Squid Love

Why aren’t clients fleeing Goldman Sachs?

Lloyd Blankfein

G oldman Sachs made a little more than $1 billion in the second quarter. That sounds like a lot of profit, but it’s far less than analysts expected. Goldman’s return on equity was a little more than 6 percent. That’s a fraction of the profits that Goldman generated at its height during the late aughts. On a conference call, chief financial officer David Viniar said he wouldn’t “sugarcoat” the firm’s bad results. The Wall Street Journal reported that analysts and investors were “wondering if the company has lost its way.”

A disappointing second quarter may inspire schadenfreude in those who subscribe to Rolling Stone writer Matt Taibbi’s Manichean conceit that Goldman is “ a giant vampire squid.”  But in truth, the results contain some very good news for Goldman. After the investment bank’s bad behavior during the crisis—and the bad publicity that resulted—it would seem logical for Goldman’s clients to disappear. But they didn’t.

Historically, Goldman Sachs’ business was a mixture of trading—generally a more mercenary game—and investment banking, which is more about serving clients and building companies. The CEOs of the firm came from both areas. Hank Paulson, who led the firm until he left to become Treasury secretary, was a banker. But after the dot-com bubble burst in 2000, banking business dried up and the firm’s business began to shift more and more toward trading. By 2004, banking, which had accounted for more than one-third of the firm’s profits in 2000, had shrunk to just a sliver.

When Lloyd Blankfein succeeded Paulson in 2006, that was seen as confirmation that trading had become Goldman’s principal concern. Blankfein had come up through J. Aron, Goldman’s commodity trading business, which is about as sharp-elbowed and bottom-line-oriented as it gets. Blankfein himself has joked that in that business, you don’t have clients—you have counterparties, meaning that the people you do business with had better fend for themselves. There’s been an exodus of top bankers from Goldman, including Peter Weinberg and Byron Trott, Warren Buffett’s favorite banker. Former partners talk about the “J Aronization” of the culture.

According to this narrative, what happened during the financial crisis was inevitable. While Goldman still touted its famous first business principle—”Our clients’ interests always come first”—it became a firm that put its own bottom line first. During the 2008 financial crisis the world figured that out. Goldman protected its own profits, not only by selling junky securities to its clients but also by creating securities that would reduce its own risk while increasing the risk borne by buyers.

If wised-up clients were going to flee the firm, such defections ought to be showing up on the books by now. But they aren’t. Goldman’s banking side is doing just fine; the second-quarter results show that revenue increased 54 percent compared with the previous year. Goldman remains No. 1 in advising clients on mergers and acquisitions, which is the banking business that investment firms most covet. Goldman also ranks No. 1 in equity business. All of the weakness was on the trading side, where revenue fell more than 50 percent. Viniar said on the conference call that investors shouldn’t read too much into the problems in trading, because they had nothing to do with the firm’s overall franchise or orientation. Some vampire squid!

Why is Goldman’s client-oriented banking side thriving? One explanation could be that Goldman’s clients are clueless. (But the sheer volume of the bad press makes that unlikely.) Another is that the clients realize full well that Goldman may put its own interests ahead of theirs, but they don’t care: They still think Goldman’s advice is better. Back in 2007, when Kerry Killinger, who was then the CEO of Washington Mutual, was debating hiring Goldman Sachs, he summed it up this way:  “They are smart, but this is swimming with the sharks.” Clients may care about the smarts more than they worry about the sharkiness. A third explanation is that they believe that Goldman, which earlier this year promised to be more transparent about its business practices, has mended its ways. A fourth explanation is that clients may think that Goldman’s behavior in the mortgage market, though reprehensible, was no worse than that of other firms, just better-publicized.

Has Goldman repented? Brad Hintz, the well-respected Sanford Bernstein analyst, told the Journal that “what we have here is a Goldman Sachs in metamorphosis, changing its business model.”  I have my doubts about that. A firm’s business principles require decades to take root; once trampled upon, they aren’t easy to restore. If Goldman really was “J Aronized,” and the firm’s client focus totally lost, then it’s unlikely it could de-Aronize in a mere three years. I’m inclined to believe that Goldman’s clients are staying in spite of the way Goldman operates, not because they think Goldman has learned its lesson. Indeed, if Goldman can ramp up its trading business again, I believe it will.

But Goldman’s business may be changing whether the firm likes it or not. Despite all the lobbying Wall Street firms did to fend off regulation after the subprime crash, they are being forced to increase their capital levels, which will decrease their profitability. There’s lots of uncertainty surrounding the implementation of the Dodd Frank financial reform law. Just how profitable will derivatives trading, which previously accounted for a big chunk of the profits at firms like Goldman, be in the future? There’s also much fretting over the so-called Volcker rule, named after the former Federal Reserve chairman who proposed it, which would force firms to sharply decrease the trading they do that isn’t on behalf of clients.

All of that helps explain why Goldman’s stock, which hit $175 earlier this year, now sells for just around $130—less than book value. Goldman’s trading profits might remain a lot smaller for some time. Despite the strong performance on the banking-side, that business is still small relative to its trading business—revenues are just 20 percent of the firm’s total. And Goldman’s business of managing other people’s money, yet another client-oriented business, is a chronic underperformer. Viniar said that Goldman plans to cut $1.2 billion in expenses by the end of the year. That means that roughly 1,000 employees will lose their jobs. The number will likely be higher if the trading business doesn’t improve. But it appears that Goldman will still have one very important asset that other firms on the Street would kill for: its clients.