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How Does Goldman Sachs Operate?

Posted by Larry Doyle on July 6, 2009 6:37 PM |

Goldman Sachs is widely regarded as the top Wall Street bank. What makes Goldman so special? Is everything on the up and up? Is it one massive conspiracy? At the request of a number of readers, allow me to share my perspectives on Goldman Sachs, in general, and my thoughts on Matt Taibbi’s article in Rolling Stone magazine, “The Great American Bubble Machine.”

Goldman Sachs has always had a tremendous investment banking franchise along with outstanding risk management capabilities within its trading operation. That said, in the ’80s and ’90s Goldman was certainly one of the best shops on the street but it had plenty of company. In my opinion, Goldman separated itself from the Wall Street crowd after the repeal of Glass-Stegall which had previously separated commercial and investment banking operations.

With the repeal of Glass-Stegall, most investment banks looked to grow origination capabilities in order to compete with the large commercial banks. At the same time, most commercial banks looked to grow their investment banking and trading operations.

Goldman stood out by taking an entirely different tact. Goldman decided to utilize its capital and balance sheet less so for origination capabilities and much more for principal trading (that is, making bets and taking positions with its own capital). Effectively, Goldman decided to operate much more like a large multi-strategy hedge fund. Goldman took enormous risks both in their proprietary books but also in their trading activity with customers. Goldman made a concerted decision to dominate the markets in which they chose to play.

While Mr. Taibbi paints Goldman as one large conspiratorial machine, I beg to differ.  In fact, the reason why I initially only skimmed the Rolling Stone article is because it oversimplifies the Goldman business model and paints the entire firm and all its employees with a broad brush.

In all of the examples Taibbi references, the indictment of Goldman’s actions could be effectively placed upon all of Wall Street. No surprise that Goldman was heavily involved in the meltdown of the Nasdaq at the turn of the century. As one of the largest equity underwriters in the business, it goes with the territory. That said, the two highest profile equity analysts implicated with pumping internet stocks were Henry Blodget of Merrill Lynch and Jack Grubman of Citigroup.

On the housing front, Goldman was hardly a major player on the origination side of the business. Lehman, Bear, Greenwich Capital, UBS, and Citigroup were larger players on the underwriting and distribution of mortgage-backed bonds. Goldman distributed bonds just like every other bank, but they were sharp enough to short the market near the top. Does that define a conspiracy? No way. That was a good trade.

Despite the fact that I am largely defending Goldman to this point, one needs to appreciate the fundamental nature of Goldman’s business model. If a firm is going to take large principal risk positions both within proprietary books and customer books (trading accounts used to trade with clients), two factors are of overwelming importance: information and relationships.

Goldman worked both of these angles very, very hard. Goldman developed extremely close relationships with the largest customers in the market and the largest power brokers in Washington and around the globe.

Given the quality and depth of their franchise, they became the envy of Wall Street. Did they abuse these relationships and information to the point where they were willing to break the law? I strongly doubt that. Were there instances when a senior Goldman executive shared information with a risk manager in confidence? Most likely. That would not be an uncommon occurrence on Wall Street.

Many of Goldman’s relationships are with very active trading hedge funds. These funds know one goal–making money. Are rules violated? I’m sure they have been. To that end, the hedge fund industry needs to be regulated aggressively. Is this a blanket indictment of Goldman Sachs? No.

On Wall Street, ‘Chinese walls’ are utilized to make sure that information is properly channeled. Has Goldman ever improperly ‘gone over the wall?’ I’m sure they have. As has every other Wall Street firm. Is it common practice? No way.

In regard to AIG being a conduit for the funneling of funds to Goldman Sachs and every other bank. I believe Lloyd Blankfein when he says that Goldman held collateral from AIG and that if AIG did not make Goldman whole on its own that Goldman would have merely seized the collateral. That is standard practice.

Taibbi’s article, in my opinion, makes for good barroom banter on a long holiday weekend. While he marginally touches on the edge of Goldman’s business model, overall his writing is more sensationalism than credible business journalism.

I am not totally vindicating Goldman Sachs. Nor am I totally indicting them. I would make the same assessment of every shop on Wall Street. It just so happens that Goldman plays the game just a little bit better than most.

LD

  • fiscalliberal

    In one of the many articles about Goldman, it was postulated that they were not blind followers of their risk software and that a executive risk committee reviewed and tempered it quarterly.

    Gee here we are with managers who assess, take and manage risk. Many companies comanies who blindly followed the risk software got burned. One famous case was software that only used recent history and no down turns in the basis data set.

    So – we have these recent business school wonders who never talked to their grandparents to hear of the depression, guiding the programers. In engineering terms the system was open loop with no feedback loops to detect problems

  • http://www.senseoncents.com Larry Doyle

    I recall reading that about Goldman as well. They would constantly inquire, ‘what is the market telling us.’ The market is always saying something, whether you want to listen or believe is an entirely different issue.

    As I wrote a few weeks back, the market is neither right nor wrong…the market is the market.

    Goldman gets that.

  • Bill

    Larry, you should read Galbraith’s description of how Goldman Sachs operated in the 1920’s, in his book The Great Crash. They peddled these forerunners of today’s closed end funds, the fount of a good part of the auction rate scandal. Today there is theoretically some limit on the leverage CEFs can employ, but in the 20’s you could leverage to the moon, and GS did it.

    WEB

    • http://www.senseoncents.com Larry Doyle

      Bill,

      Thanks for the recommendation. I will put The Great Crash on the list.

  • http://jbjd.wordpress.com jbjd

    I am so confused. You insist, where GS ended up in the black, this was not the result of breaking the rules to any greater extent than is done by others; and then, only as an exception to past practice. Mr. Taibbi’s article indicates, where GS did not break the rules this results from the fact, before they did what they wanted to do, anyway, they changed those rules.

  • http://www.senseoncents.com Larry Doyle

    JBJD,

    Let me try to clarify.

    I took Mr. Taibbi’s article as a blanket indictment of Goldman Sachs which is not truly fair. There could be individuals within GS who “press the envelope” and who likely go over the line in doing so.

    My point was, those situations are not specific to GS and occur all over Wall Street.

    In short, there are elements of Mr. Taibbi’s article with which I agree; however, I do not think GS or Wall Street is one complete conspiracy.

    The crooks should be rooted out. Bad business practices should be exposed.

    I hope this helps you understand my position.

    • http://jbjd.wordpress.com jbjd

      Here is just one contiguous section of MT’s article, which provides several examples of what I meant by saying, GS not only ‘occasionally’ oversteps the Chinese wall, as you say, but also changes the rules so as to abide by these rules.

      By the end of March, the Fed will have lent or guaranteed at least $8.7 trillion under a series of new bailout programs — and thanks to an obscure law allowing the Fed to block most congressional audits, both the amounts and the recipients of the monies remain almost entirely secret.

      Converting to a bank-holding company has other benefits as well: Goldman’s primary supervisor is now the New York Fed, whose chairman at the time of its announcement was Stephen Friedman, a former co-chairman of Goldman Sachs. Friedman was technically in violation of Federal Reserve policy by remaining on the board of Goldman even as he was supposedly regulating the bank; in order to rectify the problem, he applied for, and got, a conflict-of-interest waiver from the government. Friedman was also supposed to divest himself of his Goldman stock after Goldman became a bank-holding company, but thanks to the waiver, he was allowed to go out and buy 52,000 additional shares in his old bank, leaving him $3 million richer.

      • http://www.senseoncents.com Larry Doyle

        JBJD…believe me, I am not trying to strictly defend GS. I think the entire oversight process for most companies is seriously deficient. The boards of many companies are nothing more than rubber stamps that protect the status quo.

        Friedman was summarily dismissed from the NY Fed, but you are correct he probably should not have been there in the first place. This is not just a GS issue, though.

        On the bank holding topic, all remaining investment banks (pretty much only 2 remained, GS and Morgan Stanley) converted to bank holding company status.

        Again, GS is no angel. No firm is. By the same token, it is not a total conspiracy, either.

        The fact that so many GS alums are in government is disconcerting, but if you looked across all government offices and agencies, you would find alums from every bank.

  • Byron

    “Goldman distributed bonds just like every other bank, but they were sharp enough to short the market near the top. Does that define a conspiracy? No way. That was a good trade.”

    It’s not really a good trade if you package the security knowing that it will default and then bet against it. That would be insider trading. You thinking it’s a good trade says a lot about you though. I’m glad your cool with all of these retired people on fixed incomes loosing their money to these people on wall street. The only option we really have as 401k investors is which jerk we are going to let steal our money. The jerkstore on Wall Street is never running out of people like you.

    • http://crossports.com Sons of Vaval

      You should have written “losing” not “loosing.”

    • Larry Doyle

      Byron,

      I have over 500 posts here at Sense on Cents on issues from trading, the economy, markets, finance, and on and on …I have no problem with your opinion about GS’ trading activity but do yourself the favor of reviewing some of my writing and then let me know what you think of me.

      To be perfectly frank, if you knew the definition of insider trading you may have a different opinion.

      Additionally, perhaps you may want to review my post, Why High Frequency Program Trading Smells, and then let me know what you think….

      Who knows, you may actually learn something in the process.






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