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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.


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