Goldman Sachs reconsidered
Over the past few weeks (and months), I have been posting a series of rants against Goldman Sachs. Yet at times I wonder if this is overblown and if most of these rumors and whispers about it may have been started and/or encouraged by its major investment banking rivals on Wall Street. Much of this review is due to a spate of news coverage which have probed beneath the surface of these charges and have shown that a number of them are exaggerated to some extent.
It might be wise to review how all the recent chatter about Goldman Sachs started. Here’s an extremely long piece in NY Magazine written by Joe Hagan which would help you do just that, among other fascinating tidbits about how the firm operates and what went on within the firm during the frenzy last Sept 2008. I have compiled below some points to consider when evaluating the stand of the critics.
Update: FT is reporting that Goldman Sachs’ public image has been tarnished since the financial crisis.
1. Why did the Treasury bail out AIG but not Lehman Brothers?
Goldman Sachs was its largest counter-party; AIG sent US$13bn out of $52 bn paid in total to Goldman Sachs. Lehman Brothers on the other hand, was an investment bank and hence one of its competitors.
A comparable deal by Merrill Lynch and XL Capital Assurance in 2008, on the other hand, yielded the former only about 13% of the amount promised under the credit-default swap agreement. One could argue that the Treasury then was more concerned about stabilising the financial system than about ensuring system-wide equality in terms of CDS payouts.
Goldman Sachs claims that it was well-hedged against the possibility of an AIG bankruptcy.
However as Matt Tabbi says:
I was on a radio show a few weeks back with a hedge-fund manager, a Goldman apologist, who insisted on the air that Goldman would actually have made more money if AIG hadn’t been rescued, because the bank was properly hedged against AIG’s collapse… it wasn’t until the show was over that I realized the proper response to that argument was just, “Bullshit!” Goldman has been making that argument ever since the AIG bailout, but it has never come out and identified that magical counterparty or counterparties who’d have been able to come up with $20 billion after a system-wide financial collapse.
Likewise, the mystery of how Goldman ever hedged itself against the possibility of a CIT collapse was never resolved. All we know is that Goldman repeatedly assured all inquirers that they were well-hedged on most of their positions. Although we don’t know exactly how they did it, it may not be unreasonable to believe that Goldman Sachs mastered the art of hedging. This recent report by Forbes highlights the fact that Goldman Sachs hedged itself very conservatively on credit default swaps:
An analysis by Forbes, using recent Securities and Exchange Commission and Federal Reserve filings, shows that Goldman Sachs has a $257 billion cushion–more than a quarter of a trillion dollars–of offsetting collateral on its more than $3 trillion of CDS activity. Forbes estimates that Goldman Sachs made about $1.8 billion in gross profits during the first quarter of 2009 from trading 12% of the total nominal amount of credit default swaps that exist. This profit would be the result of collecting only a 1.5 basis points spread on the $3.171 trillion CDS position. This estimate of $1.8 billion is before overhead, interest and taxes. Goldman reported total net profit of $1.8 billion for all of its activities during the first quarter.
2. Goldman Sachs took on irresponsibly high levels of risk even after it was bailed out and downgraded into bank-holding company.
Goldman Sachs, together with Morgan Stanley converted to regular bank-holding companies in the wake of the Sept 2008 financial turmoil. Doing so gave it access to cheap credit readily available at the Fed’s lending window, and by the Fed, I don’t just mean Bernanke’s Fed but the Fed Reserve of New York as well, whose current president Dudley is a former chief economist at Goldman (1986-2007) and whose previous chair resigned over apparent conflicts of interest between his purchases of 52,600 Goldman shares whilst serving on the board.
A glance at Goldman Sach’s earnings report for Q2 2009 shows that it had the highest VaR (value-at-risk) of US$245M as compared to Morgan Stanley’s US$117M and JP Morgan’s US$214M. This has not escaped the notice of Congress, who recently wrote to the Fed demanding an explanation for why Goldman was allowed to engage in profligate high-risk trading whilst leveraging itself with bargain Fed loans. There is concern that the moral hazard created by the feds would encourage investment banks like Goldman to take on risks.
As Joe Hagan notes:
It turned out that Goldman’s conversion to a garden-variety bank-holding company offered an amazing advantage: Goldman now had access to incredibly cheap money. Exploiting its new status, Goldman became the first financial institution to sell $5 billion in government-backed bonds through the Federal Deposit Insurance Corporation, which allowed Goldman to start doing deals when the markets were at a near standstill. “Goldman was desperate for it,” says a prominent Goldman alumnus. “Everybody knows it. Those FDIC notes they got were lifesaving because they couldn’t issue any debt. If it had gone on another week or two, Goldman would have failed, they would have gone the way of Lehman, and you’d be talking about Lloyd the way you talk about [Lehman CEO] Dick Fuld.”
The FDIC had intended to stimulate lending to consumers with the bonds, but Goldman had no street-level banking, nor did it intend to fundamentally alter its business model. But it could certainly have used the bonds to create leverage and maximize its trading profits. (A Goldman spokesman insists the company had “ample reserves” without the bonds.)
In other words, Goldman exploited cheap credit which was originally intended to help commercial bank make loans to consumers and businesses, without having to actually do so.
3. Goldman Sachs has people in high places, who are able to substantially influence the trading climate under which Goldman makes money.
Joe Hagan writes:
Somehow not recognizing (or perhaps not caring about) the brewing backlash, Paulson continued to appoint Goldman Sachs alumni to positions of power after the AIG decision; he named Edward C. Forst, a former head of Goldman’s investment-management division, to help draft the $700 billion Toxic Asset Relief Program (of which $10 billion went to Goldman Sachs), and then Neel Kashkari, a former Goldman V.P., as the TARP manager. And of course Edward Liddy, former Goldman board member, was already serving as the new CEO of AIG. Suddenly, everywhere you looked, men who had passed through the Goldman gauntlet of loyalty and rewards were now in key positions overseeing the rescue of the financial system.
The appearance of a government of Goldman enablers didn’t improve when Stephen Friedman, serving as both a board member at Goldman Sachs and chairman of the Federal Reserve Bank of New York, bought 52,600 shares of Goldman stock while he was supposed to be responsible for the firm’s oversight. Friedman had a temporary waiver saying he could still act as a Goldman board member, but it was hard to shake the impression that Friedman had sidestepped the rules, particularly since the subsequent rise in Goldman’s share price made him $3 million richer. (In May, he resigned from the Fed over the alleged conflict of interest.)
Add to the above the current president of the NY Fed, Dudley, whom served at Goldman for twenty years before entering public service.
4. Goldman Sachs engaged in unethical high-risk behaviour.
There is good reason to believe this is true. Joe Hagan points the following out:
Goldman’s profiting from this ethical gray area was exemplified by the real-estate market and the subprime-mortgage collapse: Goldman Sachs sold subprime-mortgage investments to its clients for years, but then in 2006 began trading against subprime on its own balance sheet without informing its clients, a hedge that ultimately let it profit when the real-estate market cratered. For some, this was a prescient call; for others, a glaring conflict of interest and inherently dishonest, since the firm let its clients take the fall.
Paul Krugman, in a Jul 17th op-ed echoes the same charge:
Goldman’s role in the financialization of America was similar to that of other players, except for one thing: Goldman didn’t believe its own hype. Other banks invested heavily in the same toxic waste they were selling to the public at large. Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.
This has caught the attention of the Senate, which recently subpoenaed Goldman, in an investigative effort to determine if the bank had knowingly advertised their mortgage backed securities and other derivatives despite internal doubts as to their credit worthiness
5. Goldman Sachs may have an unfair leg competitive leg up over the rest in the area of high-frequency trading.
This was addressed in an earlier post together with Goldman’s response.
In conclusion, although it appears that certain criticism of Goldman may have been exaggerated there still remains good reason to believe critics of Goldman Sachs are on to something. To my readers, I’ll say: Draw your own conclusion.