Why Goldman Sachs (and Warren Buffett) Always Win
Last week’s stock market turmoil was a reminder that America continues to struggle to recover from the financial collapse of 2008-2009. Benchmarks of our economic progress, or lack of it, are over 40 million people on food stamps, unemployment rates stuck over 9%, and GDP growth slowing, as it just missed expectations of 1.3% growth. The Obama Administration’s massive deficit spending has almost doubled the publicly held debt which was $5.808 trillion on 9/30/08, or 40% of GDP, to an estimated $10.672 trillion as of 9/30/11, or almost 71% of GDP. This is all just in 3 fiscal years. The road to recovery for most people looks longer than anyone expected.
But the American economy, being what it is, there are bright spots for some people. From the March 15, 2011 Wall Street Journal:
Warren Buffett‘s Berkshire Hathaway Inc. said Monday it will buy chemical maker Lubrizol Corp. for $9 billion, in its latest expansion into the industrial sector, where the billionaire investor has been seeking new avenues for growth.
Cash-rich Berkshire said Monday it will pay $135 a share and assume about $700 million of debt in its deal to acquire Lubrizol….
The purchase price represents a 28% premium to Lubrizol’s closing price Friday on the New York Stock Exchange and is 18% above the stock’s all-time closing high in October….
The deal was unveiled about two weeks after Mr. Buffett, Berkshire’s chairman and chief executive, wrote in his annual letter to shareholders that he was “itchy” for a major acquisition.
Big business deals like this are often fraught with problems. This one resulted in a sticky disclosure problem about who knew what and when they knew it. From the April 27, 2011 Wall Street Journal:
A committee of Berkshire Hathaway Inc. directors pinned the blame on the stock-trading controversy dogging the conglomerate squarely on former executive David Sokol, saying he misled top executives, including Berkshire Chairman and Chief Executive Warren Buffett.
In a report released Wednesday, the audit committee of Berkshire’s board said it has determined that Mr. Sokol’s conduct and trading activities in the shares of a chemicals company that Berkshire recently agreed to buy violated the Omaha, Neb., company’s standards of business ethics and insider-trading policies.
Striking a much harsher tone than Mr. Buffett did when he first disclosed Mr. Sokol’s stock purchases in late March, the report criticized Mr. Sokol’s disclosures about them to Berkshire’s senior management as “misleadingly incomplete,” and said Mr. Sokol “violated the duty of candor he owed” Berkshire….
The report said Berkshire’s board may consider legal action against Mr. Sokol, whose stake in Lubrizol rose in value from $10 million to roughly $13 million after Berkshire reached a deal in mid-March to acquire the company for $9 billion cash.
It is a principle of fair and transparent financial markets that people do not act on inside information to which they have access before the same information is released to the public when everyone can act on it at the same time. This is a constant problem in the financial markets. But, what we see here is a strict standard imposed on an executive making a $3 million profit on stock which he allegedly owned before his employer, Berkshire Hathaway, purchased the same company for $9 billion. Yes, it is good to see such high profile people in the financial industry arguing for and adhering to high standards of conduct in not utilizing inside information to increase profits outside a transparent market.
Very recently, another fascinating, if not controversial, member of the financial industry published its financial results. These results, like the American economy, were somewhat downbeat. From the July 20, 2011 Wall Street Journal:
Long envied as one of the savviest gamblers around, Goldman Sachs Group Inc. surprised Wall Street with a steep decline in trading revenue because it stopped rolling the dice.
Goldman’s nimble trades routinely put the firm at the top of the heap over the past decade, notably during the financial crisis. But executives said Tuesday that economic and political turmoil around the world has caused the firm to lose much of its appetite for taking chances. In particular, Goldman stumbled in its core fixed-income unit and in commodities trading.
‘I don’t want to sugar coat it…Maybe we made a bad decision in taking too little risk,’ David Viniar, Goldman’s chief financial officer, told analysts Tuesday. ‘I don’t know….’
In the second quarter, Goldman’s revenue from trading bonds, commodities and currencies plunged 53% to $1.6 billion from $3.37 billion a year earlier. That badly bruised the New York company’s bottom line, even though overall profit jumped 78% to $1.09 billion from an anemic year-ago quarter….
On the bets Goldman did take, it suffered losses in commodities, bonds backed by riskier mortgages and in European and Asian credit markets. And when Goldman didn’t take losses, it bought expensive hedges that reduced the company’s profit, executives said.
…But Goldman is unlikely to soon repeat the easy profits of 2009 when other rivals were still weak and markets were rising from their lowest levels in decades….
The securities firm reported earnings of $1.85 a share, missing analysts’ predictions by 42 cents, the fifth time Goldman fell short of expectations in its 12-year history as a public company. Goldman’s revenues of $7.2 billion fell 18% from one year ago.
These results pretty much speak for themselves. But, we would take issue with comments about Goldman’s “nimble trades.” In fact, Goldman Sachs publicity about itself is larger than life, if not untrue. You can better understand Goldman Sachs’ success, or lack of it, through the financial crisis by examining in detail the way it presented its financial statements for the 3 years between 2007 through 2009.
The purpose of this Mysterious Business statement of earnings is to see what Goldman Sachs looks like without its mundane Businesses of Investment Banking and Asset Management and Securities Services. From a pro forma elimination of them, we can see what the remainder is all about. This is art and not science since Goldman’s financial report is usually 150 to 200 pages long. This analysis is for perspective setting.
On the revenue side, there are two key points. Net revenue collapsed from 2007 to 2008 by $21.330 billion, or -63%. What company do you know of that could have this type of revenue collapse in one year and not be in real trouble? Then there is the bizarre increase in net income in 2009 to $7.407 billion from $4.276 billion in 2008 and $3.987 billion in 2007. And this was in spite of the fact total interest income had declined $32.061 billion or -70% and total interest expense declined $35.481 billion or -84%. So, in the worst business conditions since the Great Depression, Goldman Sachs experienced a huge increase on interest spread while their net revenues declined -63%. Oh, how very unusual! The only way they could have avoided a complete catastrophe in 2008 was to cut compensation and benefits by $9.256 billion or 45%. Did they fire half of their employees, or did have their employees quit? Did anybody from Goldman Sachs go on food stamps? Here is something very important that we can discover about Goldman Sachs from the July 20, 2011 Wall Street Journal:
When it comes to dividing the spoils at Goldman Sachs Group, the firm is making sure employees get hearty helpings, while shareholders are left with crumbs.
The Wall Street titan posted a disappointing first quarter. Revenue in Goldman’s core fixed-income trading division fell 63% sequentially and 53% year-over-year due to reduced trading activity and economic uncertainty. That, along with weakness in its lending-and-investing division, led to an 18% year-on-year decline in overall firm revenue.
The result was a very un-Goldman-like return on common equity of 6.1%. Investors looking at that number could be forgiven for thinking they had mistakenly picked up Morgan Stanley‘s results-due Thursday-since Goldman’s long-term average is about 20%. Meanwhile, compensation, although down 16% in dollar terms, was equal to 44% of revenue, unchanged from the first quarter and not far off the firm’s long-term average of around 45%.
As long as that disparity between returns and compensation persists, Goldman’s stock will suffer. And returns don’t look likely to bounce back soon….
What you can see from this is that Goldman Sachs principal reason for existing is to pay its employees a lot of money. But, they employ a whole lot of other people’s money to do this. If you look at their Balance Sheet in 2008, you may be stunned to see that their total liabilities were $820,178,000,000. Yes, that is billions. This is definitely a lot of other people’s money. Let’s put this into perspective. Goldman Sachs total debt exceeds the publicly held debt of 22 of the 27 nations of the European Economic Community. In descending order of nations, it would look like this:
Now Goldman Sachs has about 35,000 employees. Their per capita debt would be $23,428,571 million. What are they doing that would every permit each employee to retire their share of this debt?
Let’s say there are approximately 140,000,000 taxpayers in the United States, and the Debt Held by the Public is$9.755 trillion as of July 31, 2011. This results in a per taxpayer amount of $69,684 each. How in the world did Goldman Sachs borrow such an outrageous amount of money? What were the lending criteria for repayment? How would they ever pay it back, especially in any type of violent economic downturn?
This forces us to go back to the official year 2008. Our Mysterious Business analysis came from the 2009 Goldman Sachs financial statements. In the 2010 financial statement, their auditors have changed the disclosure for revenues as follows:
How good of the auditors to now, ex-post facto, disclose not just a net decline in revenue, but a $10.048 billion realized loss in “Other Principal Transactions.” Well, if they had a realized loss of $10.048 billion, what do you think their unrealized losses might have been? Let’s just do a simple proportioning.
In 2007, Trading and Principal Investment Revenue was $29.714 billion and then precipitously dropped to just$8.095 billion in 2008. This is a decline of 72%. So, for starters, let’s say 72% of their assets had declined in value. Anyone who was working in the financial industry at this time knows that almost every market locked up, and went illiquid including money market funds. What could have happened to markets for Goldman Sachs more esoteric assets? Since, total debt in 2008 was $820 billion and total assets were $884 billion, any material decline in their assets’ value and or liquidity would put them in a desperate position. It would also put their lenders of the $820 billion in a desperate position. Were they insolvent and broke?
We prefer to turn to an expert for a final opinion on the matter:
Well, as a matter of fact, it (Goldman Sachs) did not survive this crisis. It was saved by the United States taxpayers who through the Federal Reserve breathed life into its dead corpse.
Lender of last resort indeed. The Federal Reserve pulled back the curtain yesterday on its emergency lending during the financial panic of 2008 and 2009….
We learn, for example, that the cream of Wall Street received even more multibillion dollar assistance than previously advertised by either the banks or the Fed. Goldman Sachs used the Primary Dealer Credit Facility 85 times to the tune of nearly $600 billion. Even in Washington, that’s still a lot of money. Morgan Stanley used the same overnight lending program 212 times from March 2008 to March 2009. This news makes it impossible to argue that either bank would have survived the storm without the Fed’s cash.
How does this happen? Suppose you are a personal investor who wants to borrow money against your stock portfolio. If your stock portfolio is worth $100,000, you could borrow 50% of this value and buy another $50,000 of stocks giving you a total portfolio of $150,000. Goldman Sachs had total shareholder equity of $64.369 billion in 2008. Using the same margin requirements, they would have been allowed to borrow $32.184 billion and then purchase another $32.184 billion in equities resulting in total equity of $96.553 billion. But, they were able to somehow borrow $820 billion. So, it turn out that the purpose of this firm is solely to make as much money as possible for their employees with the United States taxpayers guaranteeing their losses and absorbing all their risks. It is just a gigantic hedge fund for the benefit of Goldman Sachs’ employees and most favored clients.
The gateway to the unjust catastrophe was opened by a former CEO of Goldman Sachs, Robert Rubin. The gate, the Glass-Steagall Act of 1929 and 1932, had been closed during the Depression when this Act forbid commercial banks and investment banks from owing each other and lending to each other in order to protect the depositors of commercial banks, whose deposits would be insured by the FDIC. Had the Glass-Steagall Act been left in place, the wild excesses of leveraged trading of almost anything and everything of the 2008 financial crisis could not have happened..
But, Robert Rubin was President Clinton’s Secretary of the Treasury:
Robert Rubin was a very powerful man. After 26 years and rising to the level of Co-Senior Partner, he left Goldman Sachs in 1994 to become Treasury Secretary in the Clinton Administration. His first major undertaking was during the Mexican bailout of 1995.
…Rubin drew criticism in Congress for using a Treasury Department account under his personal control to distribute $20 billion to bail out Mexican bonds, of which Goldman was a key holder.
For 1998, the first year which we have public financial information on Goldman Sachs, their total revenue was $22 billion and their net profit was $1.256 billion. It is highly probable that the $20 billion was extremely helpful to Goldman Sachs-if not essential to its continuing existence.
Rubin had a friend named Sandy Weil, who wanted to sell a collection of investment banks organized under Travelers Insurance Corporation to the intended buyer Citicorp, the largest commercial bank at the time in the United States. But, under the Glass-Steagall Act, Citicorp could not purchase Travelers Insurance Corporation. With chief spokesman and former Goldman Sachs CEO Robert Rubin leading the charge, the Glass-Steagall Act was repealed in 1999.
Sandy Weil Would make billions of dollars, Robert Rubin would make a $100 million sitting on the executive committee of Citigroup and the way was paved for the near or actual failure and rescue of both Citigroup and Goldman Sachs because of their accumulated excessive leveraged trading which culminated in the 2008 financial crisis.
Everything that happened during the Great Depression that the Glass-Steagall Act was designed to prevent happened again during the 2008 financial crisis. Thus, removing it set the stage for the crisis.
It would be interesting to get some perspective on how some of Goldman’s customers have been doing. This will not be dull:
The Senate Permanent Investigation Subcommittee’s report on the financial crisis is an important document. It is an exhaustive look at certain main aspects of the financial crisis, a report which heavily criticizes Washington Mutual, the now-defunct Office of Thrift Supervision, the credit ratings agencies,Goldman Sachs and Deutsche Bank.
The focus in the media, as well as in Senator Carl Levin‘s news conference on the report, has been the criticism shed on Goldman Sachs for betting against clients who bought collateralized debt obligationsfrom it….
Morgan Stanley‘s representative reported to a colleague that when Goldman rejected the firm’s request to sell the poorly performing Hudson assets, “I broke my phone.” He also sent an e-mail to the head of Goldman’s C.D.O. desk saying: “One day I hope I get the real reason why you are doing this to me.”
The paragraph concerns the $2 billion synthetic C.D.O. Hudson Mezzanine-1. Goldman had created and began marketing the Hudson C.D.O. in October 2006. The firm took the entire $2 billion short position on this C.D.O., meaning that any losses on the residential mortgage-backed securities underlying the C.D.O. would mean a gain for Goldman.
Set against Goldman Sachs, Morgan Stanley took almost a $1 billion position on the long side, betting that housing prices would remain stable or go up.
The paragraph above details an exchange that occurred in 2008. By that time the Hudson C.D.O. had been downgraded and Morgan Stanley was trying to salvage its billion dollar bet.
Goldman, being Goldman, was serving multiple roles in the C.D.O. Goldman had a small $6 million long position and was also collateral agent. The Morgan Stanley banker here was begging Goldman to use its position as collateral agent to sell some of Hudson’s assets in order to stem Morgan’s losses, a request Goldman refused….
This sad tale exposes the real point of this report. Wall Street went wild in the years leading up to the financial crisis and in the aftermath, the penalties have been few. Morgan Stanley lost about $960 million on Hudson, a bet put on by Morgan Stanley’s proprietary trading desk….
Goldman claims that it was not a fiduciary or investment adviser to these clients and instead a market maker, simply making a market where sophisticated clients could fend for themselves….
This is not to say that bashing Goldman has not been useful. As William Cohan has written, this type of rhetoric and Goldman’s reputational missteps with the Abacus C.D.O. are likely what got us Dodd-Frank and financial reform.
A market maker is supposed to make liquidity in a market and smooth the ups and downs of supply and demand. The key question here is whether or not the Goldman’s market making department knew that Goldman had a 100% short position on this security. The fact that this so-called market making department offered no price suggests that this department knew the firm had the position 100% shorted and, therefore, it was conflicted against a potential seller. It is the same old question of what the market making department knew and when did it know it?
And the author’s comment, “Goldman, being Goldman, was serving multiple roles in the C.D.O.” is unintentionally incisive. This is a straightforward admission that it is commonly known that Goldman has these types of conflicts and is therefore subject to “reputational missteps.” Using less graceful language than the author, you might say that most people in the industry know Goldman is conflicted and they get by with it. In other words, no one inquires who knew what and when they knew it. The judgment that their “reputational missteps with Abacus C.D.O are likely what got us Dodd-Frank and financial reform” is just damning their lack of integrity, crass opportunism, and violations of regulations.
Here is another amazing performance described in the May 31, 2011 Wall Street Journal:
In early 2008, Libya’s sovereign-wealth fund controlled by Col. Moammar Gadhafi gave $1.3 billion to Goldman Sachs Group to sink into a currency bet and other complicated trades. The investments lost 98% of their value, internal Goldman documents show.
What happened next may be one of the most peculiar footnotes to the global financial crisis. In an effort to make up for the losses, Goldman offered Libya the chance to become one of its biggest shareholders, according to documents and people familiar with the matter….
Discussions inside Goldman about how to salvage the fractured relationship included Lloyd C. Blankfein, the company’s chairman and chief executive, David A. Viniar, its finance chief, and Michael Sherwood, Goldman’s top executive in Europe….
Goldman offered the fund an opportunity to invest $3.7 billion in the securities firm. Between May and July of 2009, Goldman executives made three proposals that would have given Libya preferred shares or unsecured debt in Goldman, according to documents prepared by Goldman for the fund. Each proposal promised a stream of payments that would eventually offset the losses….
The most important information in this data is that between “May and July of 2009, Goldman executives made three proposals….” You will recall in our analysis of Mysterious Business that during 2009 Goldman had a complete reversal of its interest income and interest expense which impacted that year’s financial results very favorably. And that this was the same time that Goldman Sachs was in the process of borrowing $600 billion from the Federal Reserve. So, the proposal to make Libya’s sovereign wealth fund whole would basically be the ultimate responsibility of the U.S. taxpayers standing by Goldman Sachs’ almost dead corpse.
And here are additional matters that reflect very poorly on this amalgam, Goldman Sachs. What is “too big to fail?” It is immunity from being held accountable for bad practices that would be corrected by market selection or rejection. It is the government taking control and picking winners and losers. It gives the federal government regulatory control of the financial sector for its benefit rather than for the benefit of depositors and customers, transparent markets, open and fair markets. “Too big to fail” produces seen and unseen “reciprocal bribery” between the government and the executives of the financial services industry. If there is a danger of failure, the government will ride to the rescue with the taxpayers’ money.
It makes you want to return to a prior time, before the 1999 repeal of the Glass-Steagall Act, when most investment banks operated as partnerships. This resulted in the executive owners having their personal wealth exposed to stupid and greedy leveraged trading. When some dumb trader could lose their net worth in a single bad trade, internal management control was much better. It was promoted by the executive owners’ full time concern for protecting their accumulated wealth.
As soon as the Glass-Steagall Act was repealed, almost all investment banks switched to the corporate form of ownership where the employees got a lot of compensation and the stockholder got the risks of loss. And it prevented executives from having to personally guarantee loans. How many executives in Goldman Sachs do you think were personally guaranteeing any of its 2008 total liabilities of $820 billion?
It makes you almost long for the integrity that Warren Buffet’s Berkshire Hathaway was propounding when they reprimanded and dismissed David Sokol. Remember that there was a controversy on his personal ownership of part of Lubizol before Berkshire purchased it for $9 billion. Since it was not clear “who knew what and when did they know it,” Mr. Sokol was treated with the greatest severity in order to protect Berkshire Hathaway and Mr. Buffet.
This reminds us also that some of Goldman Sachs’ customers do very well, as we can see from this article from September 24, 2008, at the height of the financial panic:
Goldman Sachs Group Inc. said it will get a $5 billion investment from billionaire Warren Buffett’s company, marking one of the biggest expressions of confidence in the financial system since the credit crisis intensified early this month.
The deal is the latest in a series of dramatic events that have reshaped American finance this month, from the federal takeover of Fannie Mae and Freddie Mac to the bankruptcy filing of Lehman Brothers Holdings Inc. to the bailout of American International Group Inc. and steps by Goldman and Morgan Stanley to become commercial banks….
The Berkshire investment will be a big boost to Goldman. Even though the firm hasn’t posted a quarterly loss since the credit crisis began, its profits have waned and its stock got hit last week. It has examined a number of options aimed at bolstering its capital position….
The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on “perpetual” preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.
Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05….
While Mr. Buffett’s investment is unquestionably a vote of confidence in Goldman, it is structured to protect him from losses. The dividends from the preferred shares will remain steady even if Goldman’s stock falls. And if it does, Mr. Buffett won’t spend the $5 billion to exercise the warrants to buy common. Including Goldman’s after-hours stock jump, Berkshire has a nearly $700 million paper profit on the deal already.
Mr. Buffett built his reputation as one of the most astute investors by betting on companies with strong brands. Goldman fits that description, but the peril it has recently faced — its stock is down about 50% this year — underscores the risk Mr. Buffett is taking. Though the government threw the firm much-needed aid by allowing it to become a bank holding company, Goldman still must undertake radical changes to adapt its portfolio of assets to this new business model….
Mr. Buffett has been known to question the value of investment banks and generally shuns them on his own deals. The notable exception has been Goldman. Mr. Buffett has a close relationship with Byron Trott, a fellow Midwesterner who heads the firm’s Chicago office. It was Mr. Trott who brought Mr. Buffett into Mars Inc.’s $23 billion acquisition of Wm. Wrigley Jr. & Co. earlier this year. Mr. Buffett agreed to put about $6.5 billion into the deal. It wasn’t immediately clear what role Mr. Trott may have played in Mr. Buffett’s decision to invest in Goldman….
Mr. Buffett was one of the first people Lloyd Blankfein, now Goldman’s chairman and chief executive, went to see when he became president of Goldman in 2003. ‘They just don’t come any smarter,’ Mr. Buffett said of Mr. Blankfein in 2006.
On Tuesday, Mr. Blankfein said, ‘We are pleased that given our longstanding relationship, Warren Buffett, arguably the world’s most admired and successful investor, has decided to make such a significant investment in Goldman Sachs. We view it as a strong validation of our client franchise and future prospects.’
One of Mr. Buffett’s other assets must be a strong stomach and nerves for what was he thinking when Goldman’s stock sunk as low as $47.41 around the late November 2008 panic?
If you paid something like $125.04 a share in September 2008 for a stock which drops to $47.41 by November of the same year, a period of about two months, your unrealized loss on a $5 billion investment is 62% or $3.10 billion. This is not chump change. A look back to 2007 would find that during that period:
…Mortgage writedowns were pounding firms. Many of them would not survive the coming year: Lehman, Bear Stearns, Washington Mutual, Wachovia and Merrill Lynch.
Was Mr. Buffet sweating “bullets” thinking that Goldman Sachs might be going down the tubes too? He was so confident in the beginning and suddenly, within two months, he is down $3.1 billion as chaos is continuing to spread in the financial markets.
History proves that at this time, November of 2008, Warren Buffett was just about to lose all his money. But apparently in 2009, Goldman experienced what from the financial statements was some sort of financial miracle. The “miracle” would be disclosed by the Federal Reserve:
…Goldman Sachs…tapped one special Fed facility 84 times to borrow nearly $600 billion in overnight money….
Without this $600 billion loan, Goldman Sachs would have gone broke and vaporized Warren Buffet’s $5 billion investment. And so his great intuitive decision about investing in Goldman Sachs was probably the worst decision he has ever made. But, wait, this raises the same old question that bedeviled Warren Buffett in his severe treatment of David Sokol for the use of insider information about his purchase of Lubizol stock before Buffett’s company purchased Lubizol for $9 billion.
What did Buffet know, and when did he know it?