Goldman Sachs: Not So Smart

Posted by: David Henry on August 31

Lost amid the talk about Goldman Sachs being a vampire squid and making money from the subprime mortgage bust is the fact that the firm lost $6 billion trading, of all things, its own stock. Yes, Goldman, which likes to be known as the smartest shop on Wall Street, bought high and sold low, plain and simple. How it happened might even show you how to make money at Goldman’s expense a few years from now.

The heart of Goldman’s mistake was excessive self-confidence. In 2006 through early 2008, the firm spent about $18 billion buying 100 million shares of its own stock, paying $184 a share on average. Then the financial panic hit in September and Goldman had to replace the money. The firm sold 94 million shares in offerings in the fall and spring to raise nearly $12 billion at $123 a share. It also sold preferred stock and warrants to the government and Warren Buffett at similarly low prices, but even without counting those special deals, the bottom line is clear: Goldman lost more than $6 billion because it was wrong to think it had enough capital to get through the trouble it knew was coming.

Goldman declined to comment on the loss, or on a related question: When will the firm add back leverage it had to forfeit? The question, as described in a recent BusinessWeek story, is being put to Goldman and other strong banks frequently now by stock analysts. The question is expected to keep coming up if the banks’ capital bases continue to grow with new profits from the firming economy and financial markets. The analysts and executives at the banks believe the banks are overcapitalized now and should be less conservative with their investments and with the leverage they use. The banks boost leverage again by borrowing to buy additional assets and by paying out cash for stock buybacks or dividends.

For now, though, the banks are holding back on doing any of that, even though it means sacrificing profits for shareholders. The executives said on the conference calls in response to the analysts’ questions that they are waiting until Washington decides what new restrictions to impose to make banks operate safely. They are also are wary that the economy and credit markets could turn for the worse again. A reversal in either could draw down banks’ excess capital. The bankers said, in general terms, that they don’t want to use additional capital until they are more confident that they won’t have to replace it at higher cost all over again.

Whether Goldman will loosen up its capital policies has become critical to its stock price. While the shares are up from $59 in January to around $163, they haven’t kept pace with the S&P 500 since the firm’s July 14 earnings call. For the stock to go higher, some analysts say, the market will need confidence that the firm will add back leverage to increase profits. By one measure of leverage, Goldman’s assets are 14 times its equity, down from its historic average of 20 times and peak of 26 times. Goldman’s use of leverage in the past has been critical in meeting its avowed goal of making profits of at least 20% of equity over the business cycle. If the stock market concludes that Washington won’t let Goldman leverage the way it has, or if analysts hear Goldman executives backing away from the goal of 20% return on equity, the shares could fall. CFO David Viniar reaffirmed Goldman’s commitment to the 20% goal in response to analysts’ questions during the July conference call.

Goldman’s aim for high returns on equity seems to have played a roll in its loss from trading its own stock. When a company buys back its own stock, the transaction reduces equity, while increasing its leverage; when there is less equity the company will report higher rates of return from each dollar of profit. So, the math makes it tempting to buy back stock, even when it is trading at rich prices. Was it this temptation that made Goldman buy the 100 million shares for $18 billion and take its leverage to a record high? Was the 20% goal a blind spot that caused savvy Goldman to spend down its capital and increase its risk even when it knew the subprime debacle was coming? We’ll never know, but it is something to remember in case Goldman ramps up leverage in a hot market in the future. Wouldn’t it be sweet to sell Goldman stock high to Goldman?

Reader Comments

JamesBruni

August 31, 2009 05:21 PM

Nice scoop + post, David. Puts all that uber-positive PR-perfect coverage of Goldman into a different perspective. One of the reasons I read BW and David Henry.

brain

August 31, 2009 06:12 PM

they should collapse and implode like those other worthless banks...they create nothing and take everything. i like the internal shady stock buyin to try and boost their margins. smart if those dumb fools could of pulled it off...

Avi Rosner

August 31, 2009 06:28 PM

Its about time people see that Goldman Sachs is not without its faults. They were not publicizing the fact that they too had losses in 2008.

Snyder

August 31, 2009 07:30 PM

Remember those recommendations from these jokers (analysts) on "Oil barrel will hit $200". why we don't see these speculative traders anymore?

Cassius King

August 31, 2009 07:54 PM

Whoever made those trades inside Goldman was probably rewarded with a 7-figure bonus, too.

james Raider

August 31, 2009 07:57 PM

Clean up WALL STREET, then recovery can begin but will still take a decade.

There is a culture of omnipotence that has been very pervasive throughout all of Wall Street’s major firms during the past two decades. It has also been very destructive.

America needs to clean house before a serious recovery can begin, and confidence reinstated.

http://pacificgatepost.com/2009/08/america-end-your-fear-of-wall-street.html

MarcGlez

August 31, 2009 08:45 PM

I wonder if former Treasury Sec. Henry Paulson gave Goldman Sacks preferred treatment and or information on all other "Smart" transactions.

Jonnu

September 1, 2009 12:11 AM

Yes, good coverage on this topic, but it is a shame this type of reporting is not applied to the rest of the magazine. I had stopped reading Businessweek because of their insistence to weave Apple in a favourable light into any tech article -demonstratable by the fact they have a blog on the company. Why not have a GE blog, or a HP/IBM blog or a Nokia blog? Each of those companies individually makes far more news worthy reporting.

sam

September 1, 2009 09:51 AM

I guess that's what justifies all the retention bonuses. The article is a nice departure from the recycling of corporate press releases that seems to make up so much of the content.

Karl

September 1, 2009 11:01 AM

Too bad Goldman's CEO only made $42,900,000.00 in fiscal 2008. Blackstone's CEO made $702,440,573.00 in 2008. I guess Blackstone's CEO is a lot smarter, huh?

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BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.

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