Goldman Sachs Case Study

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Goldman Sachs Case Study

  1. 1. 11/12/2009 MANAGEMENT 573 GOLDMAN SACHS CASE STUDY Brady Gear, Adam Heying, Maxwell Kagan, Kelly Schilling, & Joseph Quinn Wingerd
  2. 2. Table of Contents Introduction .................................................................................................................................................. 4 History ........................................................................................................................................................... 4 The Nineteenth Century ............................................................................................................................ 4 The Twentieth Century .............................................................................................................................. 5 More Recent Times ................................................................................................................................... 6 Who’s Who List of Former Goldman Sachs Executives ................................................................................ 7 Business Segments ........................................................................................................................................ 9 Investment Banking ................................................................................................................................ 10 Financial Advisory ................................................................................................................................... 12 Underwriting ........................................................................................................................................... 12 Trading and Principal Investments.......................................................................................................... 13 Fixed Income, Currency and Commodities (FICC) .................................................................................... 14 Equities .................................................................................................................................................... 15 Principal Investments .............................................................................................................................. 16 Asset Management and Securities Services ............................................................................................ 17 Asset Management ................................................................................................................................. 17 Securities Services ................................................................................................................................... 17 TARP and Goldman Sachs ...................................................................................................................... 18 Warren Buffet’s Investment in Goldman Sachs ................................................................................. 22 Goldman Commercial Bank Conversion ..................................................................................................... 24 Regulation of Goldman and the Financial Markets .................................................................................... 29 Enforcement ............................................................................................................................................ 29 Banking Reform........................................................................................................................................... 31 Transparency........................................................................................................................................... 31 Credit Rating Agencies ............................................................................................................................ 33 Mark-to-Market Accounting ................................................................................................................... 34 Bank Compensation ................................................................................................................................ 35 Bank Capital and Pro-Cyclicality ............................................................................................................. 36 Recapitalization of the Banking System .................................................................................................. 38 Local Rules, Global Markets .................................................................................................................... 39 2|Page
  3. 3. Capital is Global, Regulation is Local ...................................................................................................... 39 Exceptional Regulatory Systems Promote and Encourage Financial Activity ......................................... 40 Regulatory Approach .............................................................................................................................. 41 Financial Analysis ................................................................................................................................... 42 Competitive Analysis .............................................................................................................................. 49 Conclusion ................................................................................................................................................... 56 Bibliography ................................................................................................................................................ 57 3|Page
  4. 4. Introduction The Goldman Sachs Group, Inc. has come from humble beginnings to become one of the largest investment firms on Wall Street. Founded in 1869 by German immigrant, Marcus Goldman, the company did not assume the name “Goldman Sachs” until his son-in-law Samuel Sachs became his partner, and officially named themselves “Goldman Sachs Company”. The company was first listed on the New York Stock Exchange in 1896, but did not go through its initial public offering (IPO) until 1906, which the firm co-managed. Throughout the Twentieth Century, Goldman Sachs helped co-managed the IPOs for some of the largest, most well-known companies in the United States, including Ford Motor Company in 1956, Sears Roebuck in 1906, Microsoft in 1986, and Yahoo! in 1996. From a history that goes across several centuries to the most recent financial turmoil, Goldman Sachs has had its ups and downs as a financial giant, but has still been able to come out of the rough times in a better position than its competition. History The Nineteenth Century Marcus Goldman began his career in the United States as a salesman, and then opened his own clothing store in Philadelphia. From there he moved to New York City and began trading promissory notes in 1869. Samuel Sachs began helping his father-in-law in 1882 and became a partner in 1885. Eventually, Henry Goldman and Ludwig joined the company, which would then be known as “Goldman, Sachs and Co.” Soon after this, the company started amassing 4|Page
  5. 5. customers that included Sears Roebuck and Cluett Peabody. Goldman, Sachs and Co. went on to list on the New York Stock Exchange in 1896 (Goldman Sachs History). The Twentieth Century Goldman, Sachs & Co. opened the Twentieth Century with a bang. Not only did the firm co- manage its own IPO in 1906, but it also comanaged the IPO for Sears Roebuck in the same year. Soon after, Goldman Sachs was recruiting an A-List of clients that included May Department Stores, F.W. Woolworth, B.F. Goodrich, H.J. Heinz, Pillsbury, General Foods and Merck (Goldman Sachs History). Goldman, Sachs & Co. was using its clout and prowess to start offering new products. They were growing so big that they were able to open their first subsidiary of the Goldman Sachs Trading Corporation. Unfortunately, that particular subsidiary was one of the many victims of the 1929 Stock Market Crash and resulting Depression. In 1933, Congress passed the Securities Act of 1933, which created the Securities and Exchange Commission. This made Goldman, Sachs and Co. work diligently to develop a much easier to read prospectus. It was events like this that led Goldman Sachs to become very customer focused and a leader in the investment industry. It was also in the 1930s that the security- arbitrage business was started. This part of the company actively participated in a myriad of investment activities, which included private securities sales, corporate mergers and acquisitions, real estate financing and sales, and block trading. In the 1940’s, Goldman, Sachs and Co. worked hard to raise investment capital through the sales of war bonds. It was not until the 1960’s that Goldman, Sachs hit their stride when it came to profitability in the investment world. 5|Page
  6. 6. In 1956, Ford Motor Company was ready to go public. Goldman, Sachs stepped in to managed the Initial Public Offering, by marketing 10.2 million shares, worth $26.5 million (Goldman Sachs History). In 1967, it was Alcan Aluminum’s turn to come out in a single block trade, and Goldman, Sachs stepped in to manage the trade. People would finance these LBOs with junk bond debt. The problem was that the junk bond debt had to paid off somehow, and it was usually with the operating profits from the purchased firm or by selling pieces of the firm for profit. Goldman, Sachs worked to steer clear of the riskiness involved in LBOs and tried to focus on transactions instead. The market crash of 1987 helped flush out those who were taking on these risky investments and leave those more moderate investors ahead. More Recent Times Goldman, Sachs decided it was time to go public in 1998. In May 1999, Goldman, Sachs and Co. went public on the New York Stock Exchange with a $3.6 billion windfall for 69 million shares. It was after this offering that the firm became officially known as “The Goldman Sachs Group Inc.” Goldman Sachs was no longer the financial powerhouse that it once was, as Citibank was three times its size, and JP Morgan Chase & Co. was twice as large. Rumors were swirling that Goldman Sachs would need to merge with one of these firms if it wanted to stay afloat. It was Henry Paulson who was able to maintain Goldman Sach’s position in the financial world. 6|Page
  7. 7. Who’s Who List of Former Goldman Sachs Executives Not many people have the right to say that they were once a member of this financial giant, but the short list reads as a Who’s Who of financial heavyweights. Some of the more notable alumni include: Jon Corzine is probably one of the most well-known of the former Goldman Sachs employees. He began his career working for multiple Midwestern banks, and earning his Masters of Business Administration (MBA) at the University of Chicago Booth School of Business. Jon went to work for Goldman Sachs in 1975 and managed to work his way up to Chairman and Co-CEO in 1994. It was after his departure in 1998, that the firm went public in 1999 and made him $400 million richer. From there he ran for a Senate seat in 2000 that he won by a small margin. In January 2006, Jon moved into the New Jersey Governor’s mansion, where he will finish his term In office in January 2010. Henry “Hank” Paulson is the most infamous of all the alum. He came from humble beginnings to become one of the most powerful financial presences in the Twenty-first Century. He obtained his Bachelors of Arts in English at Dartmouth and then went on to pursue his MBA at the Harvard School of Business (Henry "Hank" Paulson, 2009). He first joined Goldman Sachs in 1974 in the Chicago office. In 1994, he assumed the role of Chief Operating Officer and then became co-CEO with Jon Corzine. Hank was appointed as the 74th Secretary of the U.S. Treasury in 2006. He had the misfortune of presiding over the Financial Crisis of 2008 and having that time period make a stain on his legacy in that role. He took the fall for many of the failed decisions made by the Chairman of 7|Page
  8. 8. the Federal Reserve, Ben Bernanke and Timothy Geithner, President of the Federal Reserve Bank of New York. John Thain has been the alumnus most recently in the news. He was success as the Chief Operating Officer and President at Goldman Sachs, but left to help the New York Stock Exchange find a new direction in 2004. He successfully turned the NYSE around and was sought by both Citigroup and Merrill Lynch to help dig them out of the slumps they were in. He ended up with Merrill Lynch where he had to weather the storm that was the Financial Crisis of 2008. Merrill Lynch was performing so poorly that they were not to survive the collapse, but Thain managed to orchestrate a deal with Bank of America, and soon he was an employee. Unfortunately, it was found out that he had passed out large bonuses before the official takeover, and had to resign in January 2009 under an ominous cloud (de la Merced, 2007). Robert Rubin left Goldman Sachs for one of the most illustrious careers, only to leave his most recent financial position in shame. Rubin was educated at Harvard University, the London School of Economics, and Yale Law School. He worked for Goldman Sachs for 26 years, two of which were spent as Co-Chairman. In 1995, he was appointed as the United States Secretary of the Treasury by President William Clinton. After serving over one of the most successful periods of expansion, he left government work for a position with Citigroup (Wikipedia). Citigroup was nearly defeated by the Financial Crisis of 2008 and Rubin was held accountable for its inability to keep up with the changes in the housing market. In a letter published in the Huffington Post Rubin said, "My great regret is that I and so many of us who have been involved in this industry for so long did 8|Page
  9. 9. not recognize the serious possibility of the extreme circumstances that the financial system faces today (Read, 2009)." Other alumni include: o Robert Steel: Goldman Sachs (1976 to 2004), Barclays Bank (2005 to 2006), Undersecretary for Domestic Finance (2006 to 2008), and Wachovia/Wells Fargo (2008 to present). o Joshua Bolten: Goldman Sachs (1994 to 1999), George W. Bush policy director (1999 to 2000), Deputy Chief of Staff for Policy at the White House (2001 to 2003), Director of the Office of Management and Budget (2003 to 2006), and White House Chief of Staff (2006 to 2009). (Wikipedia - Joshua Bolten, 2009) o John Whitehead: Goldman Sachs (1947 to 1984), U.S. Deputy Secretary of State (1985 to 1989), Chairman of the Board of the Federal Reserve Bank of New York (Wikipedia - John Whitehead, 2009). Business Segments Goldman Sachs separates its principal operating activities into three separate business segments: Investment Banking, Trading and Principle Investments, and Asset Management and Securities Services. The following graph shows the net revenues of the operating activities from 2006 to 2008. 9|Page
  10. 10. Net Revenues by Segment (in millions) (2) 40,000 30,000 20,000 10,000 - 2008 2007 2006 Investment Banking Trading and Principal Investments Asset Management and Securities Services Investment Banking Goldman Sachs, although not exclusively an investment bank, is a leader in the investment banking industry, ranking number one in global Mergers and Acquisitions (M&A) and in worldwide public common stock issuances (Wetfeet, Inc., 2009). Goldman’s investment banking segment assists corporations and financial institutions plan and execute financial strategies in the capital markets. Through its investment banking segment, Goldman offers clients a wide range of advisory, structuring, and underwriting services, including debt and equity financing, mergers and acquisitions, and project financing. Over the past three fiscal years, the investment banking segment of Goldman’s operations has been the smallest of its business segments by net revenues, but is still fundamental to Goldman’s consistent profitability. Investment banking operations provided net revenues of $5,185 million, $7,555 million, and $5,629 million for the 10 | P a g e
  11. 11. years ended December 2008, 2007, and 2006, respectively (The Goldman Sachs Group Inc., 2008). The investment banking segment of Goldman Sachs is divided into two components: Financial Advisory and Underwriting. Goldman also divides the investment banking into functional groups including: Communications, media, and entertainment Corporate finance Energy and power Equity capital markets Financial institutions Health care High technology Investment banking services Leveraged finance Mergers and acquisitions Principal investment area (merchant banking) Real estate Real estate principal investment area Risk markets group Special execution The following graph indicates the net revenues earned in millions in financial advisory and underwriting. 11 | P a g e
  12. 12. Investment Banking Net Revenues (in millions) (2) 5,000 4,000 3,000 2,000 1,000 - 2008 2007 2006 Financial Advisory Underw riting Financial Advisory Included in the financial advisory component of Goldman’s investment banking segment are advisory services related to mergers and acquisitions, restructurings and spin-offs, divestitures, and corporate defense activities. Net revenues from financial advisory services were $2,656 million, $4,222 million, and $2,580 million for the years ended 2008, 2007, and 2006 respectively (The Goldman Sachs Group Inc., 2008). Underwriting Underwriting of both debt and equity securities is the second component of the Investment Banking segment of Goldman Sachs. The underwriting component at Goldman focuses on assisting corporations and financial institutions with public offerings as well as private placements of debt and equity instruments. Net revenues from underwriting services for the 12 | P a g e
  13. 13. years ended 2008, 2007, and 2006 were $2,529 million, $3,333 million, and $3,049 million respectively (The Goldman Sachs Group Inc., 2008). Trading and Principal Investments Goldman Sachs’ largest business segment is its Trading and Principal Investments with net revenues of $9,063 million, $31,226 million, and $25,562 million for the years ended 2008, 2007, and 2006, respectively, as shown in the graph below (The Goldman Sachs Group Inc., 2008). The trading and principal investments segment focuses on executing transactions for customers with wide variety of individuals, corporations, financial institutions, and governments. In addition, it engages in floor-based and electronic market-making as a specialist in U.S. equities and option exchanges and clears customer transactions on major stock, options, and futures exchanges worldwide. In connection with Goldman’s merchant banking and other investment activities, it makes principal investments both directly and indirectly through funds that it raises and manages. Goldman’s trading and principal investments segment is divided into three components: Fixed Income, Currency and Commodities, Equities, and Principal Investments. 13 | P a g e
  14. 14. Trading and Principal Investments Net Revenues (in millions) (2) 20,000 15,000 10,000 5,000 - 2008 2007 2006 (5,000) FICC Equities Principal Investments Fixed Income, Currency and Commodities (FICC) Under the fixed income, currency and commodities component of operations, Goldman focuses on the marketing and trading of fixed income and derivative securities. These securities include: interest rate and credit products, mortgage-backed securities and loan products, other asset- backed products, currencies, and commodities. Risk management is a strong focus in this business component, especially in the areas of interest rates, liquidity, commodities, credit, and currencies. Net revenues from the fixed income, currency and commodities component for 2008, 2007, and 2006 were $3,713 million, $16,165 million, and $14,262 million (The Goldman Sachs Group Inc., 2008). The fixed income, currency and commodities component is also further divided into the following functional groups: Capital markets Corporate securities 14 | P a g e
  15. 15. Dealer sales Futures services Government securities High-yield securities Industry resource groups Money market instruments Mortgage- and asset-backed securities Municipal securities Currency and commodities strategies Energy Foreign exchange Metals Equities The equities component of Goldman’s trading and principal investments business segment brought in net revenues of $9,206 million, $11,304 million, and $8,483 million for fiscal years 2008, 2007, and 2006, respectively (The Goldman Sachs Group Inc., 2008). This component focuses on the trading of equities and equity-related products, structuring and executing equity derivative transactions, proprietary trading. The equities component also executes and clears customer transactions on major exchanges around the world. Profits in this component are generated primarily from commissions made from trading activities for others and from gains 15 | P a g e
  16. 16. on proprietary investments. The following functional groups comprise the equities component of the trading and principal investments business segment at Goldman: Equities arbitrage Equity capital markets Equities management Global securities services Institutional sales Private client services Trading Principal Investments The principal investments component of Goldman’s equity division deals primarily with its merchant banking investments. These investments are generally made in the areas of real estate and corporate principal investments. Income is generated on these investments from gains made when the returns on merchant banking funds exceed certain thresholds and on the returns from these investments. Net revenues for 2008, 2007, and 2006 from Goldman’s principal investments were ($3,856 million), $3,757 million, and $2,817 million, respectively (The Goldman Sachs Group Inc., 2008). 16 | P a g e
  17. 17. Asset Management and Securities Services Goldman’s third business segment is its asset management and securities services division, which brought in net revenues of $7,974 million, 7,206 million, and $6,474 million for the years ended 2008, 2007, and 2006, respectively, as shown in the graph below (The Goldman Sachs Group Inc., 2008). Asset management services are separated from securities services as individual components. Collectively, this business segment offers investment advice, planning, and strategies for all major asset types to Goldman’s individual and institutional investors. This segment also provides finance, brokerage, and securities service to funds, endowments, foundations, and high-net-worth individuals. Asset Management This component is responsible for both financial planning and investment advisory services for individual and institutional investors. Net revenues produced from the asset management component for the years ended 2008, 2007, and 2006 were $4,552 million, $4,490 million, and $4,294 million (The Goldman Sachs Group Inc., 2008). Revenues are generated from management and incentive fees generated as a result of these services. Assets under management include alternative investments, equity, fixed income, and money market products. Total assets under management were $779 billion, $868 billion, and $676 billion for 2008, 2007, and 2006 (The Goldman Sachs Group Inc., 2008). Securities Services 17 | P a g e
  18. 18. The securities services component at Goldman provides prime brokerage services, financing services and securities lending services to institutional clients, including hedge funds, mutual funds, pension funds and foundations, and to high-net-worth individuals across the globe. Revenues are primarily generated from these services in the form of fees or interest rate spreads. Asset Managment and Securities Services Net Revenues (in millions) (2) 5,000 4,000 3,000 2,000 1,000 - 2008 2007 2006 Asset Management Securities Services TARP and Goldman Sachs TARP allows the United States Department of the Treasury to purchase or insure up to $700 billion of "troubled" assets. "Troubled assets" are defined as "(A) residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before March 14, 2008, the purchase of which the Secretary determines promotes financial market stability; and (B) any other financial instrument that the Secretary, after consultation with the Chairman of the Board 18 | P a g e
  19. 19. of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress.” (The Troubled Asset Relief Program: Report of Transactions Through December 31, 2008, 2009) In short, this allows the Treasury to purchase illiquid, difficult-to-value assets from banks and other financial institutions. The targeted assets can be collateralized debt obligations, which were sold in a booming market until 2007 when they were hit by widespread foreclosures on the underlying loans. TARP is intended to improve the liquidity of these assets by purchasing them using secondary market mechanisms, thus allowing participating institutions to stabilize their balance sheets and avoid further losses. TARP does not allow banks to recoup losses already incurred on troubled assets, but officials hope that once trading of these assets resumes, their prices will stabilize and ultimately increase in value, resulting in gains to both participating banks and the Treasury itself. The concept of future gains from troubled assets comes from the hypothesis in the financial industry that these assets are oversold, as only a small percentage of all mortgages are in default, while the relative fall in prices represents losses from a much higher default rate. The Act requires financial institutions selling assets to TARP to issue equity warrants (a type of security that entitles its holder to purchase shares in the company issuing the security for a specific price), or equity or senior debt securities (for non-publicly listed companies) to the Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares, or will agree not to vote the stock. This measure is designed to protect taxpayers by giving the 19 | P a g e
  20. 20. Treasury the possibility of profiting through its new ownership stakes in these institutions. Ideally, if the financial institutions benefit from government assistance and recover their former strength, the government will also be able to profit from their recovery. Another important goal of TARP is to encourage banks to resume lending again at levels seen before the crisis, both to each other and to consumers and businesses. If TARP can stabilize bank capital ratios, it should theoretically allow them to increase lending instead of hoarding cash to cushion against future unforeseen losses from troubled assets. Increased lending equates to "loosening" of credit, which the government hopes will restore order to the financial markets and improve investor confidence in financial institutions and the markets. As banks gain increased lending confidence, the interbank lending interest rates (the rates at which the banks lend to each other on a short term basis) should decrease, further facilitating lending. (Nothwehr, 2008) The TARP will operate as a “revolving purchase facility.” The Treasury will have a set spending limit, $250 billion at the start of the program, with which it will purchase the assets and then either sell them or hold the assets and collect the 'coupons'. The money received from sales and coupons will go back into the pool, facilitating the purchase of more assets. The initial $250 billion can be increased to $350 billion upon the President’s certification to Congress that such an increase is necessary (Summary of the Emergency Economic Stabilization Act of 2008, 2008). The remaining $350 billion may be released to the Treasury upon a written report to Congress from the Treasury with details of its plan for the money. Congress then has 15 days to vote to disapprove the increase before the money will be automatically released. The first $350 billion 20 | P a g e
  21. 21. was released on October 3, 2008, and Congress voted to approve the release of the second $350 billion on January 15, 2009. One way that TARP money is being spent is to support the "Making Homes Affordable" plan, which was implemented on March 4, 2009, using TARP money by the Department of Treasury. Because "at risk" mortgages are defined as "troubled assets" under TARP, the Treasury has the power to implement the plan. Generally, it provides refinancing for mortgages held by Fannie Mae or Freddie Mac. Privately held mortgages will be eligible for other incentives, including a favorable loan modification for five years (MHA Guidelines). The authority of the United States Department of the Treasury to establish and manage TARP under a newly created Office of Financial Stability became law October 3, 2008, the result of an initial proposal that ultimately was passed by Congress as H.R. 1424, enacting the Emergency Economic Stabilization Act of 2008 and several other acts (Gross, 2008). As this relates to Goldman Sachs, they gave taxpayers their due in September. Goldman Sachs said it paid the government $1.1 billion to redeem the stock-purchase warrants it issued Treasury last fall. The payment marks the first time taxpayers have recovered the full value of warrants issued to a major institution under TARP. The Goldman Sachs TARP warrant deal is the best deal that taxpayers have got to date. Since at least April 2009, representatives from Goldman Sachs have said that taxpayers deserve a fair return for their investments. Taxpayers received a 23% annualized return for their $10 billion investment last fall in Goldman. 21 | P a g e
  22. 22. Warren Buffet’s Investment in Goldman Sachs Warren Buffett's ride to the rescue of Goldman Sachs with a $5 billion cash infusion at the height of the Wall Street panic is an opportunity to examine what the terms of his deal might tell us about the future of capital in the financial sector. Buffett didn’t buy Goldman common stock. Instead, he privately negotiated a very special preferred stock deal that made the capital very expensive for Goldman. He took taking $5 billion worth of perpetual preferred stock that promised him a 10% dividend and warrants to buy $5 billion of common stock with a strike price of $115 a share. In many ways, Goldman operates for Buffett the way a profitable hedge fund does for its limited partners. The general partner of a hedge fund usually makes very little unless the firm’s earnings cross a specified hurdle. Similarly, Buffett’s 10% dividend means he gets the first cut of Goldman’s revenues, before the Goldman partnership itself. If they don't earn enough to pay Buffett, there's nothing left to pay the partnership (Carney, 2009). Perhaps surprisingly, the perpetual preferred shares mean that Buffett’s interests are very closely aligned with those of the Goldman partnership. He has a concentrated interest in Goldman and little interest in having the firm pursue short term gains. Similarly, the Goldman partners have their fortunes tied to the profits of a single firm, both through their interests in the firm continuing to pay them and their large holdings of its stock. Both have an interest in the firm being cautiously “long-term greedy” (Brand, 2009). 22 | P a g e
  23. 23. Compare that to an ordinary investor in Goldman’s common stock. Those folks are happy if just 20 percent of the firm’s revenue goes to equity. They stand behind Goldman’s partners, employees and overhead when it comes to seeing a cut of the revenues. Their capital is in a far riskier position. What’s more, ordinary shareholders tend to hold Goldman as part of a diversified portfolio and don’t much care about the fate of a single firm. They want more risk than Goldman’s partners want. The structure of Buffett’s investment also resolves some of the dangers of Goldman’s partners becoming too cautious if they are forced to lower their leverage. Ordinarily, a combination of debt load and stock options helps encourage the management of corporations to overcome the excessive risk aversion that comes from their undiversified interest in their company. Their interests become aligned with their shareholders since they need to achieve enough returns to be profitable after the fixed costs of debt payments. In short, the guys in charge need to make sure the firm makes enough money that they can get paid after the lenders get paid (Haruni, 2008). As firms lower their debt, the barrier between revenue and the bosses paycheck lowers. This lowers the appetite for risk. But Buffett’s guaranteed 10% puts that barrier back in place, re- creating the role of debt to incentivize risk taking. As firms and regulators attempt to reduce leverage and risk in the financial sector, we wouldn’t be surprised if the capital structure of many Wall Street firms began to shift in this direction. The problem of excessive risk is solved by a fixed return, and the problem of excessive risk aversion is addressed by forcing managers to make distributions. 23 | P a g e
  24. 24. Goldman Commercial Bank Conversion On September 21, 2008, Goldman Sachs received Federal Reserve approval to transition from an investment bank to a bank holding company. As part of the credit and banking turmoil, the nation’s three largest investment banks, Goldman Sachs, Morgan Stanley, and Merrill Lynch have become “banks.” They come from a rough-and-tumble, hard-charging business where Goldman Sachs in particular has thrived on disruptive change. Not always nice, they are here to stay and will strive to bring change that works to their advantage. Corporate executives and directors, particularly those who rely on banking organizations for access to capital, will be wise to anticipate the impact on the credit markets and on financial relationships that will develop with the new contenders acting as bank holding companies. The banking industry is being joined by companies that have been living and winning by very different rules. They’ve been in a rougher business with more risk-taking and faster change and they have thrived on it. They have no intention of becoming “normal” commercial banks (Ellis, 2009). Clearly the change was not voluntary. Goldman Sachs, Morgan Stanley, and Merrill Lynch (now part of Bank of America) got caught in a capital-market tsunami. As public companies with enormous leverage and funding requirements plus mark-to-market accounting, they were compelled to accept the change to regulated bank-holding-company status when the plummeting market prices of many of their assets decimated their capital. While Goldman Sachs was the least distressed of the three, it was given only one choice. The other choice for 24 | P a g e
  25. 25. Goldman was to opt for a state charter rather than becoming a national bank, so it’s regulated by New York State rather than the federal government. The state could be more accommodating. During the intense market turmoil at the height of the October storm, Goldman Sachs severely threatened by an inability to roll over short-term credits like commercial paper and losing substantial prime-brokerage assets held for hedge funds was nearly forced to merge itself into a giant commercial bank, reportedly Citigroup. But no transaction materialized, and Goldman Sachs moved ahead with its own strategy. Goldman Sachs is certainly not a “beginner” bank. As soon as it became a full-service New York State-chartered bank as Goldman Sachs Bank USA, it ranked as one of the 10 largest banks in America, with assets of $150 billion (Reynolds, 2008). A few important financial changes will come with the transition to bank-holding-company status: lower leverage ratios, higher capital ratios, more liquidity, and “cushion” capacity to absorb short-term losses. Also, three or four dozen bank regulators will be on the firm’s premises, as they are at all large bank holding companies. Further expected consequences include slower growth in profits most likely partly offset by more consistent earnings growth and therefore somewhat higher price-earnings ratios on its stock. So in some ways, Goldman Sachs will be changed by its new bank status. But odds are that this won’t be the major change. Goldman Sachs Bank will alter corporate banking more than corporate banking status will alter Goldman Sachs. First, consider how much the businesses of Goldman Sachs have changed in past years while the essence of what makes Goldman Sachs Goldman Sachs has changed so little. In a single generation, it has absorbed, and adapted to exploit profitably, such major 25 | P a g e
  26. 26. changes as brokerage commissions’ plunging by more than 90%––from 40 cents a share to less than 4 cents––and the transformation of bond dealing, foreign exchange, and commodities trading from commission-based agency-service businesses to gigantic, complex, capital-at-risk principal businesses. During that same time, the firm has gone from being almost entirely domestic and losing money in Europe to earning a majority of its profits overseas, and from a U.S. partnership with 2,000 employees to a global, publicly owned corporation with some 30,000 employees and a balance sheet over $1 trillion. It has built a major private equity business, a major investment-management business, and a major prime-brokerage business serving hedge funds. In these and dozens of other businesses, Goldman Sachs has embraced and capitalized on change. Corporate executives and directors will like most of the surprises still to come from the firm’s transformation into a regulated bank holding company. While projecting the future of free competitive markets is notoriously risky––and the market for corporate financial services is notoriously free and competitive––corporations can confidently anticipate that Goldman Sachs will combine its old strengths with its new strengths in ways that are innovative and assertively entrepreneurial. As a major bank, Goldman Sachs will be able to combine credit—swiftly and on a large scale—with any of the firm’s current strengths in real estate, mergers and acquisitions, private equity, commodities, foreign exchange, and other areas. Some of the combinations will be fairly conventional, but if history teaches one thing about Goldman Sachs, the lesson is that its people will conceive of and create strongly profitable new ways of meeting the objectives of the thousands of corporations and dozens of governments with which it already has major working relationships (Montia, 2009). 26 | P a g e
  27. 27. Information technology has become a core strategic force in banking strategies. The ability to syndicate large loans swiftly is now the norm and has already changed the basic business model of banking. Managing lending risks by hedging with sophisticated analytical models and derivatives continues to change the traditional concepts of loan portfolio management. Balance sheets and loan syndications are still important, but access to the world’s enormous capital markets is becoming more important. These are areas where Goldman Sachs excels. The “universal bank” business model, already dominant in Europe and Asia, has in recent years become increasingly important to America’s major corporate banks as they have sought to muscle in on the more profitable business enjoyed by securities dealers and investment banks. Suddenly the major investment banks have become universal banks at least they’re now regulated bank holding companies. They got there for defensive reasons, but they won’t stay on the defensive for long; they will go over to the offense soon. The critical advantage of universal banks is that they accept deposits and therefore have access to much more capital than investment banks do. Clients of Goldman Sachs have increasingly asked it for substantial financing, with the firm acting as financing principal, to help them convert advice into action. This was central to Goldman Sachs’ consideration less than a decade ago of acquiring JPMorgan––and its declining to do so. When the firm decided not to make that acquisition, it was because Henry Paulson, then CEO, was convinced Goldman Sachs would soon meet or beat what was arguably the best corporate bank in each area of capability. There was also a cultural gulf. Taking just one factor in isolation, the culture of Goldman Sachs included being at work before 7 a.m. and often working well into the night and on most 27 | P a g e
  28. 28. weekends, largely because the work was so interesting and compelling and the rewards so great. Goldman Sachs people could not relate to bankers who worked only from nine to five or even eight to six (Montia, 2009). What already makes Goldman Sachs “different” embraces many attributes. A few are crucial: exceptional recruiting, risk management, teamwork, intensity of commitment, and distributed, driven leadership. All these are energized by the entrepreneurial imperative to create, discover, and develop profitable businesses—and make them grow by capitalizing on the organization’s many strong corporate relationships, its power in many markets, advanced technology, and an extraordinary communications network that links thousands of professionals into one interconnected team that is flexible, adaptable, and, to any and all competitors, dangerous. Only a few universal banks have as much competitive strength as Goldman Sachs, and no bank of any kind has such formidable strength in service after service in market after market or the speed and intensity of internal communication or the number of action-taking leaders well over 1,000 distributed with action authority into parts all over the world. Corporations will need to decide how they will work with the new Goldman Sachs. Will they want to compete with rivals in their industry to be one of the firm’s particularly important clients? How crucial might it be to get the first call with new ideas? At what executive level will they locate their relationship––CEO, CFO, or AT (assistant treasurer)? Goldman Sachs traditionally builds its principal relationships with CEOs and CFOs. Will companies concentrate their corporate finance business with one or two banks like Goldman Sachs or distribute their business more widely to achieve supplier diversification? Managers and directors will want to 28 | P a g e
  29. 29. answer such long-term “strategic supplier” questions early, because having the right partners in corporate finance is clearly becoming more important, and powerful strategic partnerships take time and care to develop (Westfall, 2009). No organization has to want to be as hard-driving as Goldman Sachs, but it is important for customers and competitors to understand and respect what such a firm has accomplished and how quickly it adapts to change and profit opportunity. Consider how it changed the investment banking business in the ’60s, the stockbrokerage business in the ’70s, commodities in the ’80s, and investment management in the ’90s. Goldman Sachs is a merchant of change in area after area of corporate finance. Initiating and driving disruptive change is in its culture. Sure, the firm has changed to a bank holding company, but the substance of what makes Goldman Sachs Goldman Sachs the culture has changed very little in 50 years, while almost every aspect of its form has changed greatly. So welcome your new kind of banker, but don’t expect Goldman Sachs to be your conventional banker. Regulation of Goldman and the Financial Markets Enforcement The main lesson learned from the financial crisis is the need for more effective systemic regulation. Again, more effective regulation is needed, not necessarily more regulation. Government and financial leaders realize that the task of a systemic regulator would be impossible without the much needed transparency and regulatory tools to instill market discipline. Lately there has been a focus on who should be in charge and exercise this enormous 29 | P a g e
  30. 30. responsibility. There was a fundamental problem with the old system in that it was far too easy for financial institutions to flat out deny and ignore problems that allow systemic risks to infiltrate the market. Whoever is in charge of exercising regulation needs to be able to first determine risk areas early to prevent them from becoming so large that they soon infect and threaten the entire financial system. If systemic problems do begin to arise, these regulators need to take immediate action to limit their overall impact and protect the overall safety of the system. In order to protect the system, the regulator must be able to first recognize all of the risks which may be exposed to an institution and require that those risks be recognized. However, it’s not enough to just recognize and identify risk exposure. Many firms, including Goldman Sachs, have argued that their assets must be valued at their fair market value price and not at the historic value (The Trouble with Wall Street Regulation, 2009). It could be argued that if institutions had been able to recognize their daily risk exposures and value them appropriately, they may have been able to abbreviate or reduce the worst risk. Because these positions weren’t monitored, value changes were often ignored until the firm’s losses grew to a point where their overall solvency became an issue. In an Op-Ed piece in the Financial Times, Goldman CEO Lloyd Blankfein stated that regulators really need to encourage a culture whereby financial firms are required to share their concerns about overall system risks with regulators. “I remember being told by my mentors we do not fire people for losses or mistakes that were honestly made,” said Blankfein. “But if anyone 30 | P a g e
  31. 31. conceals or fails to escalate a problem, they must be held accountable immediately. The same principle should inform regulatory oversight” (Blankfein, 2009). One suggestion is that regulators could establish a committee in charge of examining certain issues such as underwriting standards and risk assessment. If practices ever slip and risk starts to become uncontrollable, regulators should be the first to know. These committees would need the authority to quickly address any massive capital deficits by reducing risk or raising capital. Of course, raising the capital requirements of holding companies would reduce systemic risk but it’s important not to overlook liquidity concerns. Leverage ratios need to be closely examined, but these ratios really tell you nothing about banks liquidity. If a large amount of a financial institutions assets are illiquid, low leverage ratios wouldn’t matter much. Once liquidity begins to dry up in the market, these institutions begin to face significant life-threatening problems. This is why the regulators need to really put an emphasis on the care and need for institutions to focus on keeping a large amount of liquidity reserve at all times which would prevent extreme events. A set of broad regulatory proposals which were recently discussed by the G20 and their effects on Goldman Sachs are presented below. Banking Reform Transparency In order to flow freely, the money system has to be trusted by everyone around the world. We have lost that trust and a lack of transparency led us to our current situation. Infosys CEO, Kris Gopalakrishnan, recently stated: 31 | P a g e
  32. 32. “Many of the economic challenges we face are the function of a global crisis in confidence. Investors… and analysts have good reason to pause and consider where their efforts and investments will be safe. This lack of confidence is preventing basic, sound business from thriving and is ultimately prolonging the downturn… A lack of transparency hid the true exposure of giants like AIG and to the detriment of international stakeholders and the American public (Gopalakrishnan, 2009). ” Greater transparency is obviously highly desirable not only for financial institutions, but for governments and credit agencies as well. The issue is far more complex than just simply requesting for more transparency. Most of the requests from governments and the public have been for greater clarity of their ‘toxic asset’ portfolio and mark-to-market valuations (O'Neil, 2009). It is not easy to do this, partly because valuations are constantly changing under mark- to-market accounting. What makes this financial crisis so different from others in the past, are the difficulties of estimating fair-value of derivatives which have been deemed worthless and in some cases, the market for which has dried up. Goldman Sachs has produced countless reports to Congress regarding different avenues to achieve a transparent market. They publicly state they support regulatory oversight but continue to play on both sides of the fence. Regulatory decay has spurred countless unregulated and unregistered market exchanges - some of which are run primarily by Goldman Sachs. Their GSTrUE (Goldman Sachs Tradable Unregistered Equity OTC Market) program is the 32 | P a g e
  33. 33. new game in town. This type of market is particularly attractive for firms who place a significant value on keeping their operations confidential and staying out of the public limelight (Ehrenberg, 2007). Below are some recent excerpts from a Wall Street Journal story that mentioned this type of market: Oaktree Capital Management LLC, a Los Angeles "alternative investment" firm, plans to raise almost $700 million by selling a stake in itself. But unlike rival firms selling shares -- such as Fortress Investment Group LLC, which has done so, and Blackstone Group, which plans to -- Oaktree won't trade publicly. Instead, it will trade on a new private market being developed by Wall Street firm Goldman Sachs Group Inc. Not only does the maneuver enable Oaktree to avoid most regulatory requirements of a traditional share offering, the deal is structured so shareholders will have practically no say in how Oaktree is run (Sender, 2009). The only reason this opportunity exists is because of the broken regulatory system in the U.S. This type of market does not seem to fit into the regulatory and transparency guidelines that Goldman has been preaching since it received TARP money last year. Credit Rating Agencies As was mentioned earlier, the credit rating agencies appear to have played a very significant role in the crisis by providing investment grade ratings for packaged securities which were not of high quality. There is a popular view that investors should do their due diligence before 33 | P a g e
  34. 34. investing in securities, however, many investors who do not have the resources to conduct strong due diligence and often rely on rating agencies when purchasing these securities. Now it is clear that they may as well use their own research and regard market prices as a better and more significant ‘rating’ for a security. These agencies were not truly independent, given that the financial services industry is the source of their fees. This creates a serious conflict of interest and a new structure of independence needs to be proposed. Mark-to-Market Accounting As we dug further into this crisis, there has been increased opposition to mark-to-market accounting. In the Global Economics Weekly of July 2009, Chief Accounting Officer Sarah Smith presented her views on why Goldman Sachs regards mark-to market accounting as more fair and more sensible than the alternatives (Smith, 2009). The parties who oppose mark-to-market accounting argue that as the prices of assets decline, mark-to-market accounting calls attention to significant problems in the balance sheets of financial institutions. By having to report these unrealized losses, banks are forced to reduce leverage which accelerates the process. In a report in the Huffington Post in April, Goldman Sachs publicly stated their major problems with the above view. We see two major problems with this view. First, it is not very credible for financial institutions to argue that marking to market is inappropriate only during downturns. Second, if the underlying assets are worth more than institutions are being ‘forced’ to value them at, presumably there will be an increase in the number of value-driven buyers of these undervalued assets. Moreover, financial 34 | P a g e
  35. 35. institutions will see mark-to-market gains when and if the assets appreciate (Nazareth, 2009). Clearly, Goldman Sachs wants mark-to-market accounting to stay put. Furthering their view, they believed that policy markets could instead choose to broaden their ‘lender of last resort’ activities and require financial institutions to raise more capital. They could also relax capital ratios in certain circumstances. CEO Lloyd Blankfein made reference to his views on the subject in the Financial Times (Blankfein, Do Not Destroy the Essential Catalyst of Risk, 2009). He disagreed with those who suggest that fair value accounting is one of the main factors exacerbating the credit crisis. “If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures,” he stated. “For the industry, we cannot let our ability to innovate exceed our capacity to manage.” Bank Compensation Most recently, the crisis has scrutinized the compensation structure of the banking industry. In an interview published in the Wall Street Journal, Goldman Sachs expressed three points in terms of what they deemed appropriate in compensation practice (Dauer, 2009). Bonus compensation should be more closely tied to the long-term performance of companies…A system of rewarding immediate apparent profit with cash bonuses is not appropriate. Non-executive directors need to be allowed to play and be capable of playing a stronger role. 35 | P a g e
  36. 36. It is important that policymakers and regulators do not place artificial ceilings on compensation. Forces of supply and demand for skilled labor need to be allowed to function. Controls will be circumnavigated (as they were in the 1970s and 1980s through generous free car schemes, etc). If it is the case that financial services employees do not constitute ‘skilled’ labor, then the demand for their services will wane. The recent executive pay limits imposed by President Obama and his administration are pointed at companies that take bailout money and will affect companies getting ‘exceptional assistance.’ This does not include Goldman Sachs. Bank Capital and Pro-Cyclicality Basel II is a set of banking regulations which regulates both finance and banking internationally. It attempts to integrate capital standards with regulations by setting minimum capital requirements of financial institutions with the goal of ensuring liquidity of the institution (Basel II). One concern about Basel II’s risk-sensitive bank capital requirements is that they could amplify business cycle fluctuations. In boom times, everything looks good – asset prices rise and credit expands in the system. In recession, everything seems very bad – banks stop lending, asset prices diminish, and this makes the macro environment and their own problems worse. There have been a variety of recommendations to deal with this problem by the Issuing Commission. One simple guideline to combat pro-cyclicality has been developed by Rafael Repullo, Jesus Saurina, and Carlos Truchart – three well respected economists. They argue that the best way to correct pro-cyclicality is to use a business cycle multiplier of the Basel II capital requirements that is increasing in the rate of growth of the GDP. Under this scheme, more risky 36 | P a g e
  37. 37. banks would face higher capital requirements without regulation intensifying credit bubbles and crunches (Rafael, 2009). Using the experience of Spain, the simple multiplier of the Basel II requirements depends on the deviation of the rate of growth of GDP compared with its long-term average. Based on their results, they recommend that the multiplier be increased in expansion phases or decreased in recessions by 7.2% for each standard deviation in GDP growth, i.e., 7.2% more capital needs to be raised when GDP is 1% above trend, and vice versa. The below chart which was obtained from Goldman Sachs shows how the cycle would be smoothed when using this approach. It may be difficult for an international regulator to enforce this rule, but it would be sensible for them to impose something similar. 37 | P a g e
  38. 38. Recapitalization of the Banking System Many questions still need to be asked. How can we somehow find enough capital to support and refuel our banking systems? In the first of three series on effective regulation, Goldman Sachs brings up three reasons which they believe it will be unlikely that we solve these problems globally (O'Neil, Avoiding Another Meltdown, 2009): It is ultimately the preserve of domestic regulators and policymakers to find capital to support the banks. While an international agreement would be desirable, in reality is it realistic or enforceable? Can we really expect all countries in the G20 to share the same belief about how much capital their banking system needs? 38 | P a g e
  39. 39. For cross-border purposes, some commonly used capital requirements are necessary but to implement a globally agreed upon banking plan isn’t likely. Despite this, it is necessary and urgent that all local governments continue with their currently implemented plans to help recapitalize their banking systems further. Local Rules, Global Markets Early in 2009, Timothy Geithner was hopeful that the leaders from the world’s 20 largest economies would lay out a plan for regulation reform which would stop banks from transferring risk to less regulated markets and security domains. He mentioned that it was extremely important that the United States work with Europe in developing a global infrastructure which has global oversight in order to prevent a global crisis. “Risk does not respect international borders,” he stated. “Rules must be enforced fairly between major financial powers (Quinn, 2009).” Governments around the world are attempting to strengthen markets and regulations to ensure that these same mistakes are not bound to repeat in the future. It must be recognized that global economic growth can only resume with well-functioning financial and capital markets. Effectively regulated markets can enable new capital to be put to use in effective areas. Capital is Global, Regulation is Local Capital is not local – it is cross-border. But regulation is local, and that identifies a clear mismatch which has increased many of the problems facing the global financial system. One way to fix this mismatch of capital location and regulation is to have one global financial 39 | P a g e
  40. 40. regulator, or at least consistent rules and regulations in financial markets. It could be helpful to have coordination amongst national regulators, but many do not think a single regulatory system is viable. It would be far too difficult for a single global regulator to monitor each country and its laws separately while enforcing standard rules. With that in mind, it would probably be best if governments focused on controlling risk in their country or jurisdictions. If this were the case, governments could set their own standards and monitor risk-taking very closely. This would not hinder cross-border financial activity and trading. Instead governments should attract financial activity to their jurisdiction in order to control it more effectively. The most effective long-term solution is for countries to contain risk in institutions which oversight and regulation can be best applied. Exceptional Regulatory Systems Promote and Encourage Financial Activity All parties in a financial transaction have an interest in maintaining a trading environment that is clear and operates under effective and sensible rules. Regulatory systems which have been proven to be exceptional attract large amounts of financial activity. Governments of those geographic areas should focus on regulations that make those markets function well and avoid regulations which cause financial activity to flee. The key to all effective global regulations include some form of transparency: legal clarity in bankruptcy and the treatment of creditors, reliable accounting standards, and regulators which have a large desire to help and the experience to provide a successful market. Factors which tend to cause a drop in market activity include legal uncertainty, politically-motivated regulators, and harsh tax treatment. The 40 | P a g e
  41. 41. question then becomes, what factors support a growth of market activity? A recent report from Sandra Lawson of Goldman Sachs International gave a list of a few principles which encourage effective capital markets (Lawson, 2009). They include: The enforceability of financial contracts, even (and especially) under bankruptcy; The consistent application of regulations and bankruptcy provisions; Respect for liquidity, which allows for faster resolutions to disputes; Fair treatment of financial counterparties (including non-residents); and Supportive tax policy Regulatory Approach When looking at global regulation, recent years have seen two separate approaches to regulation: a rules-based approach, as in the United States, or a principles-based approach as in the United Kingdom. In general: The rules-based approach is proscriptive, offering an extensive list of what is allowed and how it must be done, with compliance focused solely on the letter of the law. Advocates of this approach argue that “bright-line” rules are simple to understand and to follow, and that this clarity removes much of the subjectivity from enforcement (Regulatory Reform for the US Financial Markets, 2009). The principles-based approach lays out broad principles and standards but does not offer detailed guidelines. Compliance and oversight lean toward meeting the spirit of the law rather than the (less detailed) letter. Supporters of this argue that it gives firms 41 | P a g e
  42. 42. more flexibility and is better suited to fast-changing markets (Principles Based Regulation on the Outcomes that Matter, 2007). Given these two approaches, it is important to note there is no strict line dividing the two. In the end, there is no perfect regulatory approach that fits all markets or societies. Instead other factors matter more in determining the effectiveness of regulation and the attractiveness of the market to issuers and investors. Financial Analysis Goldman Sachs has been a staple in the financial industry for years. With a market capitalization of $87.73 billion it is among the largest financial institutions in the country. It makes up approximately 6.6% of the financial sector and is held by over 2,500 institutions. The company boasts 31,700 employees, with revenue of nearly $2 million per employee. Goldman Sachs displayed a very favorable Return on Equity (ROE) in the years leading up to the financial crisis of 2008. The table below displays Goldman Sachs’ ROE in relation to the commercial banking industry and several competitors from the year 2000 through 2008. 42 | P a g e
  43. 43. Comparative ROE 40.00% 35.00% 30.00% 25.00% Industry ROE 20.00% GS 15.00% JPM 10.00% MS 5.00% BAC 0.00% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year Source: SEC 10-k filings and FDIC Statistics on Depository Institutions reports Goldman Sachs’ increasing use of financial leverage through these years enabled the firm to realize such high levels. Restructuring in the latter part of 2008 caused Goldman’s leverage to fall from a high of 26.16 at the end of 2007 to 13.5 on their most recent quarterly report filed November 4, 2009. The company’s ROE for the quarter ending September 2009 was 4.87%, showing some improvement over the year end of 2008, but far from nearly 35% at the end of 2007. Goldman Sachs’ Return on Assets (ROA) has been historically lower than the commercial banking industry as a whole. The table below displays Goldman Sachs’ ROA in relation to the commercial banking industry and several competitors form the year 2000 through 2008. 43 | P a g e
  44. 44. Comparative ROA 2.50% 2.00% 1.50% Industry ROA GS 1.00% JPM 0.50% MS BAC 0.00% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year Source: SEC 10-k filings and FDIC Statistics on Depository Institutions Reports Goldman Sachs’ ROA has been lower than the commercial banking industry largely because of its narrow net interest margin. Compared with other financial institutions with a broader array of services, Goldman’s ROA is fairly in line hovering steadily around .35%. Goldman historically made up for this narrow margin by engaging in non-interest income producing activities such as trading and financial advisement that give the company a typically negative burden, raising total ROA (2008 was the first time that Goldman Sachs experienced a positive burden based on its non-interest income and expenses). Goldman Sachs is currently comprised of three business segments, which may also be broken down into separate components as follows: Investment Banking o Financial Advisory 44 | P a g e
  45. 45. o Underwriting Trading and Principal Investments o FICC o Equities o Principal Investments Asset Management and Securities Services o Asset Management o Securities Services Trading and Principal Investments has significantly more earnings than either of the other two. Goldman Sachs has wisely increased this line of their business as it is also the most profitable with a net operating margin of 40.23% compared to 16.38% and 17.14% for Investment Banking and Asset Management, respectively. Below is a chart displaying the breakdown of Goldman Sachs’ business segments. Business Segment Makeup Percent of Revenue Asset Investment Management Banking 12% 9% Trading & Princ. Investments 79% 45 | P a g e
  46. 46. Source: November 4, 2009 10-Q SEC filings In the third quarter of 2009 the Trading and Principal Investments segment earned $4.5 billion in operating income. Goldman Sachs’ interest income has declined dramatically since the 2008 financial crisis, largely due to a steep decline in interest rates. The company has lost significant interest revenue particularly in their securities borrowed category, falling from $2.917 billion in the third quarter of 2008 to just $122 million in the similar quarter, 2009. Likewise, their interest expense has dropped in a related category: securities loaned with interest expenses falling from $1.639 billion in 2008 to $246 million in 2009. The result is that Goldman Sachs’ net interest margin has narrowed to just .19% in the third quarter of 2009, but gains in non-interest income have offset this, creating once again a negative non-interest related income and expenses burden. Goldman Sachs’ balance sheet reveals a strong financial company that is becoming more financially sound. Because the company is de-leveraging (largely caused by Goldman Sachs’ shift to a bank holding company) they have been forced in recent months to shift the focus of their business ever more towards Trading and Principal Investments. Because the company’s thin interest margins necessitated utilizing leverage to increase ROE, their focus must now shift to the more profitable area of their business. While Goldman Sachs has decreased their risk by reducing their leverage, they are now engaging in more risky investment opportunities with a higher rate of return to make up the difference. Below is a graph showing Goldman Sachs’ 46 | P a g e
  47. 47. operating income over time from FICC-the riskiest part of the Trading and Principal Investments segment. FICC Operating Results $30,000.00 $25,000.00 Millions of Dollars $20,000.00 $15,000.00 FICC Operating Results $10,000.00 $5,000.00 $- The company’s employees enjoy some of the highest compensation to be found, with $168,801.26 in compensation per employee in the third quarter of 2009 alone. This allows the company to recruit some of the best talent available, but cuts into their returns by increasing the financial burden. Employee compensation makes up over 70% of Goldman Sachs’ non- interest expenses. The company has come under scrutiny recently for its high compensation. Indeed with new restrictions on the company’s leverage they may have to decrease compensation to keep their ROA positive and reduce their burden. 47 | P a g e
  48. 48. Goldman Sachs employs an above average amount of off-balance sheet trading as well. The company holds off-balance sheet items totaling 927.56% of total assets, or $1.11 trillion worth. These are primarily composed of credit derivatives totaling $1.04 trillion, split roughly evenly between derivatives purchased and those that the bank has written. The company has been reducing its off-balance sheet holdings in recent months, reducing total items by 30% since the year-end 2008. Below is a graph showing the off-balance sheet items held by Goldman Sachs’ competitors as a percentage of total assets. Off-balance-sheet Percent of Total Assets 1000.00% 900.00% 800.00% 700.00% 600.00% 500.00% Off-balance-sheet Percent of Total Assets 400.00% 300.00% 200.00% 100.00% 0.00% GS MS JPM BAC Source: FFIEC Uniform Bank Report: 6/30/2009 While it appears that Goldman Sachs is using off-balance sheet derivatives responsibly, their presence increases the company’s overall risk. The average daily value at risk has increased in 48 | P a g e
  49. 49. 2009 from 2008 to $231 million due to the company’s more aggressive trading strategies. Goldman Sachs is heavily exposed to shocks to the financial system due to its heavy volume of trading activities. If securities prices are over-inflated and the company is not adequately hedged then it could suffer significant blows to its bottom line. Competitive Analysis As the banking system continues to stabilize in 2009, markets are rising and consumer confidence is returning. Although a weaker than expected consumer spending report at the end of October, 2008 sent stocks fleeing, there is a general consensus that the economy is stabilizing. GDP is showing positive growth and the banking industry has taken advantage of improving market conditions. Risks remain, however, as the depths of commercial credit losses have yet to be discovered, and while consumer debt shows signs of improving, provisions for commercial real estate losses may not cover the actual costs of these loans. It is in this climate that Goldman Sachs is operating. With few consumer loans on hand, Goldman Sachs must tread carefully in their portfolio of loans written to companies holding risky assets. If the company can successfully walk the tight rope it may have a competitive advantage against some of its staunchest competitors, such as JP Morgan, Bank of America and Morgan Stanley. JP Morgan is has a market capitalization of $168.18 billion, which is nearly twice the weight size of Goldman Sachs. They have been able to buy assets including Bear-Stearns and Washington Mutual at extreme discounts through the financial crisis of the past year. Though they engage in retail banking to a greater degree than Goldman Sachs, their investment banking potential is 49 | P a g e
  50. 50. nothing to scoff at. The company’s ROA is roughly even with Goldman Sachs’ while JP Morgan has a more diversified business. Bank of America has also weighs against Goldman Sachs in the financial services sector. With a market capitalization of $128.02 billion it also holds more of the sector than Goldman. Bank of America, however, lies in much worse shape than JP Morgan and poses less of a threat to Goldman Sachs. By overpaying for Merrill Lynch during the financial crisis and keeping billions in bad commercial real estate loans on its books, Bank of America does not fare as well against some of the more well-placed financial companies. Bank of America has also seen its debt to equity ratio rise in the past year and its financial leverage fall, reflecting an increase in debt and a decrease in assets. Morgan Stanley is another brokerage firm in direct competition with much of Goldman Sachs’ business. With a market capitalization of $43.68 billion it is roughly half the size of Goldman Sachs. Much like Goldman Sachs, Morgan Stanley reclassified itself as a bank holding company coming out of the economic crisis. Also similar is the fact that Morgan Stanley is required to reduce leverage and look for high return business opportunities to bolster its returns. Below are various comparisons for the companies. 50 | P a g e
  51. 51. Valuation Ratios P/E P/Book P/Cash Div. Yield Flow GS 37.9 1.5 40.8 0.90% JPM 74.6 1.1 1.6 1.20% MS 20.4 1 0.5 1.30% BAC 12.5 0.6 1.5 2.40% Industry 58.1 1.5 2.2 1.60% S&P 19.1 2.1 6.5 2.20% Goldman Sachs appears to be the most overpriced stock, trading at 40.8 times cash flows and 37.9 times earnings. While JP Morgan’s Price-Earnings (P/E) ratio appears inflated as well, their price to cash flow ratio is much more in line with the norm. Each company’s price to tangible book value appears to value the stock similarly. ROE Industry GS JPM MS BAC 2008 1.35% 3.60% 4.91% 2.60% 3.04% 2007 9.12% 34.20% 13.08% 14.10% 12.95% 2006 13.02% 25.17% 11.32% 27.00% 16.86% 2005 12.87% 17.30% 6.37% 18.17% 14.47% 2004 13.71% 11.83% 3.29% 15.49% 10.07% 2003 15.33% 6.34% 7.54% 11.58% 10.89% Goldman Sachs’ return on equity has been one of the highest over the last few years while JP Morgan has typically trailed, though this trend appears to be changing. The sharp decline in ROE seen in 2008 comes from one of two sources: in the case of Goldman Sachs and Morgan 51 | P a g e
  52. 52. Stanley, quick de-leveraging pulled back their returns while JP Morgan saw their burden sharply increase from -.22% to 1.01% from 2007 to 2008 causing ROA to fall. Bank of America had a similar problem, though their situation was exacerbated by a decrease in the net interest margin from 1.93% to 1.37% after allowing for losses on loans. ROA Industry GS JPM MS BAC 2008 0.13% 0.26% 0.19% 0.27% 0.33% 2007 0.93% 1.98% 1.53% 0.40% 1.55% 2006 1.33% 1.64% 1.34% 0.98% 2.36% 2005 1.30% 0.98% 0.82% 0.87% 1.73% 2004 1.30% 0.80% 0.42% 0.80% 1.42% 2003 1.40% 0.50% 0.67% 0.72% 1.10% Similar to ROE, each company saw a sharp decline in ROA from 2007 to 2008. While conditions are improving in 2009, companies are being forced to find more profitable lines of business to give a boost to ROA. Net Interest Margins GS JPM MS BAC 2008 0.48% 2.60% 0.38% 3.35% 2007 0.45% 1.77% 0.33% 2.55% 2006 0.39% 1.43% 0.22% 2.56% 2005 0.35% 1.33% 0.44% 2.27% 2004 0.34% 1.13% 0.46% 2.07% 2003 0.36% 0.87% 0.36% 1.52% Goldman Sachs and Morgan Stanley, as brokerage firms, have the tightest Net Interest Margins (NIM) due to the amount of non-interest income and expenses they have. They are able to 52 | P a g e
  53. 53. make up profits in securities trading and wealth management. JP Morgan, as an institution leaning more on the commercial bank side, shows higher NIM than either Goldman or Morgan Stanley while Bank of America, which leans mostly upon its commercial banking business, has the highest net interest margins. This all makes sense and when comparing the two brokerage firms, Goldman Sachs shows the most promise in its net interest margin. $30.00 Historical Earning Per Share $25.00 $20.00 Earining Per Share GS $15.00 JPM MS $10.00 BAC $5.00 $- 2002 2003 2004 2005 2006 2007 2008 2009 53 | P a g e
  54. 54. Stock Prices from 1/6/03 through 11/2/09 $250.00 $200.00 $150.00 Stock Price $100.00 $50.00 $- 1/6/2003 1/6/2004 1/6/2005 1/6/2006 1/6/2007 1/6/2008 1/6/2009 GS JPM MS BAC The stock price and earnings data charts give a visual representation of volatility risks involved with these stocks. The stock’s betas are displayed as follows: Beta Though Goldman Sachs appears to be the most volatile stock in the graph GS 1.48 JPM 1.2 above, the beta chart shows that Bank of America has historically deviated MS 1.37 more from the market than any of the other three stocks. Goldman Sachs BAC 2.66 does have the most volatility if Bank of America is excluded, and according to this measure, is riskier than the other two stocks. In addition, Goldman Sachs market exposure subjects it to risks of market fluctuations to a greater degree than any of the other three stocks. Though Morgan Stanley is a brokerage firm as well, it has followed the path of wealth management rather than trading activities to bolster its returns. JP Morgan’s business is diversified to a 54 | P a g e
  55. 55. degree that it is much less exposed to market fluctuations than Goldman Sachs. Bank of America’s investments in Countrywide and Merrill Lynch cause its risk profile to increase with regards to both market exposure and fixed income securities. This is likely why its volatility is so high because a change in any number of economic factors could cause a loss for Bank of America. Goldman Sachs holds off-balance sheet derivatives far in excess of any of the three competitors examined. This additional exposure to market risks should cause investors to pause. Although many of the off-balance sheet liabilities are offset by assets, they are dependent on timing and the direction of the markets. These items total $1.11 trillion in notional value and represent a real risk hidden within Goldman Sachs’ books. As a percentage of total assets, this amount is much higher than any other competitor, the next closest being JP Morgan with 472.12% of total assets in off-balance sheet items. Because of off-balance sheet items, higher securities trading volumes (particularly in the FICC segment), and higher stock price volatility Goldman Sachs does have a higher risk profile than Morgan Stanley or JP Morgan, though Bank of America’s purchase of Merrill Lynch and Countrywide combined with its high beta likely make it the riskiest out of the bunch. That being said, Goldman Sachs does have higher earnings potential per share than either of the other competitors though the valuation analysis shows that this has likely already been priced into the stock. 55 | P a g e
  56. 56. Conclusion From a very auspicious beginning to a near-death during the Depression; from the IPO of an automobile giant to a bleak future in the new century; Goldman Sachs has been able to prevail. Goldman Sachs was able to take its volatility and high earnings per share and remain a steadfast icon in the financial world while many firms were collapsing all around. The setbacks experienced during the Financial Crisis of 2008 may have forced Goldman Sachs to make some changes, but from almost every perspective, the firm has come out in a better position than most others. Warren Buffett’s investment and the payback from AIG has only helped to secure a better perception for the firm. Goldman Sachs is now poised to continue on to great things in the future due to the determination of the current senior management team. 56 | P a g e
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