Speaking in early November at a financial industry conference hosted by Bank of America Merrill Lynch, Lloyd Blankfein did not sound like a man in the fight of his life. “We no doubt will encounter our fair share of challenges and missteps,” he said in the confident tones of the skilled tax lawyer he once was. “We already have.”
The audience of about 350 portfolio managers, analysts and shareholders gathered in a ballroom at the Grand Hyatt in midtown Manhattan sat quietly. If Blankfein and his company, Goldman Sachs Group, were causing some kind of stir, it wasn’t evident here. But outside, in the media, the firm was caught in a public relations firestorm. CEO Blankfein’s joking comment to a London newspaper the previous weekend that Goldman was “doing God’s work” served as an accelerant and subjected the proud, 140-year-old Wall Street firm to growing public outrage for its methods and famously high compensation.
But that day, Blankfein calmly assured attendees, "[The Goldman legacy] must be continually nurtured and passed on to future generations.” Client service and performance will trump, he added. Goldman will remain ascendant. “I have never been more confident of that outcome.”
With the White House and bank regulators — including the Federal Reserve Board, the Securities and Exchange Commission, the Commodities Futures Trading Commission and Treasury — as well as lawmakers in the Senate and the House seemingly set on reining in Goldman’s risk-taking and compensation, can Goldman really expect to continue generating outsize profits?
Many believe that they can and will.
“Regulation is not likely to contain Goldman,” asserts Kenneth Grant, CEO of Risk Resources, a New York–based risk management consulting firm for hedge funds. “There is a monstrous trading edge that pervades everything they do.”
Guy Moszkowski, a veteran Wall Street analyst, insists that Goldman, postcrisis, is “more dominant than ever.”
A bet on Goldman’s being successful has been a lock for the past decade. Since going public in 1999, Goldman shares have generated a cumulative total return of 159 percent, compared with a slightly negative return for the Standard & Poor’s 500 index. Net revenue has roughly quadrupled during that period, to the approximately $40 billion anticipated for full-year 2009.
And despite being vilified as a greedy bank running high-stakes bets on the taxpayers’ tab, Goldman is nevertheless considered by many in the financial industry to have an unmatched and powerfully effective approach to risk-taking.
Taking risk isn’t just at the heart of what Goldman does, it is what Goldman does, in booms, busts and especially in times of market dislocation.
“This is a group of people who can spot the markets where they have an edge and then go after [that edge] with all the intellectual firepower they have,” says Robert Stellato, a former Goldman managing director in charge of Nasdaq Stock Market trading. “They don’t take shortcuts.”
But where can Goldman go next?
Blankfein talks about the firm’s bid to expand services into emerging-markets countries such as China and India, using its potent sales force to reach out to institutions, companies and trading counterparties in those markets while also building on its global private wealth management business. But make no mistake: Goldman is banking on its core competencies — trading and risk-taking.
Consider the second quarter of 2009, with the investment world still walking on eggshells, Goldman having shored up its balance sheet with billions in taxpayer dollars and private (read: Warren Buffett) capital, and last remaining archrival Morgan Stanley back on its heels. Goldman saw an opportunity to harvest low-hanging fruit in the fixed-income and credit derivatives markets, among others. It upped its risk, at least as measured by one common metric, value at risk — financial accounting shorthand for the most money, theoretically, Goldman is willing to lose during any given day.
Goldman, say current and former employees, is driven by its ability to assess the playing field in any given market and, leveraging the firm’s vast information base, spot potential rewards clearly while effectively mitigating risk. Because virtually every large institutional investor relies on Goldman every day for at least some transactions — and because Goldman’s specialty is catering to the largest of them — the firm can bring all of its strengths to bear on its conjoined, concurrent pursuits: making markets and money for counterparties, and proprietary trading, or trading purely for itself, in stocks, bonds, interest rate instruments, credit derivatives, commodities futures and currencies.
The firm has a deep bench of franchises not limited to trading. Assets under management are closing in on $900 billion, more than three times the amount Goldman had when it went public. The division that houses prime brokerage was good for nearly $1 billion in net revenue in each quarter of this year. Former trader Stellato describes the sheer scope and depth of Goldman’s many simultaneous global moneymaking pursuits as “awe striking.” Since the beginning of 2007, Goldman has underwritten more than $1 trillion in corporate debt products and equity-related products in 1,800 offerings for 750 clients around the world. Across the gamut of its bond and stock trading desks, Goldman is involved in 2.5 million daily transactions on average and has 2,000 institutional clients.
“In carrying out so many simultaneous trades, no firm works harder to understand and manage risk than Goldman,” notes Jim Delaney, CEO of Township of Washington, New Jersey–based Market Strategies Management.
Goldman may well be “too big to fail,” a term broadly employed by former Treasury secretary and Goldman boss Henry (Hank) Paulson Jr. to justify taxpayer support for the biggest of the investment banks. Despite Goldman’s reputation as the smartest shop on Wall Street, the firm almost did fail, in late 2008. Not that Goldman has never felt failure. There are culturally undermining precedents: The Penn Central Railroad fiasco of the early 1970s, for instance, or the bond losses of the early 1990s. But Goldman has had far more success stories in its past, perhaps none more so than J. Aron & Co., a small commodities trading firm the bank bought for $120 million in the early 1980s. The purchase, which at the time seemed like a mismatch of genteel bankers and hardcore, raucous traders, is widely considered Goldman’s best acquisition (the firm has made very few) — if only for the cadre of talent and the dedication to stringent risk management it inherited, which eventually came to be embedded in the entire firm’s DNA. Run postacquisition by steely young Goldman partner Mark Winkelman, Goldman’s commodities arm produced a slew of skilled traders — among them Gary Cohn, now president and COO, and Blankfein — and plenty of profits. Winkelman had the right match of technical trading comprehension and cold-blooded hatchet man toughness to be a manager of traders (not the most common skill set on the Street). The J. Aron division became a powerhouse within the firm. Says a former Goldman trader: “Winkelman was the most feared person at Goldman, and he had the best understanding of how to manage risk. He passed this along to all of the guys running the firm today.”
Goldman, incidentally, would in 1997 acquire another respected player: Commodities Corp., a Princeton, New Jersey–based manager of commodities fund managers. Leading up to Goldman’s 1999 IPO, trading in general became a larger component of the firm’s overall mission, although its ability to move securities merchandise — equity and debt issues — had long underpinned its M&A business. Additionally, under Gus Levy, Goldman had pretty much invented equity block trading.
But there was much more to come. On the equity trading front, Goldman in 1999, the year it went public, snapped up Windy City market maker Hull Trading Co.; in 2000 it acquired another market maker, Spear Leeds Kellogg, forming SLK Hull. Along the way, Goldman took a majority stake in electronic-trading juggernaut Archipelago, an electronic communication network (ECN) that was single-handedly transforming the structural underpinnings of the equity trading world.
The New York Stock Exchange’s hire of Goldman banker John Thain as CEO and, under Thain, the exchange’s subsequent merger with Archipelago, as well as the political ascendancy of former Goldman execs Jon Corzine, a senator and governor from New Jersey, and Paulson at Treasury, seemed to confirm one of Wall Street’s most often repeated conspiracy theories: that Goldman has a high-paid bench of killer talent and one hell of a government feedback loop.
“Goldman is like the New York Yankees,” explains Sean Gambino, a former NYSE floor trader and current managing director at I-Bankers Securities, a boutique investment bank. “If you work there or if you root for them, you love them, but if you compete against them, you hate them. You may begrudgingly respect them, but you hate them nonetheless because they are so good.”
The Yankees of Wall Street, humbled in 2008, have enjoyed unrivaled dominance in a number of areas, including electronic equity trading. Consider this: One quarter of the volume at the NYSE is done via program trading — computer-generated multistock bundles that human hands never touch. Goldman has seized the largest share of that business. Among off-exchange dark pools, Goldman’s Sigma X is the third largest, with Credit Suisse and Knight controlling the two larger pools, according to Rosenblatt Securities. With a bigger slice of the equity market, and its sweet spot, commodities, entering a boom, Goldman expanded its purely proprietary trading arm, Goldman Sachs Principal Strategies, to complement and, some of its critics would say, feed off its institutional business.
In 2000, Goldman’s formidable trading and principal investments (TPI) segment generated $6.6 billion in net revenue, compared with $5.4 billion for investment banking and $4.5 billion for asset management and securities services, a fairly even spread. But beginning in 2003 the trading segment, powered by the fixed-income, currency and commodities (FICC) business — actually five separate businesses because fixed income is divided into three units: credit, rates and mortgages — began to generate record revenue. That year trading kicked in $10 billion; investment banking contributed $2.7 billion and asset management and securities services, $2.9 billion. Trading in 2003 represented a little more than half of Goldman’s net revenue. A year later, in 2004, it was nearly 60 percent of revenue. In 2006, trading, powered by a record year for FICC, recorded revenue of $25.6 billion, or almost three fourths of total net revenue.
Goldman successfully built up its proprietary trading group, producing a slew of talented sluggers that moved on to hedge funds — Dinakar Singh, Christian Siva-Jothy and Mark McGoldrick, to name a few. Some former Goldman prop traders, such as Ranaan Agus, have taken different roles at the firm but are still involved in trading and taking risk and are believed to be among its highest-paid employees. Many people close to the firm continue to believe that Goldman is making the most of its TPI money by trading its own capital, utilizing less leverage than before but still levering up. Goldman Sachs Principal Strategies has at least a dozen separate subdivision desks dedicated to proprietary trading that have no client interaction — “they look, feel and act like hedge funds,” says one former staffer — including the team in London, headed by Pierre-Henri Flamand.
Just as Goldman is driven by trading, trading is driven by risk management. There are numerous forms of risk management — committees, analytics, entire teams of staffers — and the dean of risk at the firm is CFO David Viniar. A few details about him are common knowledge: The 53-year-old keeps a meticulous office on the 30th floor of Goldman’s 85 Broad Street headquarters, with nary a paper clip out of place. And he relies on an equally rigid approach to measuring, quantifying and mitigating risk. That Viniar called in December 2006 for a meeting of senior executives from Goldman’s mortgage desks and the firm’s risk management division — a sit-down that led to a prescient if not controversial mortgage market hedge — is well documented. Goldman, despite its housing hedge via credit default swaps, continued to underwrite controversial credit structuring as late as 2007 but had bailed on a particularly dicey market — asset-backed-securities collateralized debt obligations, or ABS CDOs.
“Goldman distinguished itself by not going into the riskiest forms of structured-credit markets as aggressively as some of its competitors and doing an apparently superior job of managing any retained risk,” says securities attorney J. Paul Forrester, a partner at Mayer Brown in Chicago and head of the firm’s derivatives and structured-products practice.
Goldman has Wall Street’s most rigorous approach to handling worst-case scenarios. Risk stewards start by compiling the worst possible standard deviation moves across multiple markets and then assume that those moves all happen on the same day. Tanya Beder, the former head of Citigroup’s Tribeca Global Management hedge fund unit who currently runs her own risk management firm, SBCC Group in New York, agrees that “no other firm takes a harder line managing risk.”
Goldman is known not only for having best-in-class risk management and trading, but also for its sales effort. Without deploying any capital, salespeople — relentless and motivated — intervene between clients and the firm’s position traders, tying all of the transaction activities together.
“Goldman was constantly pushing things on clients when I was there,” recalls Nomi Prins, a Goldman managing director in the FICC division from 2000 to 2002 and author of It Takes a Pillage: Behind the Bailouts, Bonuses and Backroom Deals from Washington to Wall Street . She explains that aggressive sales teams convince clients they need solutions to problems they didn’t know existed, such as foreign exchange exposure.
At most banks there are at least three distinct kinds of trading desks: those that only execute trades for clients; those that make markets, which requires the firm to invest its capital alongside that of clients (and take prop bets); and those that simply make proprietary bets using the firm’s money. Prins says there were inevitable conflicts: “Of course, info gets shared — that base of knowledge is what makes Goldman Goldman. The prop trading and the client trading are intermingled; in some cases, the same person is doing it or the groups are next to each other.”
Goldman says it ensures that the proprietary trading it does purely for the bank is both physically and technologically separate from the prop trading it does for clients, and that information does not cross these barriers. Moreover, Blankfein insists that 90 percent of all prop trading done by the firm is tied to activity on behalf of clients. Goldman’s critics beg to differ.
“This notion that Goldman invests principal mostly on behalf of clients and only makes a small percentage of revenue from prop bets is completely disingenuous,” contends Prins. “Besides, whether it’s for themselves or for clients, it’s still risk.”
Blankfein often counters assertions that his firm must be leveraging off its information base. But pure prop, which Blankfein says contributes only a small portion of spoils, should not be confused with the prop trading that accompanies market making and client order implementation. Take this hypothetical: A Goldman equity market maker is tasked with executing a massive sell order for a large buy-side equity mutual fund over the course of 30 days. When the trader knows the fund is done selling — relieving the downside pressure on the stock — he is, in this example, likely to buy up the last of the fund’s shares, hoping to make a decent profit in the coming days. The prop trading embedded in market making is by far Goldman’s bread-and-butter business.
Goldman’s return on equity has dipped, from what used to be 30 percent during the bubble years to below 20 percent in recent quarters. Equity returns were diluted by share issuances done last year to shore up the balance sheet. “For a financial, ROE is everything,” analyst Moszkowski points out. “What matters is, how is it taking all the capital that has ever built up over the years and deploying it? Are the returns holding up, or are they deteriorating? When the ROE starts to dip, that’s when you become concerned.”
Despite Goldman’s skills the clock on risk may be running out. Roy Smith, an economics professor at New York University’s Stern School of Business, warns that “banks are not out of the woods yet” as far as what business activities they will be permitted to pursue. “The Congress and the regulators are surely going to have something to say about these issues,” he says. “Proprietary trading activities may end up being too expensive for bank holding companies, causing some banks to rethink where their trading businesses ought to be. Some may want to spin them off to shareholders to free them up.”
Indeed, carving Goldman into pieces was suggested a few months ago on Capitol Hill by Simon Johnson, a professor of economics at Massachusetts Institute of Technology. Goldman is a big hedge fund, nothing more, he said, and taxpayers shouldn’t be held liable for its risks. And there’s the compensation issue. Goldman’s employees are among the highest paid in the business. How else, argues Goldman, can it keep its roster of top players? Moving to defuse public outrage, the firm announced before Christmas that its top 30 executives would receive all-stock bonuses for 2009, which can’t be sold for five years, and investors would be given a nonbinding advisory vote on compensation principles at the shareholder meeting.
Goldman could find itself caught up in any number of small scandals that could escalate quickly. Under way are regulatory examinations into industry practices such as trading huddles and practices associated with dark pools in which high-frequency traders get millisecond peeks into electronic equity order books. (Goldman notes that its “huddles” are perfectly legitimate analyst discussions of such issues as earnings, sales numbers and economic data, and furthermore that it does not offer “peeks” at orders to any traders, high frequency or not.)
“It still won’t matter,” asserts former Goldman managing director Prins. “Even if they are hit by a big scandal, Goldman exists to do one thing: figure out ways to make money.”
