It's a Goldman World

By Gary Carmell | September 20, 2007 | 9:57 PM | 3 Comments

 

This article was actually outlined a few months ago but I decided to shelve it for no particular reasons other than I was too lazy to type it up and my handwriting is indecipherable so it would have been a waste of time to have someone else do it. Nevertheless, with today's blowout earnings from Goldman Sachs I decided to revisit it.

I penned this article on a flight from New York to Los Angeles after attending a conference with some extraordinary panelists including Treasury Secretary Henry Paulson, Carl Ichan and Lloyd Blankfein (the head of Goldman Sachs), just to name a few.  I also serendipitously ran into someone I met during our freshman year in high school whom I have only seen one other time in nearly 25 years. He works at Goldman Sachs and it turns out he is a peer with someone who used to work for my company as an intern during college and shortly thereafter and now has a major job at Goldman in Tokyo. In addition, one of the women at my table, who is the head of investor relations for Eton Park Capital, used to work at Goldman and joined the same year as my high school buddy. The founder of Eton Park Capital, a speaker at the conference, was the youngest partner in Goldman Sachs history at age 27. He left some time later flush with $3 billion to start his own hedge fund. He used to work for Jon Corzine, who is a former U.S. Senator and now is governor of New Jersey. He is also very close to Robert Rubin, former head of Goldman Sacs, Treasury Secretary, and now Vice-Chairman of Citigroup.

The conference was held at the New York Stock Exchange and the first speaker was the president of the exchange, John Thain, who used to run Goldman before taking over leadership of the NYSE. Did I also mention that Secretary Paulson left his job as top dog of Goldman Sachs to take on his new role?

There's a song with the line "I'm a Barbie girl and I'm living in a Barbie world." While I can't say I'm a Goldman boy, I can say I'm living in a Goldman world.  Incidentally, being a Goldman boy isn't all bad as Lloyd Blanfein made $53 million last year and the average employee compensation exceeded $650,000.  Goldman's balance sheet now exceeds $1 trillion, it recently raised over $20 billion for its private equity group, it is the global leader in arranging mergers and acquisitions, it has one of the largest hedge fund businesses in the world (less so now with the implosion of Global Alpha), a very large global real estate portfolio, a huge lending arm to hedge funds, a successful venture capital group, and one of the leading asset management businesses.  My friend was heading to a Goldman function after the conference to celebrate the completion of a $1.5 billion capital raise.  He was a little cryptic about what the money was for, but I believe it was to take advantage of some distressed debt situations. Don't forget that this was a couple of months before the recent carnage in the credit markets.

What a business!  They help create all this debt and get paid for doing so and, as a result, they get to know where all the bodies are buried when these loans start going bad and then they can make a fortune buying up this debt for pennies on the dollar, restructuring the business and balance sheet, and getting repaid at a higher amount down the road.

Blankfein said securities firms have to make hay when the sun is shining and navigate the rough seas without the boat tipping over when conditions change. If Goldman's stock price is any indication, they have done this very well, indeed.  Although the stock is off approximately 15% from its all-time high, it has nearly quadrupled since 1999.

Yet, despite all of these amazing accomplishments and enormously talented people, I couldn't help get the feeling by the end of the conference and walking around the city, that something was a little off, that in some way we have lost our bearings a little bit in a way that is important for investors and society at large.  It's not so much a feeling of impending doom, but one more akin to shaking one's head in mild disbelief thinking to myself that when financial historians write about this period, the readers will say "what were they thinking?"  Maybe I was influenced by Carl Icahn, the last panelist, who was lamenting how much of society's talent goes into Wall Street to produce what he believes is very little value.

And that was what was gnawing at me.

We have had an incredible bull market in complexity over the last five years.  While I am a pretty strong proponent of free markets and capitalism, like anything, it can go too far and have unintended consequences.  My radical view is that with so much of the world's capital flowing through the Wall Street behemoth investment banks, they have become one of the most extraordinary global manufacturing and distribution businesses.  It can access the ultimate raw material-money-from from investors around the world and repackage it into countless types and quantities of securities staking claims on the money flowing to individuals and businesses needing that money.  I emphasize "needing" because the underlying premise regarding this system is that there is an efficient means of allocating this capital so that it flows to where it can generate the highest return for the risk being undertaken. 

This all sounds good on paper and in economics classes and text books, but it completely ignores human nature.  We are emotional creatures often driven by fear, greed, and envy, just to name a few powerful emotions.  This is true for large investors, individuals making personal financial decisions, and businesses worried about what competitors are doing.  Most importantly, it applies to people who invest other people's money and Wall Street bankers who have to find users of the money they raise.

And this is my key point: Our highly concentrated distribution system, but tremendously dispersed supplier and consumer base, make both investors and borrowers susceptible to manipulation by Wall Street to do stupid things.  This means to protect careers, short-term profitability, and personal compensation (bonuses), borrowers must be created, rather than found, at the late stage of a credit cycle.

Loan performance, until very recently, has been stellar. Wall Street promotes this track record, staffs up to raise more money for a product that is in hot demand by career-fearing, herd following, envious investors who don't want to miss out on the next hot thing. Lending terms then loosen up as there is a much greater supply of money for the same limited number of good ideas and qualified borrowers.  More seasoned players take advantage of easier money while clearly recognizing that this always ends badly so they don't take on commitments that can't be repaid when the tide goes back out.  New ones, however, salivate over not only the favorable cost of money and amounts available, but the accessibility for someone without much of a track record.  Wall Street firms have now become arms dealers. As long as money is flowing, they will do extremely well.

This is how we got into the sub-prime mess with spillover effects clearly present in the LBO and commercial real estate markets.  Traditionally, most lending was originated by federally regulated banks, savings & loans, and Fannie Mae and Freddie Mac (through purchases of loans).  Wall Street-generated loans, however, are not regulated, although their riskiness is supposedly rated by S&P, Moody's, and Fitch-who get paid a lot of money to help structure and rate these securities.

Although they have amazingly gotten a pass so far, the ratings agencies clearly exploited the AAA designation because it is in such short supply, yet there is such high demand as banks, regulated by Basel II accords, can free up much more capital by buying AAA securities than making home loans directly to a borrower.  Thus, the system was gamed. It's that simple.

With the incredible alchemy-like powers of securitization, in which pools of loans are aggregated and sliced into different pieces from lower risk to higher risk, many billions of dollars of "AAA" securities were created, with the rating putting them supposedly on par with Berkshire Hathaway and Exxon Mobil. And more remarkably, the ingenious Collateralized Debt Obligation (CDO) has been able to buy large amounts of the more risky securities (Not AAA!), then repackage these instruments into new tranches of securities, including, lo and behold, newly formed AAA bundles!

Investors around the world accepted these ratings and priced them accordingly, until deciding just recently that risk was clearly mispriced. People are up in arms over China's export of tainted toys to the United States, as they should be, but it can fairly be said that we have been exporting tainted financial products to the rest of the world at the same time. A bailout of a German bank here and a bank run in England there, thousands of lost jobs, no biggie. It's just collateral damage, caveat emptor.

Career concerns have deluded investors around the world to believe in these ratings generated by for-profit companies looking in the rear view mirror. Combine this with a bull market in complexity and you get conditions ripe for stupid decisions that will likely result in a permanent loss of capital, Warren Buffett's simple definition of risk.

After the Federal Reserve lowered the Federal Funds rate to 1% there was an extraordinary global demand for yield and absolute returns.  People wanted positive returns and were willing to take risk to get it.  With long-term interest rates between 4% and 5%, there was an incredible opportunity to print money by borrowing at low short-term rates and lending at much higher ling-term rates.  The risk of short-term rates rising was mitigated by Alan Greenspan's commitment to keep them low "for a considerable period," a perfect set of conditions for hedge funds to proliferate-one akin to the Big Bang.

Actually, rabbits come to mind when I think about the proliferation of hedge funds.  Suddenly there are billions and billions of dollars under the control of hedge fund managers.  Since the last thing they want to do is stop growing or go out of business, they position themselves as very bright and capable of executing extremely sophisticated investment strategies to generate strong returns which justify their compensation

But a funny thing happened on the way to the Alpha Printing Press.  The famous carry trade was eradicated as short-term rates came to exceed those of longer maturities.  No problem, we'll just borrow more money to offset the lower spread between our borrowing costs and returns from our investments. In addition, because we are so smart and sophisticated, we can evaluate very arcane, illiquid instruments, so bring them on because our investors can't do this on our own.  Smelling an opportunity, Wall Street (Goldman Sachs returns!) capitalized on this demand for complexity and created supply to this willing group of risk takers.

Well, my friends, I think the sub-prime blowup is just the beginning.  I have a feeling that a lot of this complexity will get unwound and investors will start asking questions about what value is really being created.  I really shouldn't use such a broad brush because there are some very important innovations that have allowed investors to better hedge themselves and get more price discovery about various securities.  Nevertheless, I believe it has also given people a false sense of security that they have truly hedged their risk.  As more insurers write more earthquake insurance, the odds of experiencing an earthquake don't change.  And when more insurance is written by banks and hedge funds to protect investors against companies from defaulting, this creates more demand for bonds and lowers the cost of capital, perhaps leading to more defaults as investor confidence may lead to a greater appetite to lend more money because of the availability of insurance, especially if it is underpriced.

Similarly, CDOs allowed hedge funds and other investors to have a false sense of security because of preposterous ratings assigned by too-smart-for-their-own-good quantitative jocks at the rating agencies.  This led to sub-prime loans being far too accessible and priced far too cheaply at loan amounts that were far too high.  Borrowers had to be manufactured and they turned out to be as defective as toothpaste from China.

Skyscrapers are a pretty good indicator of economic peaks as money is readily available, confidence is sky high (no pun intended), and no clouds appear on the horizon. The indicator that has caught my attention recently is the extraordinary demand among investment banks for enormous trading floors. It is clear that is where they see much of their future profitability. No longer will they be content being middle men; they want to be The Man. When I piece together a mosaic of an extraordinary bull market in complexity, burned international investors, upside down homeowners, government regulation on the horizon, a teetering U.S. dollar, record financial profits, and the desire for massive trading floors, I think simplicity and caution should be the mantras. To that end, I'll leave you with some wise words from that great investment advisor, William Shakespeare:

When clouds appear, wise men put on their cloaks;
When great leaves fall, the winter is at hand;
When the sun sets, who doth not look for night?
Untimely storms make men expect a dearth.