Tuesday, October 13, 2009

Will Goldman Sachs "Do It Again"?

The key to the game is your capital reserves, If you haven't got enough, you can't piss in the tall weeds with the big dogs. Gordon Gekko

Sidney Weinberg must be rolling in his grave at the news that Goldman Sachs, according to press reports, intends to pay its employees bonuses totaling some $23B. Mr. Weinberg, if you're unfamiliar with the name, was the man who brought Goldman Sachs back from the brink of disaster after the Crash of '29. One key aspect of his management approach was capital retention. Like the mythical Mr. Gekko, Mr. Weinberg knew the key to the game.

Admittedly, the game has changed. The former partnership went public in 1999 and become a bank holding company last year. I wonder how many owners (direct or indirect) of GS are aware that their holdings help finance these big payouts. The shift to bank holding company and consequent access to the Fed's discount window also facilitates the shift from Weinberg's capital retention mode to the current capital distribution mode.

These days, Goldman Sachs (GS) is on top of the world. GS men like Mr. Rubin and Mr. Paulson became US Treasury Secretaries, and many others seems to find opportunities in the state effortlessly.

What a recovery for a firm that was almost brought to its knees in 1929.

Last weekend I flew to Chicago and read The Partnership: The Making of Goldman Sachs, which I highly recommend, if you can manage to stomach the all too frequent claims of absolute integrity wrapped around some very dodgy activities (like getting caught forcing Penn Central to buy back its commercial paper while it was selling same to the public right before the railroad went bankrupt in June, 1970).

From the Court Record of the Case of Welch's et. al (who got stuck with the bankrupt paper) vs. GS:

Question: Were you aware that on Feb. 5, 1970, Wilson [a GS partner in the CP division] asked Penn Central to buy back $10M of its commercial paper from the inventory position of Goldman Sachs?

Gus Levy [GS Managing Partner]: It was in the memorandum, so I knew about it.

Question: Was that nonpublic information?

Levy: That was definitely nonpublic information.

Question: Did you instruct disclosure of that fact?

Levy: I did not.

The above, however, is not the "meat" of what I sat down to convey today. By "do it again" I refer to the Goldman Sachs Trading Corporation, about which, Seeking Alpha opines here (GSTC), the disastrous failure of which required 30+ years of diligent effort from Mr. Weinberg et. al. to repair.

In the latter half of the 19th Century, Goldman, Sachs & Co. was a mercantile (commercial) paper finance company started by Marcus Goldman. His son, Henry, expanded into investment banking before siding with Germany in WWI which led to his resignation. He eventually relocated to Germany and ran into Hitler in the 1930s (in case you thought their senior partners never made bad calls- what a horror that must have been).

Henry Goldman was replaced, in a sense, by Waddill Catchings, who promised The Road to Plenty in 1928 with William Foster. Despite early trepidation about the bull market of the 1920s he "caught the bug" and decided to launch GSTC. The book relates a quote on this decision from Walter Sachs which may prove quite ironic (again) in a few years time, "All would have been well had the firm confined its activities to the type of business which had been done over the years."

Launched in 1928, GSTC jumped out of the gate rising from its IPO price of $104 to $226 quickly and an eventual high of $326. Although already owning 10%of the shares, and contracted to receive 20% of the trust's net income as manager, GSTC bought another $57M of its shares in the first few months. In a few short years GSTC would trade down to $1.75.

What sin did GSTC commit, and Walter Sachs notice? GSTC (and via the ownership thereof, GS) stopped being an intermediary and took a position. The "boring" choice of simply being a financial intermediary was not enough for GS in the final stages of the 1920s US equity bull, and, it seems to me, the equally "boring" choice of being simply a financial intermediary in the final stages of the US's bull market has been eschewed by current GS management.

There's an interesting anecdote from the book which highlights this choice:
[Fischer, of Black and Scholes fame, then an employee of GS] Black was quantitative to a fault. The rigor of his logic and his infallibility to be anything but entirely logical led him to state some positions that were so perfectly rational that they were really very irrational. For example, one day he stopped everyone's clock with his conclusion that Goldman Sachs should go short- ten million dollars worth short- in financial futures. "If we are intellectually honest with ourselves, we will go short futures by enough to fully hedge our exposures to the cash markets, instead of always being net long. That way, we will be operating the firm with zero net exposure to market risk."

......

 "For Fischer," [recalls Silfen] "it was completely rational." But that was the theory, and the pragmatists of Goldman Sachs-with less than one billion dollars in total capital- simply couldn't imagine establishing a "simple" short position that was ten times as large as the firm's total capital. For them, Black's idea might be academically valid, but it was so totally irrational that it was insane.

In the years since Mr. Black made his suggestion, GS' capital leverage has only grown. Long ago they decided to not simply be intermediaries, but to be players. You can't make big profits, as Mr. Catchings likely advised in the late 1920s, without exposure.

This time it isn't just stocks which seem to drive profits. GS, in particular relative to other BHCs, seems to make money when US liquidity is rising and US yields are falling- as I noted in From Black Scholes to Black Holes.  This is a bet on a continuation of the "exorbitant privilege"- the ability to force as many US$s down the rest of the world's financial throat as they wish- which one might construe as yet another Road to Plenty.   Someday in the not too distant future, former Nixon Treasury Secretary Connally's quip might prove false- we (and GS) might discover that our currency is, in fact, our problem.

I suspect when the dust settles we'll discover that GS "did it again"- got leveraged in the wrong market at the wrong time. Hopefully, as occurred in the 1970s, the failure of GS won't be seen as tantamount to a failure of the US, because it isn't.  In the 1970s the US courts handed GS a string of defeats related to Penn Central and, to the best of my knowledge, never worried if the company would fail.  Ah, the good old days.

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