Capital Markets

Keeping Up with the Goldmans

Goldman Sachs's record profits are not a signal to relax.
Economist StaffJuly 17, 2009

To the survivors, the spoils. That is the cry going up at Goldman Sachs after it chalked up recession-defying-nay, record-breaking-quarterly profits on July 14th. Minting more than $3 billion in three months, so soon after its own near-death experience in the wake of Lehman Brothers’ demise, will enhance Goldman’s reputation as Wall Street’s overachiever. But it will also strike some as obscene given the scale of public support needed to keep the firm and its peers from buckling last year.

The first half of 2009 was fertile territory for investment bankers as markets rebounded and companies (not least banks themselves) rushed to raise debt and equity. But none of the banks due to report after The Economist went to press, not even a resurgent JPMorgan Chase, was expected to come close to Goldman’s blowout performance. Having incurred smaller losses than rivals, it is still prepared to deploy risk capital where others fear to tread.

Goldman claims that most of its profit came not from “proprietary” trading, or punting its own money, but by acting as a middleman, making markets for clients in everything from bonds and shares to currencies and commodities. Such business, barely profitable in the boom years, has become a gold mine as competition has dwindled and bid-ask spreads (the money dealers pocket on trades) have ballooned. A bank with the capital and cojones to deal mortgage-backed securities issued by Fannie Mae or Freddie Mac can earn 10-15 times more than before the crisis.

Goldman, a dyed-in-the-wool trading firm, is grabbing such opportunities with glee, taking business from once ubiquitous but now reeling rivals such as Citigroup and UBS. It also helps that its arch-rival Morgan Stanley has pulled in its horns. By contrast, Goldman’s value-at-risk number-an imperfect but popular measure of risk appetite-hit a new high in the second quarter. But with spreads so high the firm no longer needs to use so much borrowed money to get results. Its leverage ratio has fallen to 14, half its pre-crisis level but still higher than a typical commercial bank’s.

Big profits mean big payouts. For the year to date Goldman has set aside $11.4 billion for compensation and benefits, more even than in the halcyon first half of 2007. Its ratio of pay to revenues continues to hover near the dizzying 50% level that was the norm on Wall Street before the meltdown (see article).

For a firm that probably would have collapsed without government capital, debt guarantees and fast-track approval to turn itself into a commercial bank (not to mention a multi-billion-dollar payout as a counterparty of American International Group), such largesse looks cheeky at best. It has already drawn rebukes on Capitol Hill, even though Goldman has repaid the government’s $10 billion preferred-equity investment. “They can’t continue along these lines or there will be outrage,” thundered Jon Tester, a Democratic senator.

The windfall will eventually dwindle. Goldman and other survivors will continue to benefit from the coming wave of debt issuance by federal, state and local governments. But dealer spreads are sure to shrink as markets normalize and those that have retreated return to the fray. This is likely to be only partially offset by a pickup in businesses tied more closely to economic growth, such as advising on mergers and acquisitions.

Wall Street also faces tighter shackles. Regulators are on the warpath against commodities speculators. A clampdown is coming in credit derivatives; America’s Department of Justice has joined those probing that market. The largest financial firms face higher capital requirements. These changes may not bring Goldman back to earth but they will clip its wings.

Markets remain fragile. Even Goldman would struggle to make money without the array of government backstops propping up the system. Others are struggling just to survive. As The Economist went to press, CIT, a liquidity-crunched lender to small and middling companies, was scrambling to avert bankruptcy by lining up emergency loans from its debtholders after the government pulled out of rescue talks. Officials had looked at several options but concluded that the firm was too sick to save-and small enough not to pose a systemic threat. But some policymakers worry that the financial system is still in no state to absorb even modest shocks.

And although a few on Wall Street are reaching for the champagne, most Main Street lenders are more inclined to drown their sorrows. Credit-card losses, fuelled by rising rates of unemployment, are at a record high. Mortgage delinquencies have yet to stabilize, with supposedly high-quality “prime” loans now also souring fast and loan-modification schemes having little impact.

Losses are also accelerating in commercial property, on which banks of all sizes loaded up in the fat years. This was the biggest stain on Goldman’s ledger, accounting for $1.4 billion of mark-to-market losses. Unnervingly for other banks, many of which carry their commercial-property loans at close to par value, Goldman marks its portfolio at a mere half that.

A Federal Reserve financing program was recently extended to commercial mortgage-backed securities but many are or will become ineligible under its present rules because of ratings downgrades. Meanwhile, a public-private scheme to take troubled loans off banks’ books has stalled, partly because of accounting-rule changes that give the banks more leeway in valuing their assets. A sister program for toxic securities finally got going this month, albeit in substantially scaled-down form.

Small wonder then that David Viniar, Goldman’s finance chief, admitted on a call with analysts that “we are way far away from being out of the woods.” The firm may be scooping up market share, but the bigger picture is still far from pretty.