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How Does Goldman Sachs Make Its Profits?

Question: How is it that Goldman Sachs and the other Wall Street firms are able to earn such huge profits and pay out such huge bonuses? Do the firms whose CEOs testified before Congress compete with each other or do they each occupy unique niches? Are their executives so talented as to be worth so much more than the rest of us, or are the firms somehow sheltered from competition?

Paul Solman: Thanks for your email, as it allows me to make a PLEA TO READERS. It just so happens that we’d been working on your question for a story on Goldman. Fact is, no one knows for sure where Goldman’s profits come from. So here’s the request: If YOU know how Goldman has been making its money – taking advantage of credulous clients, say, or front-running the big ones (see below) – please write and let us know. Our ideal respondent is a former Goldman banker who dealt with clients and has since wondered about the economic validity of the business. Or a Goldman banker, past or present, who thinks the firm really has been, in CEO Lloyd Blankfein’s words, “doing God’s work.”

Meanwhile, as we wait for replies, here’s the larger picture as we currently understand it, put piquantly by a Republican friend who used to work at the Treasury. “Goldman Sachs is a hedge fund,” he says, “masquerading as a bank.”

It works like this. Because the Fed is holding the overnight funds rate so low, AND because Goldman is deemed TBTF (too big to fail), Goldman can borrow short-term at very low cost and very low risk. It can then take the borrowed money and invest it at much greater risk, for which it earns commensurately greater, hedge fund-like returns.

Goldman’s financial filings with the SEC report the following results for the 9 months of 2009, through September, on the trading of the following varieties of investment:

Interest rates: $8,314 bn gain

Credit: $4,358 bn gain

Currencies: $4,038 bn loss

Equities: $7,515 bn gain

Commodities and other: $4,307 bn gain

Total: $20,456 bn net gain

The results make it rather clear: Goldman is a trading company, first and foremost. And thus if it makes $8 billion dollars in 9 months on “interest rate” investments, the presumption is that whoever it traded with LOST $8 billion, or at least paid $8 billion to Goldman for its role in the trading. But since its trading techniques are “proprietary,” that’s pretty much all we know for certain.

Did Goldman make most of this money, for example, by “front running”: knowing what major clients were going to invest in and investing just before (in front of) them, thus benefiting from the run-up in price once the big trade went through? Did Goldman simply fleece those on the other side of its proprietary trades because its people are more sophisticated — smarter? Did Goldman benefit from fat profit margins on the trades it made because it no longer had to compete against former rivals like Lehman and Bear Stearns? All of the above?

Stay tuned. We’ll let you know when we do.

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