubble can be seen (charitably) in hindsight as a period of glorious experimentation, with some durable innovators that have changed the daily conversation (Google, Microsoft, Apple, just for starters).

Perhaps, then, we should have been more prepared for a backlash.

But what precisely are the terms of that backlash?

A large part of it, I respectfully submit, stems from the outsized importance that the financial services sector took on (Economist).

For a quarter of a century finance basked in a golden age. Financial globalisation spread capital more widely, markets evolved, businesses were able to finance new ventures and ordinary people had unprecedented access to borrowing and foreign exchange. Modern finance improved countless lives.

But more recently something went awry. Through insurance and saving, financial services are supposed to offer shelter from life's reverses. Instead, financiers grew rich even as their industry put everyone's prosperity in danger. Financial services are supposed to bring together borrowers and savers. But as lending markets have retreated, borrowers have been stranded without credit and savers have seen their pensions and investments melt away. Financial markets are supposed to be a machine for amassing capital and determining who gets to use it and for what. How could they have been so wrong?

The core function of finance, after all, is not complicated. It's to channel capital from investors (be they private equity and hedge funds, university endowments, or CD buyers at your corner Bank of America) to productive users of capital. And to reallocate risk in the process from those less willing or able to be exposed to it to those more willing and able.

This is where financial services failed us in the past several years. And in the process, or as the result, of that failure, they have betrayed our trust. Again, to the Economist:

Financial transactions are a series of promises. You hand your money to a bank, which promises to pay it back when you ask; you invest in a company, which promises you a share of its future profits. Money itself is just a collective agreement that a piece of paper can always be exchanged for goods or services.

Imagine, for a second, how finance began, with small loans within families and between trusted friends.... Trust in a modern economy has evolved to the miraculous point where people give complete strangers sums of money they would not dream of entrusting to their next-door neighbours. From that a further miracle follows, for trust is what raises the billions of dollars that fund modern industry.

Trust's slow accumulation pushes financial markets forward; its shattering betrayal batters them back.

A new era of financial regulation is, to be sure, called for (and more work for us, not incidentally). Our patchwork of largely Depression-era regulators, supplemented by rudely bolted-on encrustations designed in haste and for which we can only repent at leisure (see: Sarbanes Oxley), could stand a blank-sheet-of-paper rethink.

After all, were we to task ourselves with the challenge of designing a 21st-Century financial services regulatory structure for the world's leading economy, what are the odds that it would bear any resemblance to what we have today?

But we have strayed a bit from the initial question.

To answer it, I can only recur to first principles, and to do that, I submit to the wisdom of the masters.

First, of course, is the intellectual namesake and virtual godfather of the publication you're reading, Adam Smith himself.

I honestly believe--without meaning to slide into exaggeration or aggrandisement--that Adam Smith did more to improve the lives of more people than anyone in human history who is not reputedly a deity.

His wisdom is too overwhelming to abandon. So I hope.

Second, Joseph Schumpeter. I hope that Wharton is right when they write that:

Stripped down to its core and at its best, American capitalism is ideologically close to the theories espoused by Joseph Schumpeter.... The centerpiece of his thinking is the concept of "creative destruction..."

Creative destruction means that old established companies under capitalism tend to lose their dynamism with time and atrophy under a layer of corporate bureaucracy and complacency. Then entrepreneurs, who usually have few links to the past, introduce bold and fresh ideas for new products, manufacturing techniques, or distribution and displace the old order. The process is often destructive, but also creative. This corporate lifecycle has repeated itself again and again in numerous fields.

The moral here is both harsh and liberating.

Harsh because it involves destruction. Liberating because it involves creativity.

Permit me to make this less abstract. We have traded:

• Howard Johnson's for Starbucks;
• American Motors for Lexus;
• Faxes for emails;
• Trunk-size "mobile" phones for BlackBerry's; and
• Google for almost everything.

Is capitalism, then, done?

As has often been said about America (but not often enough, of late) and has equally often been said about New York City (same), "nobody ever won by betting against them." The same, I devoutly believe, goes for capitalism--although it will surely have a longer reign in the history of the human race than, as passionately as I love both, either America or New York City.

And what has this to do with Law Land?

We're about to experience an unprecedented multiplication of business models in our industry, an exhilarating and tragic journey through what works and what doesn't, an effervescence of creativity and a mournful descent into destruction, all carried out in accelerated time.

Global law firms are not "over" unless you believe that globalization is over. Wall Street law firms are not over unless you believe that Wall Street is history. Boutiques are not over unless you believe we will never see visionary iconoclasts again. Regional firms are not over unless you believe in the brotherhood of man.

The only future that's certain is one of an efflorescence of creativity, right in front of our eyes.

Hold on to your hats.

The online sites, first as they're easy to handle in a condensed fashion:

• David Warsh's Economic Principals is perhaps the single most studious, well-written, thoughtful, and occasionally (but not doctrinally) contrarian site I know of. David publishes on a faithful, if quaint, once-a-week schedule, just like the print journalist he was, with provocative pieces such as "More than two aspirin," and "What comes after a golden age?."
• Truth on the Market bills itself as 'academic commentary on law, business, economics, and more," and it's surely worth checking out for that promise alone. While uneven at times, at its best it can be great fun.
• Matrix (on interpreting the real estate economy, with a focus on New York City) is a remarkably wide-ranging and thoughtful site covering the industry that's arguably at the root of all our evil woes, written by Jonathan Miller, who is the gold standard of appraisers in the New York City market.
• Academic Earth bills itself as "thousands of video lectures from the world's top scholars."  And it is.  Origins of the Financial Mess (Alan Blinder, Princeton) is a good place to start.
• Marginal Revolution talks about a wide variety of topics in an often irreverent tone. A current post about the AIG bonus PR nightmare consists in its entirety of:
  

  Outrage, outrage, blah, blah, blah, etc. Often I feel that some topics are too obvious to blog.
  The real lesson is that this is another reason not to nationalize banks. It means politicizing every decision which ends up in the newspaper.
  Here is a good post on why the bonuses should be paid.
  Outrage, outrage, blah, blah, blah, etc.

But forthwith to the book review.

Animal Spirits, by George Akerloff (Nobel Prize Winner in Economics) and Robert Shiller, father of the famous Case-Shiller real estate index, was reviewed in the Financial Times:

[The authors] argue that the key is to recover Keynes's insight about 'animal spirits'--the attitudes and ideas that guide economic action. The orthodoxy needs to be rebuilt, and bringing these psychological factors into the core of economics is the way to do it. . . . The connections between their thinking on the limits to conventional economics and the issues thrown up by the breakdown are plain, even if they were unable to make every link explicit. Even more than Akerlof and Shiller could have hoped, therefore, it is a fine book at exactly the right time. . . . Animal Spirits carries its ambition lightly--but is ambitious nonetheless. Economists will see it as a kind of manifesto.

What are "animal spirits," again?  The most concise explanation was actually provided by a reviewer on Amazon:

In his epoch-making General Theory of Employment, Interest, and Money (1936), John Maynard Keynes noted that concerning investment decisions, "most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits--a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." Because of this propensity of investors to base decisions on variables other than "market fundamentals," the aggregate investment function of an economy will tend to be highly variable and erratic. Indeed, even today, it is virtually impossible to predict aggregate investment successfully, although the other sources of aggregate demand and supply are relatively well understood.

The book explores, in its Part I, five different dimensions of animal spirits and how they affect the economy: 

• Confidence
• Corruption
• The "money illusion" (basically, people's propensity to ignore modest levels of inflation and deflation and to believe in a constant value of money)
• "Stories" which can mislead (for example, "the Internet will revolutionize everything..."); and
• Lack of perceived fairness (for example, AIG bonuses).

Part II, in turn, looks at some consequences of animal spirits' role in economic decision-making, and how they can help explain the answers to such questions as:

• Why do economies suffer depressions?
• What's to be done about the current financial crisis?  (Caveat:  Events are moving so quickly on this front that the authors' discussion is already looking quite dated.)
• Why can some people not find a job?
• Why is saving for the future so arbitrary?
• Why are financial prices and corporate investments so volatile?

The most valuable aspect of the book is that the authors show how human decisionmaking—as it's really performed, animal spirits and all—violates the classic notion of purely rational homo economicus.  Consider this thought experiment they offer:

Of course, neoclassical economic theory essentially addresses only the top left cell, whereas animal spirits help inform our understanding of the other three cells.  Actually, I would argue that we can ignore the entire right hand column for present purposes, since it's by hypothesis in the realm of the "non-economic," but even if you wipe that from the attention of your cortex, the bottom left quadrant is clearly where a lot of the fascinating debate today around "fairness" (AIG bonuses again), "moral hazard," "fragility," "systemic risk," and so forth revolves.

Indeed, our again-helpful Amazon reviewer, who has simulated the behavior of individuals in markets, reports:

There is nothing in economic theory that says that rational individuals interacting on markets will produce stable, efficient outcomes. The Walrasian general equilibrium model says that if there are no market externalities, there are market-clearing equilibria that are Pareto-efficient, but this model has absolutely NO attractive dynamical properties. When I subjected this model to an agent based simulation (Herbert Gintis, "The Dynamics of General Equilibrium", Economic Journal 117 2007:1289-1309), I found that there is a robust tendency towards market clearing equilibrium, but this is always offset by highly volatile stochastic movements in prices, wages, capital demand, and other macroeconomic variables. This stochasticity is due to the fact that the macroeconomy is a complex, nonlinear, dynamical system, not because of "animal spirits."

Jargon patrol:  A "Walrasian equilibrium" essentially means a competitive environment and not one populated by players with market power.  "Externalities" are costs imposed upon, or benefits enjoyed by, actors not participating in the market in question.  "Pareto-efficient" means that there is no possible change which would leave every player no worse off and at least one player better off.

The fascinating point here is that a core result is "always" "highly volatile stochastic [random] movements in [key] macroeconomic variables." 

And isn't that just what we've seen in the subprime meltdown and its aftermath?

The really stunning fact about the current macroeconomy is that disequilibrium in the home mortgage market could so seriously compromise the American financial system. Even those who foresaw the housing crisis did not predict so massive and credit collapse, leading to levels of government intervention that would have been inconceivable in the past.

Animal Spirits is without doubt an intriguing, thoughtful, and timely book (and a quick read as well at 264 pages including notes and index), but I fear that its very focus on the quirkiness of human decision-making might serve as a pleasant distraction from the core and unavoidable truth that under- or improperly regulated markets cannot be counted upon to produce economically or socially desirable results.

Given the general level of surprise and intellectual shock that have accompanied this global meltdown,, it has become increasingly common to hear calls for a "new capitalism" or for some inchoate reworking of the received canon of wisdom in economics to help us navigate these seemingly unprecedented times.

If you're tempted, as I admit I occasionally have been, to pursue this path, I commend to you Amartya Sen's Capitalism Beyond the Crisis in the March 26,2009 issue of The New York Review of Books.  Sen was the 1998 Nobelist in economics for his contributions to "welfare economics,"  ("Welfare economics," roughly speaking, is the branch that concerns allocative efficiency within a society, income distribution, and—you guessed it—achieving Pareto-optimal results.)

Sen's article is, by and large, an effective effort to debunk the mythologies that have been attributed, for motives base and innocent alike, to the Big Thinkers in economics including Adam Smith and John Maynard Keynes.  Perhaps we should not be surprised that the imprimatur of these legendary names would be appropriated for ideological or expedient means, but it's worth going back to what they actually said, as Sen does, to realize that we may have the blueprint for recovery in front of us if only we choose to see it. 

Here is Sen on the "public/private mix" that undergirds all of today's First World economics.  Forgive the somewhat lengthy excerpts, but Sen's argument is subtle and his prose pleasant:

What are the special characteristics that make a system indubitably capitalist--old or new? If the present capitalist economic system is to be reformed, what would make the end result a new capitalism, rather than something else? It seems to be generally assumed that relying on markets for economic transactions is a necessary condition for an economy to be identified as capitalist. In a similar way, dependence on the profit motive and on individual rewards based on private ownership are seen as archetypal features of capitalism. However, if these are necessary requirements, are the economic systems we currently have, for example, in Europe and America, genuinely capitalist?

All affluent countries in the world--those in Europe, as well as the US, Canada, Japan, Singapore, South Korea, Australia, and others--have, for quite some time now, depended partly on transactions and other payments that occur largely outside markets. These include unemployment benefits, public pensions, other features of social security, and the provision of education, health care, and a variety of other services distributed through nonmarket arrangements. The economic entitlements connected with such services are not based on private ownership and property rights.

[...]

[T]he pioneering works of Adam Smith in the eighteenth century showed the usefulness and dynamism of the market economy, and why--and particularly how--that dynamism worked. Smith's investigation provided an illuminating diagnosis of the workings of the market just when that dynamism was powerfully emerging. The contribution that The Wealth of Nations, published in 1776, made to the understanding of what came to be called capitalism was monumental. Smith showed how the freeing of trade can very often be extremely helpful in generating economic prosperity through specialization in production and division of labor and in making good use of economies of large scale.

Those lessons remain deeply relevant even today (it is interesting that the impressive and highly sophisticated analytical work on international trade for which Paul Krugman received the latest Nobel award in economics was closely linked to Smith's far-reaching insights of more than 230 years ago).

[...]

Even though people seek trade because of self-interest (nothing more than self-interest is needed, as Smith famously put it, in explaining why bakers, brewers, butchers, and consumers seek trade), nevertheless an economy can operate effectively only on the basis of trust among different parties. When business activities, including those of banks and other financial institutions, generate the confidence that they can and will do the things they pledge, then relations among lenders and borrowers can go smoothly in a mutually supportive way. As Adam Smith wrote:

When the people of any particular country have such confidence in the fortune, probity, and prudence of a particular banker, as to believe that he is always ready to pay upon demand such of his promissory notes as are likely to be at any time presented to him; those notes come to have the same currency as gold and silver money, from the confidence that such money can at any time be had for them.[1]

Smith explained why sometimes this did not happen, and he would not have found anything particularly puzzling, I would suggest, in the difficulties faced today by businesses and banks thanks to the widespread fear and mistrust that is keeping credit markets frozen and preventing a coordinated expansion of credit.

It is also worth mentioning in this context, especially since the "welfare state" emerged long after Smith's own time, that in his various writings, his overwhelming concern--and worry--about the fate of the poor and the disadvantaged are strikingly prominent. The most immediate failure of the market mechanism lies in the things that the market leaves undone.

And here, if you will, is the punch line:

Smith called the promoters of excessive risk in search of profits "prodigals and projectors"--which is quite a good description of issuers of subprime mortgages over the past few years. Discussing laws against usury, for example, Smith wanted state regulation to protect citizens from the "prodigals and projectors" who promoted unsound loans:

A great part of the capital of the country would thus be kept out of the hands which were most likely to make a profitable and advantageous use of it, and thrown into those which were most likely to waste and destroy it.[4]

The implicit faith in the ability of the market economy to correct itself, which is largely responsible for the removal of established regulations in the United States, tended to ignore the activities of prodigals and projectors in a way that would have shocked Adam Smith.

The present economic crisis is partly generated by a huge overestimation of the wisdom of market processes, and the crisis is now being exacerbated by anxiety and lack of trust in the financial market and in businesses in general.

Sen also writes that unappreciated in the current crisis is the relevance of Arthur Cecil Pigou (a contemporary of Keynes, also at Cambridge and also in fact at King's College).  Whereas Keynes viewed the economy primarily through a mechanistic and hydraulic lens (the value of the famous "multiplier" being a primary example), Pigou put his focus on psychology, where Sen (and yours truly) believe it belongs.  At the root of economic fluctuations, Pigou wrote, were "psychological causes," namely "variations in the tone of mind of persons whose action controls industry, emerging in errors of undue optimism or undue pessimism in their business forecasts.[5]"  Sen goes as far as to say that "the real crisis...has become many times magnified by a psychological collapse," and he scarcely overstates the case.

Perhaps we should conclude with the culminating irony of this short tour of the landscape of Fabled Economists:  It is that while Smith and Pigou are traditionally seen as "conservative," and Keynes as something of a rebel, the first pair were far more outspoken, insightful, and insistent upon the importance of non-market institutions and non-profit values.

What else am I reading? Alpha by author:

• Geoff Colvin's Talent is Overrated:  What Really Separates World-Class Performers from Everybody Else.  This book, based soundly in empirical research, delivers the hard message that true excellence depends upon hours and hours (10,000 hours, to be precise) of "deliberate practice"—be it the young Mozart composing, the young Tiger Woods practicing, or any aspiring concert violinist.  The same, by extension, is true of surgeons, mathematicians, CFO's—and lawyers and writers.  As Colvin puts it, this is good news and bad news:
  
  "What would cause you to do the enormous work necessary to be a top-performing CEO, Wall Street trader, jazz, pianist, courtroom lawyer, or anything else? Would anything? The answer depends on your answers to two basic questions: What do you really want? And what do you really believe? What you want - really want - is fundamental because deliberate practice is a heavy investment."
  
  
• Jerry Coyne's Why Evolution Is True.  Demolishes creationism and "intelligent design"—and then intellectually carpet-bombs them again, to make sure "the rubble bounces," as Churchill described the goal of a particular bombing campaign in WWII—but does so with respect and patience.  I can do no better than to repeat the aphorism that "Nothing in biology makes sense except in the light of evolution."  Coyne explains why, and brings you up to date on recent developments in this endlessly fascinating science in the bargain.
  
  
• Niall Ferguson's The Ascent of Money: A Financial History of the World:  Ferguson recapitulates the history of money from the pre-Christian era through today's subprime meltdown and global credit freeze, noting that bubbles are as much a part of economic history as are booms and concluding with a warning that excessively precautionary regulation  cannot and should not remove the possibility of extinction for institutions which are weak.  That is to say, financial crises should and must result in casualties.  Or, as Joseph Schumpeter put it in The Theory of Economic Development (1934):  "This economic system cannot do without the ultima ratio of hte complete destruction of those existences which are irretrievably associated with the hopelessly unadapted."
  
  
• Dexter Filkins' The Forever War  A harrowing account of the "war on terror" from the rise of the Taliban in the 1990's through virtually today in Iraq and Afghanistan, by one of the New York Times' star reporters.
  
  
• Michael Lewis' Panic:  The Story of Modern Financial Insanity, a tour de horizon of recent financial embarrassments, using the tool of reproducing contemporaneous (and a few subsequent) accounts and analyses, and covering the collapse of Long Term Capital Management, the Asian financial crisis of the 1990's, the dotcom meltdown, and early warning signals of our present distress.  Plus c'est change.
  
  
• Jessica Livingston's Founders at Work:  Stories of Startups' Early Days.  The stories of mostly legendary (and a few relatively obscure) entrepreneurs, told in their own words through extensive interviews, about the early days at their would-be companies, including:  Max Levchin/PayPal, Steve Wozniak/Apple, Mike Lazaridis/Research in Motion, Mike Ramsay/Tivo, Charles Geschke/Adobe, and Ron Gruner/Alliant Computer.  Utterly charming.  And the moral?  (1)  Expect the unexpected.  (2) And meet it with persistence. 
  
  
• Daniel Pink's A Whole New Mind:  Why Right-Brainers Will Rule the Future.  Pink's thesis, fairly widely adopted today, is that human economic organization has moved from the agricultural to the industrial to the information and now to the conceptual age, where the value is on those individuals and firms capable of integrating empathy, meaning, design, and a narrative (a/k/a "story") to their products and services.  If you or your firm can't master those skills, beware of "Asia, Abundance, and Automation."
  
  
• Robert Samuelson's The Great Inflation and Its Aftermath:  The Past and Future of American Affluance.  An economic and political history of what is now a curiously forgotten period, the "great inflation" of the 1970's and early 1980's, famously cut off at the knees, along with much economic activity, by Paul Volcker and Ronald Reagan in the 1981-'82 recession.  Not, perhaps, a deep or subtle read, but a fascinating and thorough portrayal of, as I say, an oddly invisible era.
  

Enjoy.

The reductions are meant to weed out less-productive partners, firm Chairman Steven Davis tells The Am Law Daily.

Those affected by the "substantial performance-related reductions to their compensation" represent a wide range of practices, Davis says. The partners include some who have been practicing for 25 or more years.

Of the 66, the more fortunate are now taking home $25,000/month, the standard draw for partners. Lower-tier partners have faced more drastic reductions, with monthly draws of as little as $10,000, or an annual total of $120,000 -- $40,000 less than the starting salary for a 2008 incoming first-year.

Both Davis and executive director Stephen DiCarmine characterize the recent actions as an intensification of the firm's long-term strategy of replacing poor performers with higher-producing laterals. "We have a merit-based compensation system," Davis says. "There are a variety of outcomes that people have experienced. It probably occurred to a greater and enhanced extent due to the merger."

Paying partners less than first-year's? What on earth, you may be asking yourself, is going on here?

To begin with, I have nothing to say about the selection criteria for who's taking these hits and who isn't (or, as the firm puts it, who is "experiencing which outcomes"). I can only take the firm at its word that they are intended to be performance-related and to alter the mix of partners over time.

The point I'm interested in is a larger one. Why would a firm feel compelled to take such drastic measures in order to--at least partially--protect the very high incomes of its other partners?

This brings us to what I call the "profit imperative."

First, required is a small digression into the wonderland that is law firm accounting. Partners (we're talking equity partners) actually wear three different and distinguishable hats, in terms of their economic participation in the firm:

• Workers/producers, in which role their job is to actually bill hours and perform client work. In this role, their appropriate compensation is what the firm would have to pay a non-equity partner to perform the same work.
• Managers/administrators, in which role they help run their practice groups or departments, manage staff, mentor associates, participate in firm committees, and so forth. In this role, their appropriate compensation is what the firm would have to pay nonlawyer executives to perform the same work.
• And last and only last, equity partners, which is to say, owners with a residual claim on the profits of the enterprise after all other expenses and claims have been satisfied--including, if you want to be rigorous about it (and some of us do), paying the first two sums listed above out of operating income.

But of course, in wonderland, partners view themselves as wearing one and only one hat, namely the last one. This means they view their compensation as coming entirely from their role as equity owners. And given the current realities of law firm organization, finance, and accounting, they are entirely right to see it that way, however economically irrational that might be in the abstract.

Why does this matter? Only because, as we're about to see, "profits" in law firm land have a special meaning, and that's why they're imperative.

If equity partners across BigLaw had been raised from 3L status on to understand, internalize, comprehend, and expect that their compensation would consist of those three different components, the last of which is highly variable, profits would not be as imperative as they are. But that's not the world we live in.

So now that we're all agreed on the financial irrationality of partners' compensation being paid entirely out of "profits," and are equally agreed that this is culturally embedded and not about to change in your lifetime or mine, it's a baby step to seeing why profits in a law firm cannot fall precipitously and expect the firm to remain in equilibrium. It comes down to expectations.

Perhaps the simplest way to explain this is to contrast it to a normal company, say, Toyota or GM.

As is exhaustively known, GM has been bleeding cash and losing money hand over fist for most of this young Century, yet it continues to exist. The fact that it may not continue for too much longer, and that its pleas for help from Washington may be rewarded, only speaks more strongly of its durability. As for Toyota, it's been coining money during the same period and, even though it may suffer its first loss in its 70 years of operations, there is absolutely zero doubt about its continued viability as a global industry leader.

And the point would be?

• Law firms cannot survive a single year with zero profits.
• That, as we know, is all that partners have to take home.
• If partners have nothing to take home, they will be gone.
• And the firm will be no more.

This may provide perspective on the drastic measures Dewey has taken. There are, of course, other examples of unprecedented Hail Mary's techniques being employed:

• Norton Rose is floating the notion of a four-day work week;
• CMS Cameron McKenna is asking partners to "volunteer for de-equitization" (no, I'm not making this up);
• 92% (92%!) of City of London partners recently polled by Legal Week predicted a drop in profits of more than 15%;
  • 65% predicted it would be more than 20%;
  • 47% predicted it would be more than 25%; and
  • 17% predicted more than 30%.
• And the drastic cuts being implemented far and wide are, at the moment, unavoidable:  "Tony Williams, former managing partner of Clifford Chance and the co-founder of Jomati consultancy [and a good friend of mine—Bruce], said: "You always have to look forward. Cutting people has not just been a knee-jerk reaction [to falling profits]. You have to take the appropriate decision at the appropriate time.""

The point?

Simply that noisy protestations about how firms are cutting people loose in wholesale numbers—be those protests boisterous and cynical or heartfelt and agonized—miss the point that a reasonable level of profitability for a law firm is not a luxury and not an option.  It is as required for survival as oxygen is to us.

In all the obsessiveness and compulsiveness about the impact that this little economic interregnum we're gamely marching through is having on our firms, our P&L's, and even our personal balance sheets, let us pause for a moment to consider the genuine human toll of layoffs.  The National Law Journal recently put it nicely:

Situation wanted: High-performance type with dashed hopes, loads of law school debt and mortgage acquired at peak of housing boom seeking self-esteem and lost identity following recent layoff from law firm. Willing to adjust once-lofty career aspirations in exchange for doing anything remotely related to the practice of law.

The ad may be fiction, but the scenario has become a reality for hundreds of attorneys who started law school just a few years ago with prospects of six-figure salaries and their pick of where to practice.

Nor should it surprise you to hear that lawyers are especially poor at dealing with layoffs—particularly the "Millenials" who have been raised on a non-stop diet of affirmation and positive reinforcement.  Lawyers' inherent traits work against them following a layoff, no matter how often they're told that it was not "performance" related:

• As Type A personalities, they're not used to anything short of excelling; a layoff comes as a complete shock and takes time to assimilate psychologically.
• This is probably the first time in their lives they've been forced to deal with feeilngs of failure.
• The loss of direction and purpose is profound.
• Classic lawyers traits—risk aversion, impatience, skepticism—work against a speedy recovery from the body blow of a layoff.
• Lawyers also are introverts and the enormous insult of a layoff tends to make them even more withdrawn and isolated.

What's going on at a psychological and physical level is the classic "fight or flight" response that kicks in whenever one feels in danger.  While this was a beneficial and even life-saving adaptation on the African savannah, study after study has shown it to be profoundly counterproductive and self-defeating in the canyons of our cities.  The continual low-level anxiety tempts people to make rash decisions, view the world in Manichean terms, and blame themselves for their fate, regardless of their actual responsibility for finding themselves on the street.

What's less widely recognized is the negative impact on those lawyers and staff who remain employed.  As noted in the LA Times in "Layoffs take toll even on survivors:"

"None of the effects are good," said Frank Landy, author of "Work in the 21st Century." An organizational psychologist, Landy specializes in understanding the emotions of work. "Layoffs clearly have emotional and practical consequences for companies and workers."Those consequences are, unfortunately, long-term.

The psychological fallout of surviving a layoff lasts six years, according to the study published by the Institute of Behavioral Science. And the effects of surviving multiple layoffs are cumulative. They add up rather than dissipate.

"It only takes one action of distrust to lose basic confidence in the employer. It's like a romantic relationship. Once the trust has been undermined, it's very, very difficult to recover," Landy said. "There's no data that suggests workers become more resilient. 'I'm a survivor, hear me shout'? It doesn't happen."

The problem, of course, is that even the "survivors" feel their situation is precarious.  They also feel—rightly or wrongly—that their firm has broken a covenant of faith with them.

Lingering distrust is one of the final stops on the emotional misery tour taken by most surviving employees. First, there's the disbelief, anxiety and desperation resulting from the initial layoff announcement. Then comes the sweeping sense of relief when one's job is spared, followed, in rapid succession, by guilt, fear and stress.

In a volatile labor climate that's rapidly shedding existing jobs across all sectors of the economy, and during which any available employment may be likely to bring less pay, that emotional trajectory is only amplified.

The risk is that the survivors are tempted to descend into cynicism.  (If you doubt me, spend not more than 30 seconds [please!] reading comments on "Above The Law.")  The temptations for the cast-off and the survivors alike are all self-destructive:

• Withdrawal (as noted).
• Increased alcohol use or drug abuse, especially of painkillers or sleep aids.
• Shockingly negative thoughts, including suicidal ones.
• A pessimistic outlook, which in turn engenders negative interactions, which lower expectations, which encourages pessimism.
• Sloppy and compulsive eating habits, with concomitant weight gain.
• Neglecting exercise.
• Sleeping poorly.

And it would be folly to predict anything other than that it will get worse before it gets better.  If you doubt me, just extrapolate the last few months from this chart, courtesy of Above The Law's "Layoff Tracker."  Since the image is small, here are the numbers:

As of March 6, 2009, there have been over 7,241 layoffs (3,045 lawyers / 4,196 staff) since January 1, 2008. There have been 5,408 (2,149 / 3,259) in calendar 2009 - 1,132 (337 / 795) in March.

Update: Andrew of LawShucks wrote to correct my reference to Above The Law, which merely republishes (with permission) the LawShucks tracking info. We stand corrected. Thanks, Andrew.

A healthy, useful, and enriching option is to volunteer—and anyone reading this page surely has a multitude of skills to offer.  In fact, if you believe From Ranks of Jobless, a Flood of Volunteers, here in New York, at least, nonprofits are enjoying almost an embarrassment of riches:

Many who run nonprofits have marveled at the sudden flood of bankers, advertising copywriters, marketing managers, accountants and other professionals eager to lend their formidable but dormant skills.

Volunteer for what?  Well, the truth is it hardly matters. The point is to get up and get out and feel you're making a contribution:

God's Love We Deliver, which provides food to the severely ill in their homes across New York City, has seen a record number of the recently laid-off among its 1,400-member volunteer corps, according to Karen Pearl, the organization's president and chief executive. Among them is Eryka Teisch, who saw her job disappear when her financial technology firm downsized in September. God's Love initially asked her for two hours a week.

"I laughed," said Ms. Teisch, 39. "I just said, 'That's great, but I kind of want to add a zero to that number.' "

Ms. Teisch said the experience -- she works in the kitchen, the office, wherever she is needed -- has been a therapeutic tonic for her workaholic, Type-A personality. A bonus is the chance to bond with her fellow unemployed volunteers.

"You try not to focus on the bitter side -- you know, 'I hated my company and I can't believe what they did to me,' " Ms. Teisch said. "At least we have something to wake up to in the morning, rather than focusing on getting another job in this very difficult economy."

If you happen to be in the New York area, VolunteerNYC is an on-line clearinghouse, funded in part by the United Way, that helps match people with nonprofits.

You should also be prepared to take advantage of the professional resources that are available to help.

The only good news may be that there are professional resources available to help.

Primary among them is the ABA's "Commission on Lawyer Assistance Programs," which describes the background to its mission as follows:

During this time of career and financial uncertainty, lawyers are experiencing new stress and trauma as a result of the recession and national belt-tightening in the profession. Law firms are finding it necessary to reduce their lawyer and support staff numbers and are in some instances closing firms. The states that have staffed lawyer assistance programs (LAPs) can provide peer support for individuals and referrals to counseling--career, mental, and financial. The lawyers helping lawyers component of LAPs has existed from the beginning and continues to be of critical assistance in times of relapse, stress, and trauma. These volunteers can share a special bond and understanding, which has been found to be true in other professional peer support programs as well.

During an extended recession in the 1980s, researchers at Johns Hopkins University were able to correlate a statistical significance between economic factors, such as joblessness and social harms, with alcoholism and suicide. The data showed that for each one percent rise in unemployment, suicides increased 4.1 percent; homicides, 5.7 percent; deaths from heart disease, cirrhosis of the liver, and stress-related disorders, 1.9 percent; and admissions to mental hospitals, 2.3 percent for women and 4.3 percent for men. Although data and intuition imply that unemployment and lack of hope, both common in recession, are correlated to addictive behavior, a cause and effect relationship cannot be automatically implied. The legal profession has previously reached number one in another Johns Hopkins study that ranks professionals in rate of depression and suicide. We are seriously concerned that these numbers will continue to increase.

If you personally have been side-swiped by this unprecedented period, you should know these resources exist and take advantage of them.  If you have escaped the scythe but know someone who hasn't, reach out to them.  They're not lepers.  Time for us to band together as best we can.  This cannot—this will not—go on forever.  Be sure you're battle-ready when the clouds finally begin to part.

The volume of commentary following my publication earlier this week of "The Great De-Leveraging" has been unprecedented.  Depending on your attitude, that is either deeply gratifying or almost overwhelming.  As one who takes the positive view by default, I choose option A.

Therefore, I wanted to recap and respond to some of the very thoughtful remarks I've received.  First, a few quick preliminaries:

• "Comments" on "Adam Smith, Esq." are broken.  Yes, I know, I know.  This is a technical issue and not an editorial decision.  We have a complete revamp of the site in the works--currently under wraps--but my devout hope is that that will cure this issue.
• I have attempted to keep the identity of all commenter's scrupulously anonymous, and I hope I have succeeded.
• Without exception--even where people disagreed with my original piece--the remarks and observations have been thoughtful, reflective, and generous.
• I have, as editor-in-chief, reserved the right to condense comments.

Without further ado.

First, "Regular Guy" takes issue with my description of the non-equity position to begin with:

One of my friends forwarded to me your article on The Great De-Leveraging. She was particularly interested in a section in which you wrote "Non-equity lawyers don't have to beat their brains out.  So they don't.  Their deal--again, a perfectly rational one, to them--is that, premised on good behavior, they have a job essentially for life at, say, $350,000 to $450,000/year, adjusted for inflation.  If you think that's not an attractive deal, I suggest you immediately take the elevator down to the street and ask the first ten people you encounter if they'd like such a job."

I am a non-equity partner in Philadelphia, but there's almost nothing in the quoted section which rings true. I (and my friends who are non-equity partners in Philly, DC and in NY) are under incredible pressure to bring in new business and to meet billable hours requirements. And we do it (at least in Philly) for substantially less than $350,000. And on top of it, we get to pay for our own benefits out of pocket. I agree: if we ever had the deal you describe, it would be perfectly rational to do it forever. But I don't know anyone at any firm who ever collected $350,000 to $400,000 for good behavior. I'll be on the lookout for it, though . . .

Frankly, I'm not quite sure what to make of this, since it was an "outlier" in terms of reactions.  Clearly different firms operate at  different economic levels and for some paying a non-equity the amounts I mention might not make sense within their overall compensation structure or not be feasible financially, so I don't doubt that "Regular Guy" is describing his world accurately. 

My point was that, regardless of the exact level of the numbers, they're quite respectable incomes in the US economy as a whole--indeed, according to our President, you'd almost certainly qualify as "wealthy" and worthy of paying additional taxes.

Next up, we have a commenter at  Legal OnRamp who provided a remarkably thorough canvas of the non-equity partner landscape.  I've highlighted key points.

Some excellent data.

Some conclusions I would respectfully differ with.

Nonequity partners, properly applied, are more profitable than associates, notwithstanding their lower production of hours, for a number of reasons. Firstly, they are considerably more experienced and efficient, and thus a higher proportion of their hours worked are billed and collected.

Secondly, their billing rates are higher, and every hour worked has a higher margin as against the allocation of fixed overhead to them as timekeepers.

Thirdly, they tend to have some book of business, just not enough to justify a full equity partnership position. This provides some breadth and stability to the enterprise business base.

Fourthly, they tend to have some real expertise and help out in landing new cases.

Fifthly, they tend to contribute to the administration and partnership duties, from recruiting, mentoring new associates, all manner of committees, etc., thus spreading the burden among a wider group.

Sixthly, it tends to be very easy to project based on years of past experience what the contribution to the bottom line of the firm will be, and their compensation and benefits packages are correspondingly tailored so that the firm makes a profit spread from every one of them.

So....you do not as a manager need to have them working 2,000 hours (though you would like that!). You get 1600 hours at $500 collected from a service partner and she puts $800,000 into the kitty. Salary and benefits at $400k, overhead allocation $150k, net to the firm $250k. Bonus structures encourage more work and there is often generous sharing for it. But it is not required because there are all these other reasons not to force them out if you are making a quarter million a year from their efforts and they carry all these other burdens that would have to be borne by your equity partners otherwise.

Contrast that with an associate doing 1900 hours at $300 per hour, but a fairly typical post billing write down of 6% on hours...or 120. Net collected 1780. All in salary and benefits is $200k, less the overhead allocation of $150k and you net $114k. But, there is great variability in associate productivity. Many will work 2,000 hours or more, but the pre-billing write-offs can amount to 15% for the first two years. Frankly, if you can collect 1600 solid hours off an associate in each of the first two years, you are not doing all that badly. And that alas means that you are about at zero net contribution. Maybe.

Additional partner time is spent reviewing work product, much of which is not billed to the client. Associates in the first three to four years have little ability to carry administrative and other burdens, at least not to the extent of the service partners. And certainly they have no real expertise in the first few years. And there is the element that large numbers of them are going to leave to pursue other directions than big law, after a couple of hundred thousand dollars of sunk costs in recruitment, summer programs etc. per person, whereas the income/service partner has become a long term participant on the team.

There are other elements that merit consideration. The income partner position is also one that allows the firm to flex with people of talent that have issues in "life" that you want to accommodate. A disabled partner who can only work 1200 hours a year, or a partner that wants to dial down the demands while she raises three young kids, would be only two of dozens of examples of ways that the firm will "park" a valued talent that is not in a position to churn and burn like an equity partner must.

It is also an "incubator" position where young associates that the firm has picked out as the "best of the best" are made partner, or are lateraled in for a term to prove themselves. The ambition is to get them up to equity partner performance numbers, because by definition that is where the real economics happen. But obviously not all of them will make it. Not uncommonly there will be some in this class that are an "investment" and will be expected to generate more business, with a few less hours (say 1750 instead of 1950 but with a slug of development hours and activities in accord with a formal business plan).

And, partner culture notwithstanding, this is a class that is effectively "at will". There may be procedures and niceties, if you don't cut it you are out. There are no illusions about this. Whereas at the equity partner level, the protections and practices of the past make the process difficult and painful when they have to be implemented. But there is some stability and comfort in that too.

There is much more to it than just this, but I respectfully suggest that this income or service partner quadrant of the firm is not a wasteland of inattention and losers in a major firm. Yes, there are some that need to be looked after and in some cases counseled out. But the fact is, most of them are PROFITABLE and contributing in myriad ways that associates cannot and do not.   And that is but one reason why as the firm looks inward to decide where and how to cut....that it will not fall on the income partner ranks as heavily as you may suggest it should.

In a nutshell, I think many of these are valid points, especially the initial ones about billable rates and realization ratios being strongly superior to those of junior associates. 

But partly, I submit, this is simply a result of every junior person being at a natural and understandable disadvantage in terms of clients' willingness to pay.  Once associates reach their middle, and certainly their senior, years, their rates and realization rise to very comfortably profitable levels.  It's hard to imagine a world where lawyers vault magically from 3L grads to 4th or 5th years with nothing in-between.  Until we can invent a time machine that warp-bypasses those years, I'm not sure how having a larger cohort of non-equity partners helps alleviate the inevitable waiting-and-training game.  How did those non-equities get where they are, after all?

So it strikes me that those points may be less cause to celebrate non-equities than cause to be grateful that junior associates finally do acquire experience and talent, as costly as it may be to watch them do it.

The point about non-equities being able to assume "administrative and partner duties" including recruiting and mentoring is one I violently disagree with.  Indeed, part of the dysfunction I perceive in firms with large non-equity tiers is precisely that they act as a buffer and "sound insulation" between the partners and the associates.  This is neither healthy for associate development nor for partners' getting to really know the rising young talent pool--not to mention associates' prospects for partnership when that day finally comes.

This would also be the occasion for me to mention--as I did not in the original article--that a common complaint about non-equities is that they hoard work, depriving associates of essential training, implicitly overbilling clients for unnecessary seniority, and gumming up the discipline of proper staffing ratios.  To observe that this is an especially severe problem in this environment would be stating the gruesomely obvious.

Likewise, the points about "life" issues frankly echo one theme I tried to address, perhaps inarticulately, in my initial column on this topic.  

Let me hasten to confess that one reason I may not have been pellucidly clear about this issue is its potential for being viewed as politically incorrect, but here I'll say it: 

I do not believe that a law firm can be simultaneously a "lifestyle" or "work-life balance" firm and an uncompromising, bet-the-ranch, "go to" firm for only the highest-value and most prestigious work.

There, I've said it.  You have a choice, and both choices are eminently defensible and rational.  But I believe you must choose.

Next comes an observer who takes issue with The American Lawyer's definition of "non-equity partner," and who therefore concludes that my entire ratio calculation is askew and fundamentally uninformative. 

While I don't doubt that he has done has research assiduously, as noted in my original piece, I took the "TAL" data at face value as having at least the virtue of a consistent metric.

One failing of using the NEP to Partner ratio is that a number of the firms with low or zero ratios just use a different title--counsel, senior attorney whatever--to hide the economic equivalents of NEPs.  As you point out in the productivity chart, counsel are even less productive than NEPs--meaningfully so in the "more profitable" firms. 

Using Skadden as the first example--mostly because I know their web address off hand--they have 236 partners and 96 counsel (not counting "of counsel" or European, regional or pro bono counsel, but including "special counsel") for a ratio of 0.406.  This takes Skadden way, way out of your circle of cultural stalwarts, which is a much more select group than the NEP:P ratio implies. 

What follows is my quick counting of website listings [and he proceeds to conduct a similar analysis across another dozen or so firms]

[...]

Anyway, very interesting post.  Thank you.

I shall re-direct his critique to Aric Press.

Next, we have a very thoughtful, even soulful, response, gracefully outlining the pressures  generated when a high-performance culture collides with the life of a mere human (highlights mine).

I would agree with you that some of those non-equity partners, senior counsel, etc. are drags on the system.  But it is profoundly difficult to make that out from just the "hours" figure.  The very deal in becoming a senior counsel is that you have something the firm wants to keep, but you aren't willing to accept as remuneration the currency that they are willing to give you for it -- equity partnership. 

As you noted, it is obvious these days that the life of an equity partner is no better than that of an associate - you just get paid more.  Eventually.  After you have paid off your buy in.  In my firm, new partners made considerably less than 8th or 9th year associates, yet had rainmaking responsibilities, etc.  Lousy deal, and increasingly, talented people noticed.  Indeed, because of all the additional time doing client development, etc. etc., the equity partners who really WORK, carrying the load for those old guys who don't, have a terrible deal these days.  You'll make a nice corpse in your expensive coffin.

So what do the talented people do?  The ones who would be offered partnership, but frankly aren't sure that they want it?  Believe it or not, those people do exist.  A lot of them are women.  And at least for a few key, biologically-driven years, they want and need to dial back on the soul-killing hours.  And if one is HONEST, billing 2500 hours is soul-killing because you worked so many more hours than that.

I was offered, and did not take, a non-equity position.  I would have been on reduced hours (work 40 rather than bill more than 40 was the deal), I could be paid on a 1/3 eat what you kill. 

I was a talented antitrust litigator capable of running cases and capable of very complex analysis.  The clients liked me.  There was a core cadre of women with this deal at my firm who were routinely offered equity partner status every few years.  Typically nobody took equity status because the extra money wasn't worth the price.  This is because we were in control of our own hours (because successful participants under this system have their own clients who are loyal and trust their work), our conversion rates billed/collected were spectacular, and we represented niche practices that were not easily replaced.  Why do you think that the firm was willing to make these deals with us in the first place? 

So yes: in a world where only the raw number of hours billed matters, these people are less profitable for the firm.  But if our conversion rate is extremely high, we're critical to the relationship with some long-term clients, your "diversity" numbers plummet and there is no one to mentor new female talent coming up, and we're a straight 1/3 pay with risk borne by the non-equity, I would argue that these people are one of the very best deals in law firms.  Indeed, the fact that the firm was willing to think outside the box to keep some of these folks tells you that there is profit there.

The bottom line of my little screed is that the raw hours worked numbers don't tell the story of a person's value to the firm.  A senior counsel (other non-equity) has a deal whereby they work fewer hours for less pay.  If the deal doesn't work for both sides, the senior counsel gets canned.  In litigation, senior counsels are sometimes called non-equity partners so that one's card will say what the client wants to see.  But really: this is a strategy for holding onto talent that has decided that working even more hours than one worked as an associate is not worth the price.

Hard to argue with.  So I won't try. 

I told you it was soulful--and deeply appreciated by me.  Next:

Bruce,

A very interesting post.  One comment to consider regarding the relative value of income partners to associates.  At least [in my non-US country], most income partners feed themselves, in the sense that they have direct client contacts that send them enough work that keeps their plates full. 

It is not enough work to keep a pyramid of associates busy beneath them, hence they are not equity partners.  Clients prefer experienced lawyers to inexperienced lawyers because they get more value from them, despite higher hourly rates.  Clients hate paying for 1st year lawyers who contribute relatively little to a file when compared with their hourly rates. 

In my experience, until associates have 2-3 years experience under their belts, they are rarely more useful than a good quality paralegal, whose hourly rates are much lower.  [Here's the same point our second commenter made, so you can mentally reprise the same reaction I had then.--Bruce]  We need junior associates only because we need a future stream of partners.  As you point out, not a very high percentage of those we bring in make it to even income partnership, let alone equity partnership. 

If you agree with Richard Susskind, as I do, that law has much work to do on refining legal work process, then there will be even less work for associates to do in the future, as, organized properly, more work can be done by paralegals, or outsourced to contract lawyers or lawyers in lower cost centers.  Yes, we will continue to need the future partners, but does it make economic sense to pay crazy wages when only one in ten or twenty will make partner. 

The cost of associates is not only in their wages, but also in the time, effort and money to recruit them, and then train them when they come on board.  The best case scenario is that when they leave, they go in-house to a client, and if you have treated them well and have a good alumni program, they may become your client. 

In the worst case scenario, you have to pay to off ramp them.  For a very large percentage, I doubt that their cost is ever re-covered by the firm.  That is why firms hold onto those with experience who can feed themselves, and give good advice to clients.  If they work fewer hours, they are compensated less.  The key is that they are generally good lawyers who are valued by clients.  I'll admit that if they can't feed themselves, then you have to ask, do you keep them on board for what they are paid relative to what associates are paid, who don't bring in any work.  When you add up the real cost of a 1-3 year associate in New York vs. an income partner who completely or largely feeds him or herself, then the economics becomes very different.

Thoughtful and, if I had to bet, penned by someone with a fair degree of exposure to economics in their background.

Next, we have an opinion about how non-equity partners' willingness to work for (relatively) less could threaten the position of equity partners in the longer run:

Your rant [Was it a rant?!?--I thought it was pretty reasonable.  Bruce] about Non-Equity partners could be dead on if you are an equity partner worrying about how to protect your $2 million draw. However, the prevalence of non-equity partners is indicative of another unpleasant reality.

There are many many lawyers who are perfectly competent to do the work and are happy or willing to do so for less money. As we all know, not everyone is a rainmaker. Most of the horned rim types engaged in the securitization mill are technical geniuses but clumsy back slappers. One way or another the redeployment of these people in the legal market place is going to put pressure on big firm economics. Particularly in world with bankers capped at $500,000.

Keep up the great blogging.
(former Big Firm equity partner happy to have left the law)

And finally, this piece from a BigLaw partner who's a regular reader (highlights, again, mine):

        Your last piece, the Great De-Leveraging Article -- is really one of your recent best analyses on the current law firm model.  Well done. 

        As you will recall, you and I corresponded a little over a year ago, when I said that I believed there was a "bubble" in law firm "stock prices" in the form of profits per partner.  The then-existing model could not continue to sustain its growth in profits per partner at the historic rate.  All the available revenue levers -- leverage, rates, utilization -- had all been taken close to their logical maximum points.  Moreover, the drive to continue increasing those profits was leading to poor business practices that would bite firms when they could no longer be increased.  For example, the increased reliance on leverage, in large part through parking associates in the income partner spot, would not be sustainable over the long term and leads to an underinvestment in new talent.  Similarly, the constant increase in rates, particularly for junior associates, was starting to alienate clients.

        As we now are starting to see, the bubble for law firms is popping.  They cannot maintain the profits per partner at the historic rates.  In an effort to prevent a free-fall in partner profits, law firms are now "de-leveraging."  And many firms who could not (or are currently not) doing this fast enough, are starting to fall apart (e.g. Heller, Thelen, etc.) because the collapse of the PPP sends the rain makers to other firms, leaving the firm to collapse of its own weight.

        I think you are right that this is the time that firms need to start afresh -- Andy Grove style -- to figure out their strategy.  But, I believe that the firm leadership in only a few firms actually understand the dramatic nature of the strategic decisions they should be contemplating.  Most firms will consider whether to downsize, and if so in which practice areas.  They'll take some actions, and those in the top quartile may even align those actions so that the resulting firm structure is aligned to those practice areas where the firm sees opportunity in the future.  But, I think the choice is much more fundamental, and most firms do not yet see it (or do not want to see it).  I think firms need to think through fundamentally what their competitive advantages are, what markets they are targeting, and as a result, they need to decide what their firm business model is going to look like. 

        A couple examples may suffice:  Some of the highly profitable, NY firms (who are listed in your article as having few, or no income partners), generally tend to generate work through the big deals and the big litigations.  Those deals are large enough that the clients become price insensitive, and they can be staffed with large teams of lawyers paying attention to every legal detail.  For those firms, the model of high fees and lots of leverage continues to work.  While they may also be able to get premium pricing structures, they don't typically have to take any risk to get those premiums.  Those firms can continue to use the "Cravath" model, where they churn through the best and brightest of law school graduates, and are left with the brightest (and most "durable") lawyers who become partners.  That model will probably continue to produce $2-$4 million PPP. And while the growth in those profits may be difficult, given the amount of those profits, the model will likely still be successful.

           A second model probably applies to many mid-tier firms  (AmLaw 20-60).  These firms will need to adopt what I would call the "production" model.  Their target markets tend to be Fortune 1000 clients.  In litigation, they may not get the "bet the company" cases, but they will get significant cases within the firm's areas of specialty.  In deal work, they may become specialists in certain types of deals (the equivalent of what securitizations work provided for much of the last 7 years).  In both categories, clients are increasingly fee sensitive.  And in both categories, the work, while not "commoditized" is certainly of a type where sophisticated firms could bid on the work on a fixed rate basis.  Those firms who can figure out how to do this -- and this requires an incredible control over internal information within the firm to ensure that projects are properly bid and managed -- will have a chance of keeping up with the NY firms in terms of profits (though I doubt they will maintain the same high level).   This "production" model requires an ingrained systematization of process controls, teams of lawyers who are deep experts, and leaders who are risk takers (for bidding purposes) and project managers (for execution purposes).  It may still be a leveraged model, but the leverage probably will not look the same as in current firms. There may still be a place for income partners, but those partners skills are now to bring deep expertise and extensive project management skills.  Think of this firm like large construction firms.  The principals take significant risk, have the potential for significant reward, but only if the team executes flawlessly.

        A third model is what I consider the "boutique" model.  These firms have very talented senior lawyers in practices that are often difficult to leverage (think of Regulatory work, Appellate practices, perhaps some IP litigation, Tax advisory work, etc.).  These firms will likely have difficulty maintaining significant leverage.  A 1:2 partner-associate leverage may be the most that can be maintained (if that).  To the extent these firms can command premium rates, they may support significant profits per partner, but probably never at the level of the large NY firms.  The question will be whether these firms can offer a culture that compensates partners in a non-financial manner that makes up for the lost profits they might earn at larger firms.  One could imagine a fairly idyllic life -- less pressure to generate business, more time engaging in the practice of law. 

        As you note in your article, most firms currently don't really know "who" they are or what their strategy is.  Strategies have focused on either "bigger, more revenue," or "focused, more profits," but I don't sense that most firms have really considered what makes the firms a cohesive entity, how the firm differentiates itself, what innovative services it might provide, or how the firm can leverage its strategic assets.  The result is behemoth firms that keep getting bigger, with shrinking equity partnership ranks in order to keep the PPP at acceptable levels, and layers of "associates," "income partners," "counsel" and "others" who largely become cogs in an indiscriminate entity.  Loyalty to those firms is at an all-time low, because all the firms basically look the same, so partners defect when they see a chance to increase income.  Clients have a hard time telling firms apart, so success in client marketing focuses mostly on the personal relationship because there are very few other differentiating factors (to be sure, personal relationships will always be important). 

        Most firms are following the crowd like lemmings, breathing a sigh of relief that now, given Latham's large layoffs, it is now "ok" to really cut into lawyer staffing levels.  When the markets return, the pecking order for law firms will probably stay the same, though mid-tier firms may be at even a greater competitive disadvantage, having lost even more of their rain-makers to higher-tier firms.  A few smart mid-tier firms might realize that downturns are opportunities.  In good times, it can be hard to rock the boat; In downturns, there is a burning platform where partners can be galvanized to take action, if a good roadmap is provided.  Firms with strong leaders will take the opportunity to "right-size" and "right-structure" their firms.  They'll adopt new business practices, invest in training on those skills critical to the firm's differentiated success (e.g., project management, or substantive expertise) (after all, their idle lawyers now have more time to attend these trainings), institute systems to track costs on the types of matters they want to focus on in the future, they will start partnering with clients now (when clients may be eager to take risks to reduce costs, and law firms may have excess capacity in their system) to find ways to take risks together to find a better long-term model. 

           The bubble has popped.  The market is in a downturn, and businesses are being reinvented.  Some law firms will keep doing the same old thing (and for some, like the NY firms, that's probably a good model).  A few well-managed firms will use this time to determine "who" they are, and how they want to compete; assess what sort of PPP they really need and want, develop a strategy that builds on their strengths to differentiate themselves from other firms, and develops a structure and set of expertise to execute that strategy. 

        But then again, for most firms, they'll just hunker down, cut costs, and hope their relative standing somehow improves when the market returns.  Good luck to them.

A fascinating roundup of responses--and all, Dear Readers, thanks to you.  As they used to say somewhere in the lost mists of collective media memory, "keep those cards and letters coming."

What, finally, then, do I think about the remarkable growth over the last decade of the non-equity tier, and of the advisability of same?

As Tolstoy famously wrote in the opening of Anna Karenina, "Happy families are all alike; every unhappy family is unhappy in its own way."  I would paraphrase, or mangle, that to observe that "single tier firms are all alike; every two-tier firm is two-tier in its own way."

By that I mean there is no template, no equivalent of the Cravath Model, for what being "two-tier" means.  We as an industry continue to experiment on this front (as we are experimenting, abruptly and unwillingly, on many other fronts, of a sudden in this environment).

But I continue to believe that the burden of proof is on those who would argue for the expansion and not the contraction of the non-equity tier.  Economic reasons, as I noted in my original piece, are the least of it--which, ironically, is at odds with the gravamen of most of my interlocutors above who argued for the non-equity tier on economic grounds.

The core of the debate, in my mind, is all about culture.  Many are the reasons to have a substantial  non-equity tier, and many are the reasons, as I have argued, to strictly limit it.  But do not, under any circumstances, pretend that you are not making a decision with vast cultural implications.

• Prof. Larry Ribstein on "the over-leveraging and over-regulation of the legal profession:"
  

  In the longer run, we now see very clearly that running law firms as thinly capitalized worker cooperatives is not an equilibrium solution in this market.

  The answer, as I've said many times before, is dropping regulatory restrictions on law firm structure and letting them be run like real businesses. This particularly includes permitting non-lawyer capitalization and perhaps even public ownership, as well as enabling firms to hold onto their intellectual property through non-competition agreements.

• A piece in, of all places, The Atlantic's blog called "There's leverage everywhere!" with this pregnant introduction to our system:
  

  But let's work the argument a little further. It surely is true that unlike their current incarnations, the old Wall Street partnerships did not destroy the world with excessive leverage. But in the pre-credit-boom era, no one else was incurring much leverage either. It might be worth considering whether there are entities that are structurally similar to the old Wall Street firms (i.e., partnerships in which a substantial portion of the partners' net worth was tied up in their employer, and could not easily be removed from same) and see whether they have taken on significant leverage in the modern age of easy credit.

  As it turns out, there are such entities. We call them "big law firms." And their example is instructive.

  and
  
  
• More than one of these new pieces has referenced something that ours truly wrote about "Leverage:  Friend or Foe? (Or Noncombatant?)" back in December 2005, where I said:
  
  Common sense would tell you that in a labor-intensive service industry, where revenue is driven primarily by sheer tonnage of hours worked, the higher the ratio of associates (and non-equity partners) to (full equity) partners, the higher the revenues and thus the profits per partner. Right? It turns out this is one of those cases where it's not as simple as it seems.
  
  [...]  Then there's the evil twin of high leverage: Low utilization. It doesn't help that your leverage ratio is through the roof if nobody's busy; indeed, welcome to the worst of both worlds.

What has changed?

For starters, the whole world is now aware of the perils of leverage.  Let me throw a few charts into the discussion for starters.  By and large, I would like to believe, they speak for themselves.

Finally, here's one that leaves you wondering whether to laugh or cry—and it's seriously out of date at this point.

It's a chart showing the large global banks' market capitalization as of the 2nd quarter of 2007 (large blue-grey circles) and then as of October 20, 2008 (small green circles). 

In order, left to right and top row to bottom, they are:  Morgan Stanley, RBS, Deutsche Bank, Credit Agricole, Societe Generale, Barclays, Unicredit, UBS, Credit Suisse, Goldman Sachs, BNP Paribas, Santander, Citigroup, JP Morgan, and HSBC:

Update (8 March 2009):  A very helpful reader, who chooses anonymity, pointed out within hours of my publishing this that the chart above is seriously misleading.  Why?  Because the circles, being two-dimensional, invite us to visually compare their areas rather than their diameters—and the latter is what the chart-drawer actually chose to represent. 

Take Citigroup:  Its market cap went from $255B to $82B in the period in question.  Now that you look at it closely, you can see that's how the chart was drawn.  But were the circles drawn to scale appropriately in terms of their area, it's clear that it would take only 3.11 of the small green circles to fill the large blue circle (since 255/82 = 3.11).  Your eyes tell you in a flash that the green circle as drawn is far too small, in fact.  (Full explanation here.)

While I apologize for this mental and visual hiccup, all I can offer in defense is that I'm not the only one:

Pretty scary, eh?  It's a chart showing the deterioration of major bank market caps since 2007.  Prepared by someone at JP Morgan based on data from Bloomberg, this chart flashed across Wall Street and the financial world a few days ago, filling thousands of e-mail in boxes.  Putting a face on the current banking crisis it really brought home to many people on Wall Street the critical position the financial industry finds itself in.

Too bad the chart is wrong.

[...] So it's a typo: no big deal, right?  Yeah, but what a typo!  It got past Bloomberg and JP Morgan and pretty much all of Wall Street before someone said, "Hey, this makes no sense!"

Here's a proper chart.  While the players are somewhat different, that's more than made up for by the fact that it's far more current:  Comparing the market cap as of March 30, 2007, with the market cap as of February 20, 2009—barely two weeks ago:

Still not great performance, to be sure, but if there are degrees of horrendous-ness, this is at least less so.  Plus truthfully representative.

Thank you, Dear Reader.  Thus concludes the update.

While there are many reasons for these breathtaking declines, surely a proximate cause was the sky-high assets to equity ratios of many of these institutions.  20 to 1, 35 to 1, and even 50 to 1 were not unheard of in the palmy days.  Suffice to say that business model is, as I heard someone remark recently here in New York, "so last August."

So other parts of the economy (shockingly large parts!) may have gone crazy.  What does this have to do with us, necessarily?

If there are analogies to be drawn across professional service sectors, leverage is out for the investment banks and leverage is out for us as well.  For the I-banks, as noted, it was (in retrospect and even, to some more astute observers at the time) outrageous ratios of assets to equity, and for us it may be the high ratio of lawyer leverage.

I said at the outset that there are different definitions of "leverage" in our world, and I want to take some time and spend a little bit of effort breaking them out, because I believe the subtle differences matter.

Courtesy of The American Lawyer, here are the top 25 most leveraged firms from the AmLaw 100 and the bottom 25 least leveraged firms.

Top:

And bottom:

These figures are calculated by dividing the total number of lawyers at the firm (full time equivalent) by the number of equity partners.  For example, using firm #100 here, Faegre & Benson has 424 total lawyers and 255 equity partners, so 424/255 = 1.89.

Again, we can debate whether this is the ideal measure of leverage or not; my own preference is to divide all lawyers who are not equity partners by equity partners, but the results would be directionally similar. (Using Faegre & Benson as an example, again, the number of "lawyers who are not equity partners" would be 424-255 = 169, and dividing that by the number of equity partners yields 169/255 = 0.66.)

Why does leverage matter? For starters, as I noted in my 2005 column I quoted at the outset, leverage is your best friend in good times and your worst enemy in bad times. While we've heard the drumbeat of client complaints about paying for useless junior associates for years, this is suddenly the kind of environment where it will grow sharp teeth and bite hard. Either: (a) massive litigations will not be pursued because they're too complicated, uncertain, protracted, and expensive; and/or (b) if they must be pursued, contract attorneys, staff attorneys, and outsourcers will provide the human throw-weight needed for massive document review; and/or (c) corporations will simply insist that document review be completed for flat fees of $X/unit [$1.00/page? $0.50/page?]. In any event, no one I talk to--absolutely no one--believes that the litigation "factory" model with one partner overseeing half a dozen or more associates who are billing 'til the cows come home will be a predominant source of revenue going forward.

All well and good, but I think a more interesting calculation compares the ratio of non-equity partners to equity partners.  The charts and calculations that follow are premised on The American Lawyer's conventions, which denote someone an equity partner if they receive a K-1 and a non-equity partner if more than half of their income is guaranteed.  This is not the place to debate that methodology; the point for present purposes is that all firms are hewing to the same metric. While the raw data is courtesy of The American Lawyer, the calculations and the sorting are my own.

Here are the firms where the non-equity to equity partner ratio is greater than 1.00:

And here are the firms where that ratio is less than 0.25:

Note that I've drawn lines segregating the 11 firms with a non-equity to equity ratio between 0.00 and 0.25, simply because—depending on what may be special circumstances unique to each firm—arguments could probably be made that they don't "really" have non-equity partners as they see it; they just have to report this way based on The American Lawyer definitions.   Also note that I alphabetized the listing, by firm name, of all those reporting 0.00 ratios.

Why does this matter?  Aren't all the firms reporting layoffs reporting exclusively layoffs of associates and staff, not partners.

Yes, but those reports reflect actions taken to date, and I want to essay a little vision into what we may be seeing in the future, and to set the stage I think the two charts above are most informative.

First, why have no firms announced partner layoffs?  Isn't this the worst kind of cronyism, safeguarding one's peers, taking it all out on the "little people," and demonstrating lousy business judgment to boot, when the cost savings realized by offing (say) 10 associates could probably be realized by tossing a single partner overboard.  (Such, to paraphrase, is how it has recently been expressed to me, in tones ranging from outrage to derision to glum resignation.)

The issue, as so often is the case, is more complex than that.

Simply put, it takes time to get rid of partners.  They are not employees at will, as associates and staff.  They must be cajoled, "spoken to," almost certainly offered incentives to walk gently towards the door.  Note, importantly, that this is almost universally true of non-equity as well as equity partners.  (Off the top of my head, essentially every partnership agreement I've seen that addresses the issue at all treats non-equity and equity partners alike on the topic of termination—that is to say, it's hard to accomplish without cause.)

And there's more.  More and more non-equity partners, that is.  This chart shows the percentage of all lawyers at AmLaw firms who are not equity partners, from 2000 through 2006.  The big red bars are of course associates, ranging from 82% of the total in 2000 to 75% in 2006.  The light grey slices are "income" partners, growing from 9% to 13%, and the darker grey slice at the very top, growing from 9% to 12%, are "other non-equity lawyer" (don't ask me about the terminology; I'm just the reporter here). The chart is courtesy of last year's Citibank/Hildebrandt Client Advisory.

Now—bear with me—one more data point. 

Here's the "productivity," measured by annual hours billed, of (a) equity partners; (b) income partners; (c) associates; and (d) other non-equity lawyers, at "higher profit" and at "lower profit" firms:

What it shows with conspicuous graphic clarity is that income partners and other non-equity lawyers are systematically the least productive lawyers in these firms.  Associates work the hardest, but equity partners work almost as hard.  (At higher profit firms, the associates record a negligible 2.5% more hours than equity partners.)

From both a human and an economic perspective, this is all perfectly logical. Non-equity lawyers don't have to beat their brains out.  So they don't.  Their deal—again, a perfectly rational one, to them—is that, premised on good behavior, they have a job essentially for life at, say, $350,000 to $450,000/year, adjusted for inflation.  If you think that's not an attractive deal, I suggest you immediately take the elevator down to the street and ask the first ten people you encounter if they'd like such a job.

What else do we know about non-equity lawyers?

They are the most expensive form of leverage.  They make more than associates, to state the obvious, and have also "maxed out" on any variable benefits one needs a certain period of tenure to earn, such as 401(k) matches, etc.

This, frankly, is the least of it. The real issue is cultural.

Go back and take a look at the firms with non-equity to equity partner ratios < 0.25. Better yet, focus on those where the non-equity tier is either nonexistent (0.00) or de minimis and probably only an artifact of The American Lawyer's reporting system.

What do they have in common?

Indeed: An unusually high combination of cultural cohesion and readily articulable strategy. Just a sampling proves the point:

• Cleary, Cravath, Davis Polk, Debevoise, Paul Weiss, Simpson Thacher, Skadden, Sullivan & Cromwell, Wachtell.

Like them or not, you can say of each of those firms that they stand for something, and that achieving partnership there is dependent on several dimensions beyond that of being a mighty rainmaker.

Vs. those with the non-equity to equity ratio > 1.00: Without (re-)naming names, it must be said of that group that their strategies are extremely diverse and, in some cases, as yet unproven. Additionally, many of the firms in that group have high proportions of relatively new lateral partners.

But back to culture. I submit that firms with high proportions of non-equity partners have changed their culture. They may not have intended to, they may not have foreseen it, but change it they have.

Thirty or twenty years ago and even pretty much today, at least in New York-based firms, the reality is truly up or out. This attracts a certain cohort of hard core Type A people who (as I felt at that time) have never been anywhere other than at the top of their classes and who don't intend to be anywhere else now. As a managing partner said to me last week, "We've all heard the statistics that only one in 25--or whatever--starting associates at Cravath will make partner. But you know what? All the Cravath on-campus interviews are hugely oversubscribed! Everybody thinks they're going to be the one in the 25."

He has a point.

So how does the introduction, and more importantly the perpetuation, of a material cohort of non-equity partners change the culture of a firm?

Let me editorialize about a few consequences:

• The culture shifts from "excellence or else" to "good enough."
  • I don't think that "good enough" is sustainable in this environment.
    
    
• In the palmy days of 2001--2007, having a flexibly extensible non-equity tier served as a crutch for firms that wanted to avoid making difficult decisions about people or having awkward conversations with them.
  • I don't think that those difficult decisions and awkward conversations can be postponed in this environment.
    
    
• One of the reasons we're seeing widespread associate layoffs--apart from the pure economic imperative to cut costs in order to match revenues to capacity--has to do with morale. It's dreadful to morale to walk the halls seeing a bunch of your colleagues with too little to do, who are then guiltily sneaking out at 5:30.
  • The non-equity tier, with nothing to aspire to and perhaps (psychological speculation on my part, which I am shockingly unqualified to offer) feeling themselves ever so slightly "damaged goods" only exacerbate this.
  • None of us, none of our firms, have room for morale-busting zombies in this environment.
    
    
• The ranks of the non-equities grew not by design but by happenstance and, frankly, inattentiveness. While it may be true, as Oliver Wendell Holmes famously remarked, that "the life of the law has not been logic, it has been experience," it's time to apply some analytic logic, some serious and rigorous strategic evaluation, to the weed on steroids that has been the growth of the non-equity tier in too many firms over the past palmy period.
  • And no, we cannot afford to do otherwise in this environment.

We read, finally, that firms are drastically cutting back their summer programs and dialing back first-year offers, postponing start dates, offering semi-paid sabbaticals, and so forth. All well and good and relatively innovative examples of rising to this dismal occasion.

The pipeline of new talent must be kept as full as anticipated demand warrants. Law firms live and die on their talent, and they cannot short-change their investment in it based on next quarter's or next year's depressing projections, although they can certainly try to size it to better approximate the new reality.

But the talent that may not be carrying its weight, that needs profound re-examination, is that of the non-equity tier.

If you were starting your law firm today, would it look as it does in terms of non-equity partners?

Better yet, or more realistically yet, perform Andy Grove's famous thought (and reality) experiment when Intel was a low-end maker of commodity DRAM chips, having their lunch eaten in the late 1970's by the voracious and talented Japanese, threatening Intel's very existence.

I paraphrase: Grove said to his top management team, "If we don't turn things around in a very serious way, the Board will fire us. So why don't we 'fire' ourselves. Let's march out of this conference room and march back in assuming we're the new team the Board has hired. What would we do then?"

They performed the exercise, decided to abandon DRAM's and invest in microprocessors. The rest is history, and it's history residing under your desk or in your lap.

I'm suggesting you perform a "Grove Intervention" on your firm. And if you've read this far, you know where I think you might start.

More info here.

Admission is free but registration is required.

It would be great to see you there, and it promises to be an interesting panel.

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• 190 associates laid off, or about 12%;
• 250 paralegals and staff, or about 10%; but
• As of this writing, no partners (of whom there are 550).
• Finally, the start date for the class of 2009 is postponed to December, with an option to defer to October 2010, in which case the firm will pay those electing the year-long deferral $75,000 and encourage them to pursue volunteer work or community service.

One admirable and salutary part of the story is the severance policy associated with this:  Six months salary, capped at $100,000, as well as six months of health coverage.  As Bob Dell rightly says, this is "quite a bit above market."  Indeed, if you believe this table, it's double the approximate "going rate" of 3 months.  Classy.

So those are the facts.  What does it mean?

At the most prosaic level, it reflects the knock-on effects of the global economy hitting a brick wall.  (Actually, it hit the wall so hard that it bounced off backwards, as the just-revised 4Q2008 GDP numbers for the US showed, with a 6.2% contraction.)  When the economy experiences that, so do your clients, and then so does your firm.  It is as unfortunately predictable and seemingly inescapable as one billiard ball hitting another and then another.

This observation is simplistic only to the extent that it ignores how different firms will be hit in different ways—and how some, based on a delightful if sometimes random confluence of their practice mix, will dodge the gunfire altogether.  This is a period where "averages" will be particularly misleading. 

But that may be part of Latham's problem, in a suddenly-unfortunate way:  The simple fact that the firm is so global, and so diversified in its practice mix, makes it almost the law-land equivalent of an "index fund" representing the overall contraction in global legal spend.

Next, what absolutely positively must be said is how terribly sad and indeed frightening it will be for all those affected.  Now is not the time when you want to be abruptly looking for work.  "Adam Smith, Esq." is a tiny tiny enterprise, and for all of you who may be in this deeply unfortunate boat:  For the record, we're not hiring.  But for those of you reading this who might conceivably have an opportunity to offer, I urge you to act posthaste.  The people affected are not finding themselves on the street for "performance" issues, nor are they there through any fault of their own.  Throw what lifelines you may have.

Other observations from a management and strategic perspective:

• It is always and everywhere best to do these things in one big whack rather than through a thousand cuts, or—unforgivably—through "stealth" layoffs.  We can only fervently hope this one whack will be the last, but as we are learning on pretty much a daily basis, these days no one can make any promises.
  
  
• One must assume, although no details on this score have come out, that the review and cull are "strategically selective," as opposed to 10% across the board.  You will have noticed that all four of the Magic Circle firms who have announced "redundancies" have made a point of emphasizing that they were all in the context of re-sizing the firms to (we hope) better align with what they forecast to be market and client demand.  Again, while no one has a crystal ball, some things are clearer than others, and I would be shocked to hear that anyone in restructuring has been let go and equally shocked to hear that no one in securitization has been affected.  In other words, as nasty and "profoundly regret[table]" (Dell's words) as these decisions are, you can make them smartly or make them dumbly.  I have to imagine Latham is too well-managed to have done the latter.

Why were no partners affected?

I have a hunch, which Dell obliquely confirms when he remarks that "current and future client demand would likely require less leverage."

My theory—which I'll devote more ink to in future—is that, among many other things, we as an industry are going through our own "de-levering" period, and that on the other side of this interregnum firms will, by and large, have lower associate: partner ratios.   Many are the implications of that, presuming I'm right, but Latham seems to be acting as if they think it's accurate.

Finally, this morning's news out of Latham tells us something with all the emphatic insistence of a fire-truck air horn:  Firms are businesses.  I hope that by now that comes as news to no one.

Before firms can live to thrive again another day—which, trust me, they will—they first have to live. 

Call it what you will (carrying excess human capacity, being underutilized, supporting fallow and unproductive assets), it's simply not viable in a competitive marketplace to have a substantial proportion of the people on your payroll sitting around with too little to do.

That is also bad for morale, bad for professional development, unattractive to talented candidates you might want to recruit, and, finally, less than useless to clients.

At the moment, understandably and inevitably, we are all focused on the "destruction" inherent in Joseph Schumpeter's powerful insight about how capitalism repairs and reinvigorates itself.  It would be much more fun if we could focus on the "creative" dimension.  But not yet.  Not just yet.

The problem is that many of us seem to feel it is, or at least that's the way the media is reporting it and, frankly, the way our political leaders seem to be responding to it--this is a crisis, they reiterate, and unless precipitate action is taken, disaster looms. Pass a three-quarter of a trillion dollar package this week, or else.

Robert Shiller, an economics professor at Yale, and co-author (with George Akerloff) of the just-released "Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism," has this to say in today's New York Times:

"People everywhere are talking about the Great Depression, which followed the October 1929 stock market crash and lasted until the United States entered World War II. It is a vivid story of year upon year of despair.

"This Depression narrative, however, is not merely a story about the past: It has started to inform our current expectations. [...]

"The attention paid to the Depression story may seem a logical consequence of our economic situation. But the retelling, in fact, is a cause of the current situation -- because the Great Depression serves as a model for our expectations, damping what John Maynard Keynes called our "animal spirits," reducing consumers' willingness to spend and businesses' willingness to hire and expand. The Depression narrative could easily end up as a self-fulfilling prophecy."

I recommend perspective. Perspective not that we deny the severity of this near-depression. To be sure, there are plenty of reasons to worry:

• It's global in nature;
  
  
• It has come upon us with shocking, whiplash-inducing speed;
  
  
• It seems inexorable, deserved, the Puritanical comeuppance for a decade or more of living extravagantly in "sand state" McMansions, furnished with super-large flat panel TV's and navigated by Hummers, consuming energy recklessly; and to the extent this narrative rings true we feel chastened, like children rightly sent back to our rooms after immature behavior, and the small voice in the back of our minds chants "we deserved this, and we brought it on ourselves, so we have no ground on which to resist or fight back;"
  
  
• It's striking at the heart of our 21st Century economy, the financial sector, as opposed to being a classic inventory hangover, consumer pullback, sustained oil price spike, or isolated tech bubble;
  
  
• Speaking parochially about our industry, we have been joined at the hip to the financial services sector for as long as the boom was going on, and even before that. The New York "white shoe" firms all made their reputations on core connections to bulge bracket investment banks, and to some extent those reputations lived on until the very recent past. I suspect they'll endure beyond this interregnum, in fact.

But let's get back to perspective.

I believe two characteristics will separate the strong from the weak firms coming out of this episode. They are: (a) cultural glue; and (b) the quality of leadership.

As for "cultural glue," you had it going into this episode or you didn't. If you didn't, I sincerely wish you the best of luck, and I hope you seize this opportunity to build some, ASAP. If you have it, on the other hand, now is the time to capitalize upon and reinforce that. Other than that, I don't have too much more to add about the strength of your culture. It takes years and years to build, as does trust, and (see: Spitzer, Eliot) can be destroyed in an instant.

This brings us to the quality of leadership.

I believe this will be the key differentiator in this period. We talk about "leadership" interminably, but we do so for a reason. It matters.

Jeffrey Sonnenfeld, President and CEO of the Chief Executive Leadership Institute at the Yale School of Management, was recently interviewed about what leadership entails in this environment, and here's what he had to say (emphasis supplied):

• "In times of genuine crisis, leaders do not have to use fear to alert people about the need to change from the status quo. When the place is on fire, it is counterproductive to frighten people. In battle, no one needs to be motivated.
  
  People want to know that their leaders are competent enough to see them through this crisis. They don't have to like you; they have to know that they can place their faith in you because you have thought it all through"
  
  
• Successful leadership in this era comes down to four critical points.
  
  The first is personal accessibility. We've seen CEOs in times of crises try to circle the wagons and stonewall the media and other stakeholders. That's not the way to go. It's critical to be out there.
  
  The second trait of an effective leader in crisis is empathy. Show some compassion for those hardest hit.
  
  A third quality has to do with authenticity and believability. [He proceeds to talk about how Wall Street executives performed, or didn't, on Capitol Hill recently, and excoriates those who dissembled and seemed to be unprepared.]
  
  The fourth great quality of leaders in crisis is that they don't let the stress of the present preclude the boldness, courageousness, and thoughtful prudent risk-taking that is still vital to success. These leaders understand that we still have to get out there and be in business. We're not running libraries and museums; we're running dynamic enterprises that can't be afraid to take calculated risks.
  
  It's really tough times that bring out the greatness in leadership. Disappointments, barriers, setbacks - they are all the punctuating moments that really define a heroic career. You don't know how good an executive is until times are tough. As such, this is the time when corporate leaders can really distinguish themselves and really punctuate successes as outstanding leaders.

Study after study, time after time, has shown that Americans are the most optimistic of all nations. It's time to invoke that.

There's no sin, hereabouts, in getting knocked down. The sin--and an unforgivable one--is in not getting back up.

It will soon be time to get back up. Wall Street may be dead for now, but it's Lazarus. It has reinvented itself every decade or so for as long as I've watched it. And our firms are the handmaidens to its serial reinventions. The notion of the "Wall Street law firm," or the international law firm with a Wall Street practice, should not yet be read its last rites.

Prepare to be optimistic. Prepare to be an American. Prepare to lead.

—Above The Law (today)

While I might nominate that quote for Understatement Of The Season, I cite it for an entirely different purpose:  Are there any alternatives to layoffs?

Actually, I don't believe there are any "pure" alternatives to layoffs, at least not in the economic sense of "substitutes," for firms under serious financial stress.  But I'd like to suggest there are "complements" (economic sense) to layoffs. 

[Jargon digression:  In economics, "substitutes" are goods or services that people can trade off between without drastic disruption or deprivation, such as coffee and tea, bagels and muffins, or red and white wine.  As you can tell from these examples, there are rarely perfect substitutes—we all have our preferences—but if our favorite is unavailable or exorbitantly expensive, we will make do with the alternative and carry on.  "Complements," by contrast, are goods or services that tend to go together.  Think coffee and sugar, bagels and cream cheese, or red wine and bread.]

In the land of law firm layoffs, it's all too easy to understand why so many firms are resorting to them in this unprecedented environment. 

Forgive me if what follows strikes you as simplistic (good for you if it does!), but I find myself explaining this to people with a frequency that suggests it's not widely understood.  Consider hypothetical BigLaw firm in 2008 and 2009:

Obviously, these numbers are simplistic and you can quibble with the details and assumptions, but the message is powerful:  Law firm P&L's are highly leveraged. In the good times, this is your best friend:  Every additional dollar of revenue drops almost intact to the bottom line.  But in the bad times, this is your worst enemy.  A 1% drop in revenue can--all else equal--lead to a 3% drop in profits.

What, then, to do?  As the famous advice has it, "Follow the money."  The money, in this case, is associate and staff compensation.  Together they are to a law firm's expenses as Social Security and Medicare are to the federal government's budget:  Enormous.  If you need to cut a lot of expense at a law firm, you don't have many alternatives but to look there.  (I'm assuming all your office leases are long-term and not readily renegotiable, especially in this environment.)

The bad news, of course, is that cutting associates and staff used to be viewed as being as untouchable as trimming Social Security and Medicare would be. But not any more. If we've learned nothing else from the drumbeat of layoffs in the US and the UK, it is that there is no stigma attached to them today.

While we're at it, let's not limit the casualties to associates and staff. Everybody ought to share the pain, including equity and (if you have them) non-equity partners. It cannot be true that every single person in category X (say, partner) is irrebuttably indispensable while everyone in category Y (non-equity) is subject to scrutiny. Note to those keeping score at home: Cutting partner ranks will also distribute the diminished profits over a smaller pool, making the hit to your PPP less, percentage-wise, than the hit to your total P.

So if the base case for the inevitability of resorting to layoffs has been made, how can we do it more intelligently? How can we be more intelligent and less reactive, more scalpel and less meat-axe, more humane and less brutal?

Let's go back to "complements."

I suggest there are a variety of techniques you can employ, not as "substitutes" for layoffs, but to enhance their cost-saving impact and trigger other savings. Let me add that, with some degree of consternation, I don't see very many firms implementing these "complements." If this column has no other purpose, it's to change that myopic behavior.

• Reduced hours for reduced pay. Forgive me, but this strikes me as blisteringly obvious. We've heard bellyaching throughout the boom years about "work/life balance" and so forth, usually to imperceptible effect, but now we have an opportunity we can embrace with gusto. Of course, the reaction of associates invited to partake of this bonanza may suddenly be less than enthusiastic. "Be careful what you wish for?" Still, you should think about it.
  
  
• Sabbaticals. Whether paid, unpaid, or inbetween, consider granting (requiring?) people to take a period of time off. Don't permit them to do nothing, however; make sure the expectation is that they will do something related to broadening themselves, learning, professional or cultural or emotional or even artistic development. You might be surprised at the new imaginations they'll return with. And in the meantime you'll have economized while maintaining loyalty.
  
  
• Shared jobs. As with our first suggestion, this is one that was oft requested and rarely honored during the boom: "Impractical and unworkable." "Clients won't stand for it." "Shirking by another name." "How entitled do they think they are?" Permit me to suggest the world has changed. Think about this again.
  
  
• Salary freezes. Been there, done that, and how shocked are you that the reaction has been so placid? Which brings me to:
  
  
• Salary cuts. I don't know if you read it here first, but it matters not where you did. Economists famously and widely insist that wages are "sticky downwards," which is their awkward formulation of the highly common-sensical notion that people hate to see their pay (at the same employer) actually drop. But these are not ordinary times, and there are ample reasons to think that people would be surprisingly amenable to this revolutionary concept:
  • Today, a job--almost any job, much less a highly respectable one at BigLaw--beats no job. Enough said.
  • There's value in shared sacrifice. Taking a hit, collectively and communally, to preserve the firm's community, is not a hard stretch or leap of the imagination for people today.
  • Dollars go farther than they did 18 months ago. Have you noticed that housing has gotten cheaper? That cars can't be given away? That "70% off" is the minimum required to get people off the street and in the door? That everyone is suddenly very very negotiable on price?
    

I'm not suggesting my list is exhaustive; it's meant to be suggestive and (we can always hope) creative.

Now's the time to innovate. Given what a straight-line extrapolation of current reality would look like, somebody better.

Update:  23 February.  I received the following correspondence from a 1L at a top ten law school.

Greetings from Law Student Land.

What an intense time to be a 1L. Just thought I'd share a few thoughts and reflections, especially as they relate to your latest column.

First, never have any doubt about the attention paid to Above the Law at the student level. Personally I have serious misgivings about that site's position as the main conduit of information between associates and management. However, looking around my Crim class the other week on that famous thursday and watching everyone tick off the layoffs as they happened, I was struck again by the power of the instant press on firm recruiting and retention.

Secondly, and building on my first comment, note this story: ( http://abovethelaw.com/2009/02/nationwide_layoff_watch_mckee_1.php ) for an example of the sort of press that will make a difference in July, when my class at [*****] begins bidding for interview slots at firms. As I'm sure firms are aware, students aren't going to be able to exclude all of the firms that have made layoffs from our job search.

However, the process by which firms lay off their associates is a chance for us to "look under the hood" at the interaction between management and associates at different firms. I am certain that firms who conducted "stealth layoffs" or that swung the scythe heavily through the first-year ranks will be penalized come recruitment time. Which is not to even mention the debacle over at Pillsbury last week.

Lastly, I note with satisfaction your mention of work/life balances issues in your latest column as a way to trim firm expenses. Sadly, it seems that though firms have realized they will need to adapt to a changed business environment, they have so far acted with the lumbering (be-suited) herd mentality that so regularly characterizes their behavior.

Someone has told them that layoffs are ok, and so they are going to attempt to cut staff numbers until their profit margins return to normal. While wages are surely sticky, they are not stuck. I am lucky enough to have secured an associateship with a firm this summer. The firm I am headed to pays its associates below the "New York rate" but in a secondary city. I am told that associates work around 50 hours a week. This strikes me as a fair bargain, and one that many of my classmates would willingly make. It seems to me that even firms that are known as "sweatshops" could create a 75% work schedule in which pay is cut in relation to the chosen billable hour requirement. The idea of a sabbatical seems like an ingenious way to temporarily de-equitize partners until work picks back up.

All of which is just to say that I think your concept of where the general mood of the lowest rung of the ladder is these days is fairly accurate. Keep up the good work.

[After I asked my correspondent whether I could have permission to republish his thoughts:]

I have no problem with being anonymously quoted. I think this is clear from my comment, but just to be sure, the scheme I am advocating is less hours for less pay, as opposed to a straightforward pay cut. I don't think this would be too much of a problem, as I am under the impression that there aren't enough hours to go around at the moment. I'm also generally not in favor of having an across the board pay cut in exchange for a promise of no layoffs. Obviously, this would reward under-producers at the expense of the hardest working associates. I think generally we as students expect firms to approximate the level of attrition that they have in good times, and therefore be prepared for our class when we come aboard in 2011.

Thoughtful commentary indeed. 

Why would it not make sense for firms to offer a tradeoff between hours and pay or, perhaps more audaciously, a tradeoff between the investment made in professional development and training, and pay? 

What I'm suggesting in the latter thought experiment is simply this: If a firm is going to work you to death and skimp on training and professional development (they're non-billable), then shouldn't you expect to be paid handsomely for your pains? Conversely, if another firm is willing to devote significant resources in time and money to an intense training effort, shouldn't you rationally be willing to accept a lower salary, recognizing that you're investing for your future in a non-monetary way?

The remarkable thing is that it seems to work in other industries—witness the old joke about how the publishing industry is a wonderful place to get training "if your parents can afford to send you there."