Goldman meets its black swan
The most profitable investment bank of all time, Goldman Sachs ducked and weaved through the economic crisis of 2007-9, with barely a scratch. However, Friday's announcement of an SEC lawsuit, which drove down its shares by 13%, indicates that Goldman may not have eluded the clutches of the "Black Swan" after all.
Whether the SEC's allegations have merit is not the issue. Rather, the question is whether Goldman's business model is viable in the post-crisis political environment. After nearly failing during the crisis, Goldman now operates as a bank holding company, thanks to the Federal Reserve.
But this arrangement seems awkward, since Goldman is an investment bank with an enormous proprietary trading desk, not a typical commercial bank. Compounding the firm's political unpopularity, Goldman continues to fumble with public relations, reminiscent of John D. Rockefeller's Standard Oil, before its breakup in 1911, or J.P. Morgan & Co. prior to the passage of Glass-Steagall, which forced the firm to split in two.
During the dark days of September 2008, the Federal Reserve allowed Goldman Sachs to convert to a bank holding company, allowing the firm access a variety of emergency government liquidity programs, and signaling that Goldman was too big to fail. Without government assistance, many believe Goldman would have suffered a fatal run.
Throwing Goldman a rope during the crisis made all the sense in the world, but should Goldman continue to operate as a bank holding company now that the crisis has passed? The mark of a "bank" is that it funds itself with customer deposits. Contrast Goldman with JP Morgan. At year-end 2009, JP Morgan held $938 billion in deposits, accounting for 50% of its liabilities. Goldman held only $39 billion in deposits, or 5% of liabilities. If it walks like a duck and quacks like a duck, it's probably a duck. Goldman more closely resembles a proprietary trading desk or hedge fund, than a bank.
If Congress adopts the Volcker rule, which would prohibit banks from engaging in proprietary trading, then Goldman will face a real quandary, since trading and principal investments made up 87% of its 2009 pre-tax earnings (the company does not identify how much of these earnings were "proprietary.")
Without continued government support, Goldman would be smaller, riskier, and less profitable. At year-end 2009, Goldman held $850 billion in assets on its balance sheet and another $871 billion in third-party assets under management, for a total of $1.7 trillion, dwarfing the world's largest hedge funds by orders of magnitude. Without government backing, Goldman would be totally dependent on market funding, an unreliable position for such a large balance sheet.
Prior to the crisis, market-funded financials were long viewed with skepticism, and during the crisis they dropped like flies, as Goldman itself nearly experienced. Post-crisis, were Goldman to return to market funding, it would need a lot more capital, which would depress its returns. At year-end 2009, Goldman's tier 1 capital was 7.6% of total assets, making the company "well-capitalized" under bank holding company rules. There is no exact math for capital ratios, but my guess is that if it were fully market-funded, Goldman would need almost twice as much.
In short, without its new-found bank holding company status, Goldman would likely be smaller, riskier, and less profitable.
Goldman is mindful of the post-crisis political environment. Its annual letter to shareholders includes lengthy explanations of its conduct during the crisis and praise for emergency government actions. But Goldman's response to the SEC lawsuit reveals that the firm is struggling to adapt. Its terse press release stated, "The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation."
Rather than pledging cooperation, the firm lashed out at the primary regulator of its broker-dealer subsidiaries - a questionable PR move, and possibly a symptom of cognitive dissonance affecting management's judgment. Symptoms of cognitive dissonance may surface when a management team cannot reconcile its company's self-image with new information.
In Goldman's eyes, the firm is the world's premier financial institution, employing the sharpest minds, generating the strongest returns, operating with the highest ethical standards - doing what CEO Blankfein sincerely describes as "God's work." The SEC lawsuit is inconsistent with that self-image. So is popular opinion. Management's combative posture reveals its frustration.
One can imagine a wide range of possible outcomes for Goldman. The more positive scenarios involve continued growth and profitability. In some of the less favorable scenarios, the firm is forced to restructure, perhaps like Standard Oil and JP Morgan & Co. If it cannot devise a new strategy, the less favorable scenarios become more likely.
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Posted by: WmarkW | April 23, 2010 8:21 AM
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