Why it's time to sell Goldman

published 3 July 2006

On Wall Street, there's a saying: "The best way to invest in a hedge fund is to buy Goldman stock."

The quip is dead on target. At Goldman Sachs, Wall Street's investment bank of investment banks, trading with borrowed money like a high-flying hedge fund far outweighs traditional banking services. Risky derivatives now account for more than two-thirds of the firm's revenues. It's a formula that's worked spectacularly in the last few years, as stocks and commodities have soared. Over the past decade, the firm has totted up revenues of more than $125bn, more than three times the level in the previous decade. In 2005, its stock price was up 23% to $128, and this April it hit historical highs of $170.

But the question is: what now for Goldman? How does it follow up such a bravura performance? Last month, the markets hinted at the answer by taking a sharp turn south. When commodities and stocks take a hit, the global derivative trade on which Goldman thrives begins to look less like a sophisticated insurance mechanism and more like a ticking bomb whose time has come. How big a bomb? At the end of 2005, the face value of outstanding over-the-counter derivatives contracts stood at around $300 trillion. Yes, that's $300,000,000,000,000.

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The implication? Sell Goldman. The firm that rode the surf of global liquidity to the crest is unlikely to escape lightly when the waves crash. Of course, in a scenario of universal derivative meltdown, the fall of the house of Goldman would be dwarfed by what came down with it. But even a less-than-apocalyptic shake-up in the markets should see the stock sink. There's simply too much chance that the steam will go out of its impressive recent run.

But it's not just higher risk, they add. Goldman also selects better traders by creaming off the hottest resums from the nation's top schools. And only a fraction of these survive the intense wooing and vetting that goes on even after hiring. For Goldman fans, the bottom line is that you get what you pay for and Goldman pays for the best, so they keep on coming. "It's like the Zulus," said Paul Deighton, chief operating officer of the firm's European business, in an interview with Fortune in 2004. "There's always another one coming over the hillside to fight."

It's not only in trading where Goldman's Zulus outnumber their opponents. Some grouse that Goldman is not just one of the biggest players on Wall Street it also sets the rules of the game with the zillion-watt manpower it routinely shunts to Washington. Since the days when CEO Sidney Weinberg played minence grise to Roosevelt and Truman, it's given the US three treasury secretaries (Henry Fowler, Robert Rubin and now Hank Paulson), an undersecretary and several deputy secretaries of state (Robert Hormats, John Whitehead, Robert Zoellick), two chairmen of the National Economic Council (Rubin and Stephen Friedman), a chairman of the Foreign Intelligence Advisory Board (Stephen Friedman), a chief of staff (Joshua Bolten), a CEO of the New York Stock Exchange (John Thain), a president and CEO of the Federal Reserve Bank of New York (Gerald Corrigan and Whitehead).

Then there's also a New Jersey governor, a US senator, a chairman of the BBC, several major hedge-fund managers, the chairmen of the Port Authorities of New York and New Jersey, a governor of the Bank of Italy, the head of the US Export-Import Bank, two US trade representatives a veritable Burke's peerage of national and international finance. To all this, add Goldman's investment banking business, which though it accounts for only 5% of revenues has a Rolodex crammed with the financial elite.

Goldman does not just trade the capital markets. In alumni terms, it is the capital markets. And the actions of those alumni have certainly helped it boom, as they have the rest of the banking industry. Note that it was on Robert Rubin's watch that we had the mega-consolidation of banking that enabled Goldman to race to the head of the pack. Note also that the erasure of the line between commercial and investment banking and the loosening of regulations in 1999 coincided with the transformation of Goldman into a publicly traded firm and the shift of risk from partners to shareholders. The firm's spectacular success was a creation of the easy money Robert Rubin and Stephen Friedman, along with Federal Reserve chief Alan Greenspan, lavished on the economy. The credit bubble that drove the dotcoms to Himalayan heights in the nineties simultaneously enabled the credit-hungry Goldman to create its own possible bubble that of derivatives. In its quest to expand and tighten its grip on world markets, it was Goldman which invented many of these complex and fragile financial instruments, just as it was Goldman which pioneered nearly every other high-risk instrument that we associate with modern finance everything from global debt offerings to electronic trading.

But shouldn't this octopus-like reach make the firm invulnerable even in a market downturn? Seemingly not. No firm, after all, is invulnerable if it starts to overstretch itself. Recently, Goldman's penchant for being in on every side of a deal has set off polyglot howls of protest around the world. Its New York branch recently had to smack down its London branch for being too aggressive in its bids to buy companies, thus threatening the firm's carefully cultivated image as a disinterested advisor. In Japan, the aggressive tactics have led to some mergers and acquisitions customers jumping ship.

In the US, some eyebrows were raised by its conflict of interest in the tie-up between the New York Stock Exchange and electronic-trading platform Archipelago. NYSE chairman Dick Grasso was ousted for accepting a pay-packet of $140 million from the NYSE board in a coup headed by then Goldman chief, Paulson. Grasso's replacement was another Goldman honcho, John Thain, under whom the NYSE merged with Archipelago. Goldman, a major investor in Archipelago, saw the value of its stake soar immediately. And who advised the NYSE to make the plushy deal? Why, Goldman Sachs. With a $100 million lawsuit going on against Grasso, there's potential for a few skeletons to be rattled.

Then there are the legal threats against the firm itself. So far, Goldman has been much better at keeping out of scandal or at least out of the headlines than its rivals. But in the firm's latest 10K a filing to the US Securities and Exchange Commission there is a 10-page section on pending legal claims against it. These include mutual-fund trading abuses, research improprieties, trading floor special abuses, initial public offering irregularities, and an insider dealing scandal in 2001 involving a tip on the sale of Treasury bonds that gave Goldman an eight-minute edge that brought the firm roughly $4 million in profits.

Most recently, regulators are looking into claims that Goldman (among others) helped managers at the US Federal National Mortgage Association (known as Fannie Mae) prettify their books to maximise performance bonuses at the company entrusted with keeping US home loans afloat. Which means that Goldman was centre stage not only in the credit and derivative booms, but in the housing boom too. (Goldman and the other firms deny wrongdoing.)

The good is obvious: its financial performance is still stellar. Goldman shares are up 44% since the end of 2004 and reported a record profit of $5.63 billion in the 2005 financial year. Net revenue rose 21% over FY 2004. Return on equity at 27% is at the top of the industry. Mergers and acquisitions advising and equity underwriting are also industry leaders. This year's results are as impressive. First quarter earnings per share at $5.08 easily beat consensus estimates of $3.29. In the second quarter, net income tripled to $2.29 billion, revenue more than doubled to $18 billion; and earnings were $4.97 a share, ahead of estimates and double last year's.

But then there's the bad, some of which is not so obvious. First, at a price-to-book value of 2.5, which is more than the value of its rivals, the stock price looks expensive to some analysts. The market may be starting to feel the same. Despite those record second-quarter returns, shares still fell $5.75 (or 4%) to $139.25, reflecting investor concerns that a weak market will take the stock down further. What's more, with CEO Hank Paulson now Treasury secretary, his stake of almost $500 million in Goldman stock will have to be sold to avoid conflicts of interest. That should trigger even more selling.

It's also hard for investors to look under the hood. The Economist reports that of the $600 billion worth of assets under Goldman's management, the only part that is publicly verifiable does no better than any run-of-the-mill brokerage, only at higher than average cost. The same goes for what little is visible of its hedge-fund services. Equity research, too, is said to be mediocre. The suggestion is that while Goldman undoubtedly does some things very well such as trading its glamorous name may be disguising pretty underwhelming performance elsewhere.

The ugly, of course, includes the risks to its reputation that we've already seen. The stresses generated by greater and greater conflicts of interest across the firm's criss-crossing empire, also mentioned above. And the sheer danger of being the champion when all your rivals are out to bring you down. The high value-added stuff that Goldman goes after in the M&A business, for instance, could also push it over the edge. Citigroup has long boasted it would depose Goldman in that area by 2007. Its rivals see it or claim to see it as increasingly vanquishable. "I view Goldman Sachs as the Charge of the Light Brigade," said one anonymous rival in Fortune in 2004.

If so, there's little doubt what Goldman's Valley of Death is likely to be its trading wing, where it just took on more risk this quarter. Traders more than doubled value at risk' (VAR) the amount of money their models say they could lose in a single day to $112 million this year. How much is at stake? According to The Economist, the face value of Goldman's derivatives exposure is more than $1 trillion. But it's hard to know exactly how large Goldman's risk exposure is, because the firm is famously secretive understandable if it wants to guard its advantages, but not conducive to helping its investors sleep well.

What's more, a market breakdown would leave the firm even more dependent on trading, because revenues from banking and underwriting would most likely plummet as they did in 2002. That's why Paulson's move to Treasury should raise a few red flags. Could he be anticipating a storm brewing? Does he, like many in the industry, see the firm under relentless pressure to adopt ever more dangerous tactics?

One big tip-off is that Paulson's replacement is Lloyd Blankfein, the former head of the fixed-income, commodity and currency division. Blankfein's appointment shouts over all the spin to the contrary that derivative trading, not traditional banking, is going to keep on playing an outsize role in the firm. As markets show signs of buckling, that makes for a dead certainty that risk will soar exponentially. Which is to say that Paulson's confirmation might just be the clearest signal yet we have for Goldman stock now. It's a SELL.

John Paul Rathbone of Breakingviews.com agreed that Goldman was "desperate to buy a trophy asset" to kick-start the fund, but predicted that investors will prove unforgiving if more deals are done at similar valuations to ABP. Goldman hadn't done itself any favours, he added, by complaining that, given more time, it would have upped its failed bid for airports operator BAA. "From this example, ABP learnt the value of patience".

Goldman's legendarily high demands on its employees' lives have also been in the press again. Recently, the bank set up the Orwellian-sounding Wellness Exchange' which will "recognise employees in all aspects of their lives, personally and professionally". The FT's Lucy Kellaway found the concept sinister. "Goldman gives wellness to its employees but, in return, what do they give back? Their working lives, with their souls thrown in, one fears." Indeed, she added, quite a few employees already seem to have made a positive choice recently. "They have left the bank".