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Unraveling the Profit Puzzle at Goldman Sachs

February 11, 2010 at 12:00 AM EDT
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As part of his continuing series of reports making sense of business and the economy, Paul Solman examines the inner workings of investment powerhouse Goldman Sachs and how it makes money.
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JIM LEHRER: Now a second economy story.

“NewsHour” economics correspondent Paul Solman begins a two-part look at the investment bank Goldman Sachs — tonight, how it makes money. The company reported a record $13.4 billion dollar profit last year.

It’s part of Paul’s reporting Making Sense of financial news.

PHIL ANGELIDES, chairman, Financial Crisis Inquiry Commission: Do you solemnly swear or affirm, under the penalty of perjury…

PAUL SOLMAN: Kicking off last month’s inaugural hearing of President Obama’s Financial Crisis Inquiry Commission, CEOs of the four biggest banks — in the hottest of the hot seats, Lloyd Blankfein of Goldman Sachs.

PHIL ANGELIDES: In the end of the day — and I’m going to press you on this — it seems to me that you survived with extraordinary government assistance.

LLOYD BLANKFEIN, CEO, Goldman Sachs: We never anticipated the government help. We weren’t relying on those mechanisms.

PAUL SOLMAN: And just a year later, venerable Goldman Sachs, beneficiary of bailout largess, is the most profitable firm in Wall Street history. So, how did they do it?

Lloyd Blankfein told The Times of London: “We’re very important. We help companies to grow by helping them to raise capital,” and that he was just a banker doing God’s work.

Now, the interview seemed to play better as comedy than P.R.

STEPHEN COLBERT, host, “The Colbert Report”: Despite collecting the highest salary on Wall Street, at $68 million a year, Blankfein never forgets that he’s — quote — “a blue-collar guy.” I believe he is referring to the sapphire choker he wears on casual Fridays.

PAUL SOLMAN: Now, Blankfein took only a $9 million bonus for 2009, much less than in recent years, despite record profits. As for a defense of finance, he elaborated under oath.

LLOYD BLANKFEIN: … is, what we do a lot for the economy isn’t that visible as an investment bank. We help allocate capital. We raise. We do — we put companies together. We launch new businesses.

PAUL SOLMAN: So, that’s how Goldman Sachs is supposedly making money, as a traditional investment bank.

Well, not according to Nomi Prins, a former Goldman Sachs trading strategist, now a senior fellow at Demos, a progressive think tank.

NOMI PRINS, former managing director, Goldman Sachs: That classical investment banking function is a very small portion of their revenues. I think it’s about 10 percent or so. So — so, if he’s doing God’s work, he’s only doing it at 10 percent capacity.

PAUL SOLMAN: Most of the rest, says Prins, is so-called proprietary trading, for the firm’s own account, rather than its clients.

NOMI PRINS: They’re a trading house. They’re — you know, they can talk about being an investment bank and doing God’s work and helping, you know, raise financing for companies and all and that, but, in the scheme of things, they do very little of that.

PAUL SOLMAN: Another longtime Wall Street insider from the other side of the political spectrum agrees, though he doesn’t disapprove.

DAVID STOCKMAN, former Reagan administration budget director: I think, first, you have to admit they are very smart, they are very capable, and they have a huge franchise in the global capital markets.

PAUL SOLMAN: David Stockman, President Reagan’s budget director, went to Wall Street in the mid-’80s.

DAVID STOCKMAN: Take their results that just came out. In 2009, they had $45 billion of revenue, of which $35 billion was from equity and fixed-income trading and commodities and currencies. Now, that’s 75 percent of their revenue was basically from trading.

PAUL SOLMAN: So, when a Republican friend of mine who used to be in the Treasury Department says that Goldman Sachs is a hedge fund masquerading as a bank, that’s true?

DAVID STOCKMAN: Absolutely true.

PAUL SOLMAN: And you could look it up, since Goldman’s financial filings are public records. Only a tenth of its revenues came from investment banking last year, more than three-fourths from trading for its own account.

But while the firm itself declined any interviews, if it’s subordinating the God’s work of investment banking to making money on proprietary trading, well, says Jeff Macke, who has run a hedge fund of his own, so what?

JEFF MACKE, former hedge fund owner: Goldman Sachs analyzes their investments as carefully as anyone. Right now, they’re saying that proprietary trading is a better business for them.

PAUL SOLMAN: But, with all due respect, that is not God’s work.

JEFF MACKE: Listen, I’m not saying that they’re necessarily doing my God’s work, but, as far as they’re concerned they’re doing financial gods’ work. You can argue whether or not they should be doing this, but what they really should be doing is making money for their shareholders. That’s their job. It’s not theirs to judge who or why or how they’re going about it. They need to make bucks for shareholders.

PAUL SOLMAN: But consider how they’re making those bucks, says Nomi Prins, on inside knowledge that comes in, as when she was there, with every trade a client asks Goldman to make.

NOMI PRINS: And just by evidence from the profits that they make and where they make them and what divisions they make them in, they’re not sitting on that knowledge. They have to be — they are trading on that knowledge.

PAUL SOLMAN: So, they know somebody is going to buy a commodity or a currency, so they either buy that commodity or currency first or a commodity and currency very much like it?

NOMI PRINS: Any information that you get, particularly if it’s going to move the markets a lot, is — is — is going to filter into the trading positions you take.

PAUL SOLMAN: But isn’t this front-running, trading ahead of your clients to profit from the price changes that will come from the clients’ trades, but for your own firm’s benefit? And isn’t that, strictly speaking, illegal?

DAVID STOCKMAN: The long and ancient secret of Wall Street is, they have always been front-running their clients. In other words, when you’re in the customer trading business, and then you’re in the proprietary business, which trade are you making first? I don’t know. And, if it’s in milliseconds, how’s anybody going to figure it out?

So, I don’t know if you ought to get all exercised on that or not, but the fact they make all this money in proprietary trading is clearly part and parcel of being a massive player, dealer, in the markets for both customer trades and house trades.

PAUL SOLMAN: So, Goldman might insist that, technically, it isn’t front-running, or that the charge could never be proved.

So, let’s move to another. How about the extravagantly profitable bets, for its own account, that “Goldmine Sachs,” as some call it, placed with insurer AIG, against the very products, mortgage-backed securities, that the firm was trading to customers?

McClatchy reporter Greg Gordon was the first to uncover the practice.

GREG GORDON, investigative reporter, McClatchy Newspapers: In 2006, Goldman began, in different ways, to make bets that the housing market would turn south. When you’re selling $40 billion in securities, U.S.-registered securities, to investors here and abroad in 2006 and 2007, and, at the same time, you’re secretly betting that these securities are going to go south, are going to lose value, well, that raises a big question.

PAUL SOLMAN: Lloyd Blankfein’s response?

LLOYD BLANKFEIN: What we do is risk management. Because we had this risk, because we were accumulating positions, which, by the way, we acquired from clients who want to sell them to us, we have to go out ourselves and provide and source the other side of the transactions, so that we can manage our risk. These are all exercises in risk management.

PHIL ANGELIDES: Well, I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars, the pension funds who have the life savings of police officers, teachers.

LLOYD BLANKFEIN: These are the professional investors who want this exposure.

PAUL SOLMAN: Professional, sophisticated investors, who should have known what they were getting into with mortgage backed securities, a theme Blankfein hit again and again.

LLOYD BLANKFEIN: A sophisticated investor that creates the exposure that these professional investors are seeking.

Again, the most sophisticated investors, who sought that exposure.

PAUL SOLMAN: And, look, says investment adviser Jeff Macke, even if Goldman’s people are more sophisticated than their clients, Blankfein’s still right.

JEFF MACKE: Caveat emptor. Goldman Sachs didn’t get to become Goldman Sachs because they’re bad traders. Of course they know more than the other guys. They’re packaging the goods. It’s their book. They know more about it than anyone. And, if they’re selling it, well, you probably don’t want to be a buyer. I want to buy things from people who I know more than, not people who are creating these instruments for me to buy.

PAUL SOLMAN: But pension funds don’t bring in the math whizzes, the quants, the people that Goldman Sachs has. They’re no match for Goldman Sachs’ salespeople or traders.

JEFF MACKE: Generally speaking, they aren’t. So, what is a pension fund doing involved in these securities?

PAUL SOLMAN: Even if you think Macke and Blankfein provide a reasoned defense, however, one huge last question remains: Has the firm been making record profits with your and my money? We will look at that next time.