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Dear John Thain Headshot

2010 Will be Challenging for Goldman Sachs

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I. Introduction

This article isn't going to talk about the charged arguments that are normally thrown around when talking about Goldman. (Should the public have funded them? Was AIG a bailout for Goldman, orchestrated by the government? Have public funds allowed Goldman to profit off of public money? Has Goldman created the crisis? Is Lloyd Blankfein a Virgo or from Mars? Exactly which deity's work is Goldman doing?) These questions, regardless of the merit or the level of interest, will not be discussed here.

I think these clarifications are important because of two recent pieces on the bank (both after this piece was mostly written). The first was a piece written by Charlie Gasparino. The second was the much more riveting, much better-supported, and much longer piece by Bethany McLean at Vanity Fair.

I feel it's important to address Mr. Gasparino's theories and arguments here, head on, before diving into the salient issues. Throughout this article I'll need to point out his flawed reasoning, lack of rigor and depth in his arguments, and a fundamental lack of understanding. I will dismantle Mr. Gasparino's arguments and examine his flawed assumptions, and his claims that have poor or missing support. The motivation for drawing these distinctions is simple: our conclusions are very similar and I do not want anyone confusing my well-reasoned and informed arguments for his.

II. Recent History

Goldman, often maligned (remember the "fight" between two of the least informed people on the planet?), has had a good year. They survived the credit crisis, paid back the treasury in short order, and have continued to make money (use whatever definition of that you'd like: stay cashflow positive, generate revenue, generate earnings, etc.). However, the future looks to be very challenging for the firm -- their profitability will likely not remain at the recent, elevated levels. To understand why, we must first look at the recent past (and explain some things).

To examine Goldman, it might help to think of the firm as a large pool of money -- this is the money that is actually owned by Goldman's shareholders, or the equity they own in Goldman (shareholders equity). When Goldman wants to purchase securities or make an investment in a company, it uses some of this equity and borrows the remainder (depending on the investment, the ratio of Goldman's money to borrowed money can go from 1:1 to 1:100; the exact amount depends on the risks of the given investment).

To help put some numbers on it, Goldman's leverage in the third quarter was 13.5x (meaning 13.5 dollars of assets for every dollar of equity, or 12.5 dollars borrowed for every dollar Goldman shareholders owned), versus a long-term average of around 22x, and went as high as around 28x in recent years. Then, when Goldman exits its investment, the borrowed money is returned--only the profits or losses and Goldman's capital remain. (As an example, let's say Goldman buys a bond for $100. In our example it borrows $99 and contributes $1 itself, or uses leverage of 100x. If that bond's goes up by $1, Goldman can sell the bond, return the $99, recoup its $1 investment and the $1 profit -- this is a 100% return on its equity.) This measure is generally what people call "Return on Equity" and its the main measure of how well a financial services firm invests its capital.

From their filings, we can see that in the third quarter of 2008 (pdf) Goldman had $42.5 billion in equity. From that filing, we also know that Goldman's return on that equity was 7.7% for that quarter and 14.2% for the first nine months of that fiscal year (both numbers are annualized). Compare those numbers to the third quarter of this year (pdf): Goldman returned 21.4% on its equity in that quarter and 19.2% over the first nine months of 2009. Further, and Goldman had $58.4 of equity at the end of the third quarter of 2009.

[Note that, in some sense, when a person buys shares of Goldman's stock they are buying part of Goldman's capital along with the firm's ability to manage and grow that capital. Put another way, I'm buying equity that I am allowing Goldman's traders and bankers to use in exchange for a share in the profits (in the form of the capital I own growing). This is the sense that financial firms are different from non-financial firms: in an industrial firm equity represents ownership of tangible assets and an ongoing business whereas in a financial firm equity represents capital used to invest. But, I digress... ]

When we compare this performance to its peers (see the chart), we can also see that Goldman's ability to invest its capital and grow it has exceeded that of its peers both consistently and significantly. The source of this outperformance is what we are going to examine -- is this pace sustainable? I do not think so.

2009-12-30-return_on_equity.png
Source: Bloomberg

III. Recent Results -- Investment Banking

Before we dig into Goldman's other businesses, one important aspect of Goldman is its investment banking business. Mr. Gasparino goes out of his way to make claims about Goldman losing ground here. Using the bluntest instrument one can think of for examining the claim, the league tables, its easy enough to disprove his ridiculous claims. Inexplicably, Mr. Gasparino seems to never cite a single number. Make no mistake, I am not a huge an of the league tables as a measure of quality -- if I do one deal whose value is $100 billion do I have a better banking franchise than if I had done 10 deals valued at $9 billion each? I would argue "No" but the single $100 billion deal would be ahead in the league tables. We can almost fix these sorts of problems by looking at the league tables based on fees and not transaction volume, but using the league tables in general still leaves a lot to be desired.

Just to hammer the point about investment banking home, merely look at the Thomson league tables for the year through the third quarter (as of the writing of the other pieces, the most recent complete dataset, free registration required). Goldman maintains the top spot in both worldwide and U.S. completed M&A when ranked based on fees. Further, when looking at fees from capital markets activity, including debt, equity, and equity-related instruments, we see Goldman maintains exactly the same position as it did last year (fourth). In short, I see no evidence that anyone can point to in the actual numbers that Goldman is slipping in investment banking.

IV. Recent Results -- Trading

Goldman's other businesses, though, show an interesting trend: Goldman's ability to generate returns on its own capital for 2009 has been massive. This is partially because Goldman was able to keep operating and deploying capital while many of its competitors weren't. A relevant fact: when firms can't borrow money against their capital, or pay higher rates to do so, this has to be reflected in asset prices -- firms will demand a higher return to cover their costs. (Example: If I'm trying to buy a house and the bank quotes me a 5% rate on my mortgage, I'll probably pay more for a specific house than if the bank quotes me a 10% rate. The fact that the borrowed money is more expensive affects the price I'm willing to pay.) For Goldman, who was viewed as more stable and whose cost of borrowing wasn't rising as much as its competitors, this drop in asset prices created a huge opportunity -- Goldman could pay the same price its competitors were willing to pay and earn a higher return, outperforming its peers.

Mortgage bonds, for example, traded at very attractive levels, which allowed Goldman to use it's cheaper borrowing and available capital to buy these bonds cheaply. In fact, Goldman had the opportunity to deploy billions to make a profit from this dislocation in the market -- in mortgages specifically, there is an opportunity to make a profit purely by having cheaper financing than the next guy (this trade is called a dollar roll -- read more here or here). What does this have to do with anything, this esoteric portion of a small market, you ask? Well, Lloyd has an answer for you (pdf):

Last month, for instance, we provided short-term liquidity to a portion of the mortgage market through a large agency mortgage transaction.  This significant extension of our capital helped keep mortgage rates from increasing by allowing billions of dollars of mortgage securities to be financed.

This must be the trade Lloyd was talking about and it was exactly what Goldman was rumored to be doing in the market -- he essentially admitted it in front of Congress (and claimed to be doing a public service in the process).

Interestingly, the Vanity Fair piece sort of gets at the heart of the issue:

But because so many of Goldman's competitors were gone or disabled, spreads -- the difference between the price at which you sell and buy a variety of securities -- were wider than they had been in years, meaning that Goldman could practically mint money.

This is a good point -- by facilitating the sale or death of so many investment banks, there were fewer institutions trading and taking order for clients, which increased the cost banks could charge for these services. However, this point neglects the part of Goldman that is unique: it takes large bets with its own capital and doesn't just sit between other institutions when they trade.

Mr. Gasparino manages to completely miss the actual point and instead of the points above, links Goldman's profitability to something completely unrelated:

As a consequence of its bailout last year, Goldman has been deemed a commercial bank, meaning it has explicit support from the Fed and can borrow cheaply at the discount window. That, combined with near-zero interest rates, has given Goldman an artificial edge: By borrowing so cheaply and with Fed protection, it can make money trading [...]

Interesting argument. However, and I'm sure this won't surprise many of the people who know things about finance and banking, the logic and facts are totally wrong. First of all, the Fed had long ago given access to the discount window to all banks, including investment banks. Second, the notion of "near-zero interest rates" is also silly to cite as a reason Goldman can make money trading. His implication, that Goldman could borrow for nearly zero, is extremely wrong. I don't think, as Wall Street's existence was in peril, that Goldman was able to borrow money for trading at "near-zero interest rates."

V. Goldman's Status as a Bank

One potentially important point that is often mentioned, as Mr. Gasparino does, is Goldman's status as a bank. Well, let's note a few things. First, Goldman is not a bank, or Bank Holding Company, anymore -- it's a Financial Holding Company. Second, Goldman has always had a bank under its control. In fact, if you look at the order that changed Goldman to a Bank Holding Company (pdf), part of the action involved converting the bank Goldman already owned (with $23 billion in deposits at the time).

So what does all this mean? Well, basically, nothing. In speaking to several people with legal backgrounds, none could tell me what it even meant that Goldman was now a Financial Holding Company versus a Bank Holding Company. It turns out the term "Financial Holding Company" was created in the Gramm-Leach-Bliley Act. This was the structure (the "FHC") and act that allowed Citigroup to form by legalizing traditional banks and investment banks being part of one company. If one reads the item I linked to above, it should be clear that this is the sole purpose of being a Financial Holding Company -- to offer financial products that previously couldn't be offered by one company.

So, in summation, Goldman Sachs, a securities firm which owned a small bank, is now a company whose classification allows it to engage in both traditional banking and investment banking (including advisory and trading) by owning a bank (which Goldman already did) and a secuities firm (which Goldman's largest subsidiaries already were). Not much difference if you ask me.

VI. Conclusion

Regardless of what one thinks about Goldman as a firm, the opportunities that I've cited, which have driven a significant portion of Goldman's outperformance, are going away as the world normalizes. Investment banks are deploying their capital again, the world is looking more stable, and there is no longer a huge question looming over every firm regarding their existence in the near future (leading to more rational costs for firms). All of this, taken together, implies the risk and return of assets will (and have) move closer to parity. And, while Goldman was well positioned to buy up cheap assets when they were looking stable and the world wasn't, those opportunities are gone -- or, at least, far fewer. Layer these reasons on top of the "new paradigm" where leverage is limited and larger firms face more scrutiny, and it's not at all clear that being a firm that invests its own capital is going to be the right business model going forward.

In short, stability has had two effects that will impact Goldman's business going forward -- the firm's capital is no longer much cheaper than its competitors and, with other firms now able to deploy much more capital, asset prices have recovered and now offer lower returns for the same risk (mainly because liquidity has returned as firms deploy capital). I believe both of these effects will have a large impact on Goldman, whose businesses generate a significant portion of their profits from investing versus trading (even in the trading divisions). The magic -- which was less magic and more being in the right place at the right time -- will not be around next year. For this reason, and because of the lofty expectations people have set for Goldman, the next year will be a trying one.