Two years ago, Goldman Sachs was on top of the world, even as its rivals teetered. Lehman Brothers had disappeared. Bear Stearns and Merrill Lynch were acquired at fire-sale prices so they wouldn't disappear. Citigroup was insolvent, kept afloat by a massive $85 billion bailout, and Bank of America was hardly better. Morgan Stanley wasn't dead, but it was bleeding money, and had to reinvent its business model in the aftermath of the financial crisis. JPMorgan gained prestige and market share, but even they were a big, stodgy behemoth. Goldman, meanwhile, made a fortune. In 2009, when most of Wall Street was conducting a post-mortem and checking its pulse, Goldman reported record earnings of $13.4 billion. For that success, they had books written about them, and magazine articles and blog posts dissected their success, whether by calling them thieves who profited at clients' expense, or lauding them as visionaries who saw the crisis coming when few others did. At that point, it looked like Goldman was the undisputed King of Wall Street. Strangely, though, that hasn't been the case.
Goldman announced its second quarter earnings about two weeks ago, and the results were pretty disappointing. Their earnings per share were more than 20% lower than analysts had expected, at around $1.85. Breaking down that result further, the biggest reason they struggled was that they had weak earnings in their fixed-income, currencies and commodities division (FICC). This is the same division that drove their success during the crisis. The question, then, is why. A lot of the people who were responsible for Goldman's best trades during the crisis are gone, but Goldman's had constant attrition and still managed to continue to do well-- Wall Street and Washington are littered with Goldman alumni: they become Treasury Secretaries (Bob Rubin and Hank Paulson), governors, senators and White House staffers (Jon Corzine and Josh Bolten), open hugely successful private equity shops (Chris Flowers and Guy Hands), manage hedge funds (Ed Lampert) and run central banks (William Dudley and Mario Draghi). All have left, but the profit machine has managed to chug along. And the leadership hasn't changed at all-- the CEO, COO, and CFO have all stayed on deck. But FICC's revenue has been down for six quarters in a row now, which is starting to look less like a blip on the radar and more like a pattern of decline. But why?
Well, I've got a hypothesis, and I think it has to do with Goldman's success sowing the seeds of its downfall (sounds cliche, I know, but I think it works in this case). Rewind to the days when Goldman was making its most profitable bets. At that point, the conventional wisdom was still that real estate-related assets were still a great investment. You could get AAA-rated CDOs that yielded more than similarly AAA-rated Treasuries, and most investors assumed that this was a conservative buy. Now, I think it's worth pausing for a minute to consider what a fixed-income group actually does. Generally speaking, they make markets-- they find a long side (a party that wants to make a bet that the price of a certain asset class, security, or other instrument will rise) and a short side (betting that this price will fall), and taking a fee to bring them together. Until Dodd-Frank passed, they could also put their own money on the line to make these bets (this was called proprietary trading, and Dodd-Frank limits banks form putting more than 3% of their capital into these trades). The two aren't always easy to distinguish from one another-- sometimes, to facilitate a deal, a market-maker will leave some of the unsold securities from the deal (either on the long or the short side) on its own balance sheet; other times, it will buy up securities as inventory if it anticipates clients placing large orders for them in the near future.
This setup created obvious conflicts of interest. What if, for instance, Goldman had a client who wanted to take a long position in housing, but Goldman itself was taking a short position in that market? What if Goldman was aggressively limiting its exposure in a certain asset class by dumping its inventory on an unsuspecting client? There's a compelling point to be made that Goldman shouldn't necessarily care-- its clients are big boys who can take care of themselves, and by and large have access to the same information. If "the Germans" (there were a lot of German banks that were losing money on Goldman's deals while Goldman was minting it in 2008 and 2009) thought housing was a good bet, they were entitled to make that decision. The purpose of this post isn't to address that line of argument, but, even if it is valid, it creates serious perception problems for banks that do it. For example, if a firm makes markets in real estate, but is massively short real estate on net, clients don't look too kindly at a bank that is, essentially, making money at their expense. In the future, they're likely to be hesitant to do business with that bank, out of fear that they'll be stabbed in the back.
And that, in a word, is what I think is happening to Goldman. Plenty of financial firms were making markets in housing in the run-up to the crisis. But when the bubble burst, those firms lost as much money as their clients did, if not more. Merrill, Lehman and Bear didn't survive, but Morgan Stanley bled money alongside its clients after the crisis. Citigroup would have gone the way of Lehman if it hadn't been for the government. But, when Goldman's clients took fat losses, Goldman recorded record profits, largely on the back of their trading operation being massively short housing. Their executives ended up so embarrassed about this that they went and lied to Congress about it; CEO Lloyd Blankfein called it a "hedge". Now, that may fly as an explanation for some people, but it's complete baloney. Yes, there were deals in which Goldman ended up stuck with mortgage-related residuals and lost money (even after taking fees). But where a hedge is intended to protect your risk, Goldman's short position was a MASSIVE directional bet. Had Goldman wanted to hedge its mortgage-related exposure, it could have unloaded significant parts of its mortgage-related assets into the market to dial down their risk. Instead, they took every conceivable step to go short housing. They dumped their mortgage holdings. They bought credit default swaps (CDS's; essentially insurance on a bond default, whether a mortgage bond or a sovereign bond or a corporate bond) on mortgage-backed securities and companies that were heavily involved in the mortgage market. They shorted the stock of those same companies. In sum, they made a huge bet that mortgage-related assets and the companies that trafficked in them were headed for a fall. And they were right.
But now the acute phase of the crisis is over. The economy is still struggling, but, unless the Tea Party decides to shoot the country in the nuts, we're past what Krugman calls the "We're-all-gonna-die" phase. And now Goldman is in a pickle. Dodd-Frank limits the amount that they can commit to prop trading, so FICC's lifeblood is now making markets. But making markets still requires being able to step in and take a portion of the position to facilitate getting a deal done. And I get the sense that clients don't trust Goldman to do what's in their best interests anymore. And, until now, FICC was Goldman's biggest profit driver, sometimes bringing in over 40% of revenue and over 70% of profits. But I get a feeling that what might be happening is that clients are afraid of getting burned in dealing with Goldman and taking their business elsewhere. Making them, in essence, the victims of their own success.
Of course, memories are short on Wall Street: two years after a lack of regulation almost drove the economy off a cliff, they were pulling out their pitchforks and screaming about Dodd-Frank overreaching. So I don't think I'm writing Goldman's obituary by any means. But being branded as a firm that's willing to stab its clients in the back for profit (whether that label/perception is fair or unfair) is something that could be a drag on the firm in the next few years.
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