Is The Era of Goldman Sachs Exceptionalism Over?

Under the leadership of Hank Paulson, from 1998 to 2006, the one-time private partnership exploded onto the scene as a public company. But since the crisis of 2008, something has been lost. The era of Goldman exceptionalism may be over.

For more than a decade, Goldman Sachs played the role of Wall Street’s Black Pearl, the ship from the movie ‘Pirates of the Caribbean,’ as it deftly took on more risk and accumulated more treasure than the other buccaneers in the great sea of global liquidity. While Goldman has survived the storm of the financial crisis in sound condition, its reputation as “nigh uncatchable” has been diminished.

Read a chapter of William D. Cohan’s new book, entitled “Money and Power: How Goldman Sachs Came To Rule The World”, in which he explores the reputational damage Goldman suffered after the financial crisis.

By almost any reasonable measure, Goldman has come through the financial crisis in good shape. If nothing else it has survived, when others failed. It did so in a series of maneuvers, converting itself into a bank holding company so that it could tap emergency funds made available by former CEO Hank Paulson, who became President Bush’s Treasury secretary in 2006. Paulson led the company during the boom years in Captain Jack Sparrow-like fashion.

Goldman – to the chagrin of many – was made whole in a series of bad bets with troubled insurer AIG, saving it from a massive loss. It also raised $5 billion in emergency capital from Warren Buffett. The bank, which has repaid its debts to Buffett and the government, is now stable and profitable. While it still faces regulatory and legal uncertainty, it is financially strong, with a pre-tax profit margin of 34 percent.

Yet something has been lost. The era of Goldman exceptionalism may be over. The Black Pearl is still afloat but no longer the fastest vessel in the water.

Under the leadership of Paulson, who led the company from 1998 to 2006, the one-time private partnership exploded onto the scene as a public company. It raised and deployed capital in a way that set itself apart from its peers. By March 2006, the height of the credit boom, Goldman’s value at risk – a measure of the average daily amount of money it could lose – was $92 million, up 135 percent from $39 million in 2001, BusinessWeek reported in a cover story that year. And during that first period of March, it earned a stunning $2.6 billion in profits on $10 billion in revenue. Those profits were driven by a readiness to use leverage, which topped out at ratio of 25 to 1.

Rivals went to extreme lengths to catch up, but Goldman was too fast for them.

“Across the Street, bankers and their bosses struggled to keep shareholders happy, taking more risks to keep generating higher and higher rates of return on equity in the (ultimately vain) attempt to out-earn Goldman Sachs,” Suzanne McGee (an Institutional Investor contributor) chronicled in her book Chasing Goldman Sachs.

As BusinessWeek has noted, Morgan Stanley CEO Phil Purcell, a veteran of the retail side of the business, probably lost his job because he wouldn’t take on more trading risk. His successor, John Mack, boosted value at risk to $56 million by mid-2006, up more than 60 percent in three years. Morgan Stanley reported $1.6 billion in profits on $8.5 billion in revenue during that first quarter of 2006--impressive indeed, but no Goldman.

In the wake of the financial crisis, Mack announced in September 2009 that he was stepping down as CEO of Morgan Stanley, which had come close to failure. Mack – who remains chairman – had faced criticism from some investors that year who were frustrated that the bank continued to post losses after the crisis, including a $1.2 billion loss during the second quarter, a period in which Goldman earned $2.7 billion. Other rivals – Bear Stearns, Lehman Brothers, Merrill Lynch – fared worse.

Thanks to a combination of troubles – some market related, some of its own making – Goldman no longer outstrips all rivals when it comes to taking on risk and generating return. Its value at risk for the quarter ended in March 2011 was $113 million, just behind that of Morgan Stanley, which reported $121 million. Goldman’s return on equity from continuing operations was 5.2 percent during the latest quarter, compared with 6.2 percent at Morgan Stanley, according to Barclays Capital. Barclays has an “equal weight” rating on Goldman and an “overweight” rating on Morgan Stanley. Goldman notes that on an annualized basis, however, its first-quarter return on average common shareholder equity was 12.2 percent.

Goldman’s mortality is on display in its fixed income business, which drove much of its profit during the boom. Fixed income revenue for the first quarter was $4.3 billion, down 28 percent from the comparable quarter of last year. That wasn’t as bad as the 40 percent decline that Barclays expected. Yes, the decline was inevitable, given shifts in the credit markets –but the fact is, a certain amount of revenue and earning power has been lost, at least for now. Goldman CFO David Viniar said on a conference call that market share and bid/ask spreads have fallen from “unsustainably high levels” in 2009 and 2010.

And Goldman still has an outsized presence in the business – its FICC revenue was more than twice that of Morgan Stanley’s $1.77 billion. But JPMorgan’s FICC business is larger. It declined a mere 4 percent during the last quarter to $5.2 billion.

“FICC is an enormous part of their business. They did well this quarter, but it was nothing sensational,” says Jeff Morris, a portfolio manager and head of U.S. equities for Standard Life Investments.

Morris says Goldman also continues to lose a certain amount of talent in trading and other areas to smaller firms, which are gaining share. “In the case of the M&A advisory business, smaller boutiques are gaining share against large rivals due to the perception that the advice they provide won’t be influenced by the potential for other financing related fees,” Morris says.

Goldman also lives under a regulatory and legal overhang. The regulatory issues – related to the implementation last year of the Volcker rule– are forcing it from the lucrative proprietary trading business, where it was able to dominate rivals. In a sense, the law almost seems to have been written with Goldman as a particular target. A Goldman spokesman noted, however, that the proprietary trading business wasn’t as big a part of the company as many people think, and that it never accounted for more than 10 percent of revenues.

While the rules that constrain Goldman are industrywide, the legal issues are specific to the company. Levin, still fuming over Goldman’s performance during Congressional hearings, has suggested that criminal charges could follow. And there is the risk that private investors will come forward with additional lawsuits.

The pressure on Goldman is evident in its M&A advisory business, too. Goldman Sachs’ once seemingly unassailable lead in the market slipped during the first quarter.

At the end of the first quarter, Goldman was a relatively distant number two in the global investment banking business, behind JPMorgan Chase. Researcher Dealogic says JPMorgan has 29.9 percent market share, and had participated in $215 billion worth of deals for the year to date.

At the end of the quarter, Goldman was number two in the global M&A business, behind JPMorgan Chase. Researcher Dealogic says JPMorgan has 26.98 percent market share, and had participated in $217.1 billion worth of deals for the period. Goldman had 23.2 percent share of the market and had participated in $187.6 billion worth of deals.

Over the last year, the company suffered a series a PR setbacks, which started with the perception that bailed out insurer AIG needed public funds, at least in part, because it made Goldman whole on a series of derivative bets gone bad. Goldman has explained that it was simply a middleman in those transactions, acting as a market maker.

Then, there was the SEC’s civil case against Goldman, which argued that the company failed to properly disclose to clients some details of how it helped hedge fund manager John Paulson bet against the subprime market. Those clients didn’t realize that they were essentially betting against Paulson and that some people within Goldman thought Paulson was on the winning side. Goldman CEO Lloyd Blankfein defended himself and the firm during congressional hearings, arguing that Goldman simply was functioning as a market maker. Regardless of the legal merits of the case, it was a PR battle that simply couldn’t be won. Goldman ended up settling the case.

And then, there was Goldman’s plan to invest $500 million in Facebook and drum up $1 billion in additional funds from investors. That transaction had to be limited to investors outside of the US., for fear that pre-announcement publicity would violate U.S. disclosure rules. The deal made financial sense for Goldman, but it seemed to some that the company was once again at odds with the SEC, seemingly ready to push the limits of the law.

The SEC suit raised concerns among some legislators that Goldman was putting its interests ahead of its clients. Blankfein told Senator Carl Levin that the bank was merely serving the clients in question as a market market and had no fiduciary duty to advise them. While Blankfein might have been on solid legal ground, it didn’t placate critics.

Blankfein’s role as a lightning rod for criticism during the last few years is a measure of how much the perception of the firm has changed. Its CEOs and senior executives have gone on to play big roles in government and in business ever since World War II. In recent years, Paulson and Robert Rubin ran the Treasury. Former chairman Stephen Friedman was chairman of the US Foreign Intelligence Advisory Board. Goldman partner Gary Gensler now runs the Commodity Futures Trading Commission. Former CEO Jon Corzine was governor of New Jersey. And former vice president Neel Kashkari ran the TARP bank bailout program.

World Bank President Robert Zoellick and New York Fed chief are Goldman alums, too.

The tradition – viewed charitably as public service, or, alternatively, as the ultimate public-private revolving door – has been firmly entrenched for decades. Former Goldman chief Sidney Weinberg was vice-chairman of the War Production Board during World War II. As BusinessWeek notes, he also was credited with creating the “long-term greedy” culture that placed long-term gains and, ultimately, public service, above an ethos of short-term profit.

Blankfein is unlikely to follow his predecessors into a high level government position. While one can argue that he has managed the firm well enough in a financial sense, the diminution of the firm’s standing with the public over the last few years is clear. And that loss of prestige and trust may well be hurting its performance, too.

The sheer breadth of alumni role in government at during the last few years –running the Treasury, the TARP bank bailout program, and the New York Fed, to mention just a few positions – put the company under intense scrutiny. The fact that Goldman appeared to benefit from the bailout and the work-out of AIG’s monumental losses has raised doubts about the fairness of its government influence. Those suspicions about its self-dealing at the government level might be impossible to prove, but they can’t really be dispelled, either.

The company’s business practices – and Blankfein’s vigorous defense of those practices on national TV – didn’t help the company’s image, either. During the height of the credit boom, it developed a “triple play” business model of participating in deals on multiple levels--as investment bankers, traders and private equity investors.

That was just fine when the markets were rising and everyone was getting paid. But as the credit boom turned into the financial crisis, investors, regulators and politicians wondered how Goldman could justify selling certain mortgage-related assets while another arm of the firm was betting against them at the same time.

During Congressional hearings in 2010, Blankfein tried to explain that the company was merely acting as a market maker--taking the opposite side of a trade for its clients, regardless of whether they wanted to buy or sell. It was a practice that evolved over the last decade, in which Goldman often took a loss on a transaction to help secure more business from a client down the road. In the case of the mortgage assets –developed by the now notorious Fabrice “Fab” Tourre – the firm just happened to make a profit on some trades, Blankfein suggested. “We are the other side of what our clients want to do,” he said.

Levin, the chairman of the permanent subcommittee on investigations, wasn’t buying it. While Levin has been derided as a buffoon in the financial world, that probably isn’t fair. Blankein’s argument, while perhaps technically true, sounded contrived to Levin, a lawyer with a Harvard degree.

“This isn’t market making. You aren’t just selling this stuff (to) people who walk in the door. You are making calls. You are marketing. You are not just selling from your inventory. That is not what I am talking about,” Levin said.

“The testimony we gave was truthful and accurate and this is confirmed by the Subcommittee’s own report. The report references testimony from Goldman Sachs witnesses who repeatedly and consistently acknowledged that we were intermittently net short during 2007. We did not have a massive net short position because our short positions were largely offset by our long positions, and our financial results clearly demonstrate this point,” Goldman said in a statement.

The fallout from the hearing continues. Levin has intimated that perjury charges stemming from the hearing could follow. And regulators at the SEC and the Labor Department are considering rules that would impose a new fiduciary duty across much of the financial services industry.

There have been calls for new leadership. The latest came from veteran bank analyst Richard Bove of Rochdale Securities, who cut the company’s rating from buy to neutral in the wake of its first quarter earnings, in which it reported earnings of $2.74 billion on revenue of $11.9 billion. While the earnings were well above analyst expectations, analysts are worried about the quality and sustainability of its earnings, and about the downward direction of revenue, which fell 7 percent.

Bove says the “burst of trading” in the first quarter, driven by the catastrophe in Japan and the uprisings in the Middle East, are unlikely to be repeated. That will limit trading income for Goldman. He says the asset management business needs to be rebuilt and that investment banking is not keeping up with its peers. “The gains on ICBC, the Chinese bank, and debt holdings are not likely to be repeated in the next few quarters particularly if interest rates go up as expected, he said in an email to clients. And he says the possible downgrade of U.S. debt hurts Goldman and other financial companies.

“I happen to think that a management change is necessary,” Bove told the Wall Street Journal’s MarketBeat blog. “There’s been no accountability whatsoever in this firm.”

That won’t necessarily happen, though. Goldman investors could have fared worse during the Blankfein era. The shares at $153 are well above their financial crisis lows in the $50 range. While they probably aren’t headed back to their high of $240 any time soon, Barclays sees little downside risk, either. And as the clouded regulatory picture becomes clearer, Barclays says Goldman could boost its return on equity from the low teens to the mid teens and command a higher multiple. During his tenure, the stock price has roughly kept pace with the Standard & Poor’s 500, with a low single digit gain, and it has easily beaten the NYSE financial index, which fell more than 30 percent during the same period.

“Despite these challenges, Goldman Sachs is likely to generate stronger returns than most large banks while being more nimble in adapting to the new financial landscape,” Morris, of SLI says.

Meanwhile, Goldman is struggling with a very unusual dilemma – excess liquidity. It has about $65 billion in shareholder equity, up from about $50 billion in 2006 in the midst of its take-no-prisoners era. That liquidity, combined with a much lower profile should protect it against the storms of legal, regulatory and market risk. But it can’t invest that money any time soon--certainly not until, as Bove notes, the risk of a Justice Department suit has been resolved. The Black Pearl will stay afloat. But with such weight in its ballast, it is no longer the fastest ship in the seas, either.

The Black Pearl will stay afloat. But with such weight in its ballast, it is no longer the fastest ship in the seas, either.

A number of elements of this story were corrected on May 30, 2011.