Sense on Cents

If I had a nickel for the number of people who have asked me how Goldman Sachs makes money, I would have a lot of nickels.

Goldman Sachs as a company is easily vilified. America always wants a villain when times are tough. Goldman makes the most money on Wall Street so they must be the ‘baddest’ guys. Well, generally speaking people are never as good nor as bad as they may seem. Look at Tiger Woods. He fooled America for a good long time. The fact is, Goldman Sachs mastered a business model which no other Wall Street enterprise fully embraced. I am certainly not a Goldman apologist and believe they very likely took advantage of situations that drove enormous profits. I highlighted the Goldman business model last July in writing, “How Does Goldman Sachs Operate?”: >>

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.

Today Goldman’s business model is under attack. America will hear from President Obama targeting the very core of Goldman’s business model, that is proprietary risk-taking on Wall Street. Surely that must be what is driving the overall market and Goldman Sachs’ stock lower. Well, yes and no.

While Obama is “proposing” (a long way from actual implementation) limits on bank proprietary risk, the simple reality is Goldman’s earnings are currently impacted by a drastically different dynamic. What is that? Earnings within Goldman’s FICC (fixed income, commodity, and currency) business declined significantly in the 4th quarter.

The WSJ attempts to put Goldman’s earnings in a positive light by utilizing the standard year-over-year comparison. Let’s zero in on the key component within Goldman’s earnings. From the article Goldman Profit Leaps as Firm Restrains Pay:

Fixed-income trading slowed after extraordinary profits in the previous three quarters. Revenue from fixed income, currency and commodities was $3.97 billion, down from the $5.99 billion in the third quarter.

Why did revenue in this division decline so much? Very simply, the toll Goldman collects (that is the spread between the bid and offer in the market) has narrowed tremendously. Previous wide spreads (in Wall Street parlance, wide enough for a Mack truck) represented very easy money. Those days are over, at least for now. The narrowing of the spread directly impacts Goldman’s bottom line and that of every other firm on Wall Street.

LD

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This entry was posted on Thursday, January 21st, 2010 at 11:32 AM and is filed under General, Goldman Sachs. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.