Capital Markets

Modern Midas

Bumper profits and a stellar reputation. Time to worry.
Economist StaffDecember 28, 2007

“It is important to be a bit institutionally paranoid, especially when things are going well.” Thus Lloyd Blankfein, chief executive of Goldman Sachs at a conference in November. After the year Goldman has had, Mr Blankfein cannot be far off hearing imaginary voices.

On December 18th the investment bank unveiled full-year results that contrived to be both widely expected and astonishing. Earnings in the fourth quarter stood at $3.2 billion, a 2% rise on the same period in 2006. Even as most of its peers have been dragged down by subprime-related investments, Goldman’s fixed-income business has boomed, thanks in part to a proprietary bet that the value of mortgage-backed securities would fall. The rest of its businesses are also steaming ahead. Its share price, as of December 18th, remained (just) up from the start of the year. Its status as Wall Street’s employer of choice is gold-plated, not least because of a bonus-and-salary pool of $20 billion. “If Goldman Sachs comes calling, you have to consider it,” says one headhunter.

Mr Blankfein’s neurotic impulses are well founded, however. Being at the summit of the banking industry is all very well, but the only way left is down. There are reasons, besides the impact of a slowing economy, to think that Goldman’s triumphant 2007 contains the seeds of a less comfortable 2008.

The first is that success on this scale always reaps a harvest of envy (never mind that Mr Blankfein’s handsome bonus will be dwarfed by the pay-off given to Stan O’Neal for leaving Merrill Lynch in incomparably worse shape). Rich, well-connected bankers have a limited call on sympathy at the best of times. Goldman’s gamble that many of America’s overstretched borrowers would default on their mortgages is unlikely to win it new friends. Signs of a backlash are visible: Christopher Dodd, a Democratic senator, has raised questions about the part played by Hank Paulson, who ran Goldman before becoming treasury secretary, in fuelling the subprime mess.

The second cause for concern surrounds Goldman’s finely balanced (or horribly compromised: take your pick) business model. As well as acting as an adviser and financier to clients, Goldman makes lots of money from putting its own capital to work. Proprietary trading and investments accounted for two-thirds of the firm’s revenues in 2007. The tensions inherent in this approach are neither new nor unique to Goldman, but they have become much more obvious now that its traders have made hay taking short positions against debt instruments of a type peddled to clients by other parts of the bank. Accusations that Goldman has been issuing deliberately bearish research in order to drive markets down and make even more money are fanciful. But some of its clients may become more questioning.

The third trapdoor concerns Goldman’s risk appetite. You may think that serenely stable share price suggests Goldman is a safe haven; its low price-earnings ratio tells a different story. Between 2003 and 2006 Goldman’s traders were losing money on many more days than other Wall Street firms. The bank’s risk-sensitive culture is rightly lauded; its agility in times of trouble has been proven. But it is neither cautious nor transparent, qualities that investors are likely to prize in coming months. Mr Blankfein’s antennae are right to twitch.

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