Goldman Strikes Gold Again

This morning Goldman Sachs posted near-record trading profits and bonuses. But behind the giddy numbers, Nomi Prins argues, are signs that the bank hasn't learned any lessons from the downturn.

10.15.09 11:21 AM ET

What a difference a year, a pile of federal capital, fewer competitors, and rebounding trading profits make. Coming on the heels of JPM Chase’s giddy profits Wednesday, Goldman Sachs’ third quarter earnings fell shy of the record set last quarter, but earnings per share handily beat analysts’ expectations of $4.24.

Third-quarter revenue was $12.4 billion, or $5.25 earnings per share, compared with $13.8 billion last quarter, and an increase of 105 percent over last year’s third quarter. Net profit was $3.19 billion, down from $3.4 billion last quarter.

Goldman will do well as long as trading on leverage does well, and as long as there remains no meaningful regulatory fallout from last year’s crisis.

Again, it was the Trading and Principal Investments Division driving the numbers, posting revenues of $10.03 billion, down from the record $10.8 billion last quarter. This included a decrease of 12% to $5.99 billion in the Fixed Income Currency and Commodities (FICC) area, the cornerstone of the firm’s trading businesses, shy of last quarter's record revenues of $6.8 billion, but up substantially over the $1.6 billion in the third quarter of 2008.

Goldman’s equity revenue was $2.78 billion, compared with $3.18 billion last quarter, and $1.6 billion during the third quarter of last year. Equity underwriting revenue was $363 million compared to $736 million last quarter, and $292 million last year. Debt underwriting was $211 compared to $336 million last quarter, and $383 million last year. Asset-management revenue rose to $974 from $922 million last quarter and $1.1 billion a year ago.

Profits and Bonuses

Where capital based trading profits go, stock prices and bonuses follow. So it comes as no surprise that Goldman’s compensation pool remains on track towards a new record of $22.2 billion (surpassing $20 billion in 2007 and $12 billion in 2008).

All this comes four months after Goldman repaid the $10 billion of TARP money it received during the height of the crisis last fall, along with $426 million in dividends. Though these gains were short of last quarter’s, they still indicate a return to the risk-taking model that has served Goldman so well in the past, with the exception of during the financial meltdown.

Going into last fall’s crisis, things weren’t so rosy. Goldman’s third quarter 2008 earnings (filed on September 16, 2008, a month earlier than this year) were already strained. Total revenue was $6.04 billion, and revenue from the firm’s Trading and Principal Investments area was $2.7 billion, 67% below 2007’s levels as credit problems were brewing. Residential and commercial mortgage losses were $825 million. Still, its stock price ended that quarter at $163.97 per share. It would sink to a low of $55.19 per share on November 19, 2008.

Things got worse, of course, in the fourth quarter of 2008. The firm reported a net loss of $2.12 billion. Trading and Principal Investments net revenues were a negative $4.4 billion, and the FICC division’s net revenues were negative $3.4 billion.

Then Came the Rebound

But many billions of dollars of federal assistance for itself, and more for the general banking sector, have a way of turning things around. In anticipation of strong earnings results, Goldman stock surged to $192.28 yesterday, although the share price was about 2% lower in late morning trading today. As of yesterday's close, Goldman Sachs’ stock had soared 122 percent this year.

Trading revenue is based on two things: having capital and leveraging that capital in order to make bets to drive the firm’s bottom line. That in turn introduces risk. Having capital has been taken care of by federal subsidies, and the ancillary impact that the government’s bank-savior mentality has had on general market psychology. Though the firm’s overall leverage was down to 17 to 1 in the last quarter, from a high of 27.9 to 1 before the crisis, Goldman still gets to compute its capital requirements the old investment bank way.

Why? Once Goldman got approval to become a bank holding company on September 21, 2008, it had two years to come into line with other bank holding companies in terms of capital requirements. But, a lot can change in two years if your influence is as strong as Goldman’s--and you don’t like constraints. Despite the new name, Goldman received a Federal Reserve waiver from the market risk rules that other banks use.

Thus, it gets federal support like a bank, but computes risk and capital reserves like an investment bank, meaning it can set aside more capital to trade with, even while its value at risk (VAR) remains high. Last quarter, Goldman’s daily VAR jumped to a record of $245 million, up 35% compared to the $181 million held against risk during the third quarter of 2008. This quarter, it was $208 million, a 17 percent decrease over last quarter.

Goldman Pays to Play

Recall from last week, the man at the number one slot on Treasury Secretary Tim Geithner’s speed-dial list is none other than Goldman Sachs, Chairman and CEO Lloyd Blankfein, which screams access.

The firm’s access last year gave Goldman $54 billion in other federal treats, outside of TARP. Those included $12.9 billion from the AIG bounty that it was supposedly hedged against, $29.7 billion of debt backed by the FDIC’s Temporary Liquidity Guarantee Program, approximately $11 billion available under the Fed’s Commercial Paper Facility, plus some unknown quantity of assistance through the Federal Reserve’s emergency programs.

Going Forward

Yes, things are great for Goldman. The firm is nearing record numbers for bonuses, trading profits and the sheer size of its influence in the banking arena. For now. But, there’s something ominous about the giddy trading figures, even besides the risk they represent. In terms of complex transactions, the more clients are convinced to add bells and whistles to their transactions, the more revenue is maximized for the bank. People get paid big bonuses for this ‘value-added’ service to clients, and the clients who didn’t get trashed last year, or even the ones that did, seem to have dipped back into exotic transaction land, bolstered by stock price euphoria and the bubble mentality of not wanting to miss anything—again. We’ve been here before. It’s amazing no lessons have been learned.

But, since they haven’t, and complexity is making its way back into the game, Goldman will continue to thrive. As Blankfein said last month at a banking conference in Frankfurt, Germany, “First, the industry let the growth and complexity in new instruments outstrip their economic and social utility as well as the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.” That’s on the way down, though. On the way up, complexity was Goldman's friend as much as cheap capital, federal favoritism, and loose regulations are. It is again.

Goldman will do well as long as trading on leverage does well, and as long as there remains no meaningful regulatory fallout from last year’s crisis. Goldman is sheltered from the general riff-raff of mortal consumer losses. One additional reason that it doesn’t need to put as much capital away in reserves for consumer-driven losses: it can use that capital to trade.

When you stack all the cards in your favor, you tend to beat the other players at the table. Goldman’s earnings are proof of that. As a result, after the market digests this quarter's numbers, their stock price is likely to continue to rise—that is, until the government gets wise to the dangers of risk driven profitability. Since that wisdom wasn’t achieved from the experience of this crisis and bailout, until and unless the next leg of the crisis smacks Washington even harder in the head, Goldman will keep winning.

Nomi Prins is author of It Takes a Pillage: Behind the Bonuses, Bailouts, and Backroom Deals from Washington to Wall Street (Wiley, September, 2009). Before becoming a journalist, she worked on Wall Street as a managing director at Goldman Sachs, and running the international analytics group at Bear Stearns in London.