11/12/2009

Brady Gear, Adam Heying, Maxwell Kagan, Kelly Schilling, & Joseph Quinn Wingerd

MANAGEMENT

573 GOLDMAN SACHS CASE STUDY

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Table of Contents Introduction .................................................................................................................................................. 4

History ........................................................................................................................................................... 4

The Nineteenth Century ............................................................................................................................ 4

The Twentieth Century .............................................................................................................................. 5

More Recent Times ................................................................................................................................... 6

Who’s Who List of Former Goldman Sachs Executives ................................................................................ 7

Business Segments ........................................................................................................................................ 9

Investment Banking ................................................................................................................................ 10

Financial Advisory ................................................................................................................................... 12

Underwriting ........................................................................................................................................... 12

Trading and Principal Investments .......................................................................................................... 13

Fixed Income, Currency and Commodities (FICC) .................................................................................... 14

Equities .................................................................................................................................................... 15

Principal Investments .............................................................................................................................. 16

Asset Management and Securities Services ............................................................................................ 17

Asset Management ................................................................................................................................. 17

Securities Services ................................................................................................................................... 17

TARP and Goldman Sachs ...................................................................................................................... 18

Warren Buffet’s Investment in Goldman Sachs ................................................................................. 22

Goldman Commercial Bank Conversion ..................................................................................................... 24

Regulation of Goldman and the Financial Markets .................................................................................... 29

Enforcement ............................................................................................................................................ 29

Banking Reform ........................................................................................................................................... 31

Transparency ........................................................................................................................................... 31

Credit Rating Agencies ............................................................................................................................ 33

Mark-to-Market Accounting ................................................................................................................... 34

Bank Compensation ................................................................................................................................ 35

Bank Capital and Pro-Cyclicality ............................................................................................................. 36

Recapitalization of the Banking System .................................................................................................. 38

Local Rules, Global Markets .................................................................................................................... 39

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Capital is Global, Regulation is Local ...................................................................................................... 39

Exceptional Regulatory Systems Promote and Encourage Financial Activity ......................................... 40

Regulatory Approach .............................................................................................................................. 41

Financial Analysis ................................................................................................................................... 42

Competitive Analysis .............................................................................................................................. 49

Conclusion ................................................................................................................................................... 56

Bibliography ................................................................................................................................................ 57

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Introduction

The Goldman Sachs Group, Inc. has come from humble beginnings to become one of the largest

investment firms on Wall Street. Founded in 1869 by German immigrant, Marcus Goldman, the

company did not assume the name “Goldman Sachs” until his son-in-law Samuel Sachs became

his partner, and officially named themselves “Goldman Sachs Company”. The company was

first listed on the New York Stock Exchange in 1896, but did not go through its initial public

offering (IPO) until 1906, which the firm co-managed. Throughout the Twentieth Century,

Goldman Sachs helped co-managed the IPOs for some of the largest, most well-known

companies in the United States, including Ford Motor Company in 1956, Sears Roebuck in 1906,

Microsoft in 1986, and Yahoo! in 1996. From a history that goes across several centuries to the

most recent financial turmoil, Goldman Sachs has had its ups and downs as a financial giant, but

has still been able to come out of the rough times in a better position than its competition.

History

The Nineteenth Century

Marcus Goldman began his career in the United States as a salesman, and then opened his own

clothing store in Philadelphia. From there he moved to New York City and began trading

promissory notes in 1869. Samuel Sachs began helping his father-in-law in 1882 and became a

partner in 1885. Eventually, Henry Goldman and Ludwig joined the company, which would

then be known as “Goldman, Sachs and Co.” Soon after this, the company started amassing

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customers that included Sears Roebuck and Cluett Peabody. Goldman, Sachs and Co. went on

to list on the New York Stock Exchange in 1896 (Goldman Sachs History).

The Twentieth Century

Goldman, Sachs & Co. opened the Twentieth Century with a bang. Not only did the firm co-

manage its own IPO in 1906, but it also comanaged the IPO for Sears Roebuck in the same year.

Soon after, Goldman Sachs was recruiting an A-List of clients that included May Department

Stores, F.W. Woolworth, B.F. Goodrich, H.J. Heinz, Pillsbury, General Foods and Merck

(Goldman Sachs History). Goldman, Sachs & Co. was using its clout and prowess to start

offering new products. They were growing so big that they were able to open their first

subsidiary of the Goldman Sachs Trading Corporation. Unfortunately, that particular subsidiary

was one of the many victims of the 1929 Stock Market Crash and resulting Depression.

In 1933, Congress passed the Securities Act of 1933, which created the Securities and Exchange

Commission. This made Goldman, Sachs and Co. work diligently to develop a much easier to

read prospectus. It was events like this that led Goldman Sachs to become very customer

focused and a leader in the investment industry. It was also in the 1930s that the security-

arbitrage business was started. This part of the company actively participated in a myriad of

investment activities, which included private securities sales, corporate mergers and

acquisitions, real estate financing and sales, and block trading. In the 1940’s, Goldman, Sachs

and Co. worked hard to raise investment capital through the sales of war bonds. It was not

until the 1960’s that Goldman, Sachs hit their stride when it came to profitability in the

investment world.

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In 1956, Ford Motor Company was ready to go public. Goldman, Sachs stepped in to managed

the Initial Public Offering, by marketing 10.2 million shares, worth $26.5 million (Goldman Sachs

History). In 1967, it was Alcan Aluminum’s turn to come out in a single block trade, and

Goldman, Sachs stepped in to manage the trade. People would finance these LBOs with junk

bond debt. The problem was that the junk bond debt had to paid off somehow, and it was

usually with the operating profits from the purchased firm or by selling pieces of the firm for

profit. Goldman, Sachs worked to steer clear of the riskiness involved in LBOs and tried to focus

on transactions instead. The market crash of 1987 helped flush out those who were taking on

these risky investments and leave those more moderate investors ahead.

More Recent Times

Goldman, Sachs decided it was time to go public in 1998. In May 1999, Goldman, Sachs and Co.

went public on the New York Stock Exchange with a $3.6 billion windfall for 69 million shares. It

was after this offering that the firm became officially known as “The Goldman Sachs Group Inc.”

Goldman Sachs was no longer the financial powerhouse that it once was, as Citibank was three

times its size, and JP Morgan Chase & Co. was twice as large. Rumors were swirling that

Goldman Sachs would need to merge with one of these firms if it wanted to stay afloat. It was

Henry Paulson who was able to maintain Goldman Sach’s position in the financial world.

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Who’s Who List of Former Goldman Sachs Executives

Not many people have the right to say that they were once a member of this financial giant, but

the short list reads as a Who’s Who of financial heavyweights. Some of the more notable

alumni include:

Jon Corzine is probably one of the most well-known of the former Goldman Sachs

employees. He began his career working for multiple Midwestern banks, and earning

his Masters of Business Administration (MBA) at the University of Chicago Booth School

of Business. Jon went to work for Goldman Sachs in 1975 and managed to work his way

up to Chairman and Co-CEO in 1994. It was after his departure in 1998, that the firm

went public in 1999 and made him $400 million richer. From there he ran for a Senate

seat in 2000 that he won by a small margin. In January 2006, Jon moved into the New

Jersey Governor’s mansion, where he will finish his term In office in January 2010.

Henry “Hank” Paulson is the most infamous of all the alum. He came from humble

beginnings to become one of the most powerful financial presences in the Twenty-first

Century. He obtained his Bachelors of Arts in English at Dartmouth and then went on to

pursue his MBA at the Harvard School of Business (Henry "Hank" Paulson, 2009). He first

joined Goldman Sachs in 1974 in the Chicago office. In 1994, he assumed the role of

Chief Operating Officer and then became co-CEO with Jon Corzine. Hank was appointed

as the 74th Secretary of the U.S. Treasury in 2006. He had the misfortune of presiding

over the Financial Crisis of 2008 and having that time period make a stain on his legacy

in that role. He took the fall for many of the failed decisions made by the Chairman of

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the Federal Reserve, Ben Bernanke and Timothy Geithner, President of the Federal

Reserve Bank of New York.

John Thain has been the alumnus most recently in the news. He was success as the

Chief Operating Officer and President at Goldman Sachs, but left to help the New York

Stock Exchange find a new direction in 2004. He successfully turned the NYSE around

and was sought by both Citigroup and Merrill Lynch to help dig them out of the slumps

they were in. He ended up with Merrill Lynch where he had to weather the storm that

was the Financial Crisis of 2008. Merrill Lynch was performing so poorly that they were

not to survive the collapse, but Thain managed to orchestrate a deal with Bank of

America, and soon he was an employee. Unfortunately, it was found out that he had

passed out large bonuses before the official takeover, and had to resign in January 2009

under an ominous cloud (de la Merced, 2007).

Robert Rubin left Goldman Sachs for one of the most illustrious careers, only to leave his

most recent financial position in shame. Rubin was educated at Harvard University, the

London School of Economics, and Yale Law School. He worked for Goldman Sachs for 26

years, two of which were spent as Co-Chairman. In 1995, he was appointed as the

United States Secretary of the Treasury by President William Clinton. After serving over

one of the most successful periods of expansion, he left government work for a position

with Citigroup (Wikipedia). Citigroup was nearly defeated by the Financial Crisis of 2008

and Rubin was held accountable for its inability to keep up with the changes in the

housing market. In a letter published in the Huffington Post Rubin said, "My great

regret is that I and so many of us who have been involved in this industry for so long did

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not recognize the serious possibility of the extreme circumstances that the financial

system faces today (Read, 2009)."

Other alumni include:

o Robert Steel: Goldman Sachs (1976 to 2004), Barclays Bank (2005 to 2006),

Undersecretary for Domestic Finance (2006 to 2008), and Wachovia/Wells Fargo

(2008 to present).

o Joshua Bolten: Goldman Sachs (1994 to 1999), George W. Bush policy director

(1999 to 2000), Deputy Chief of Staff for Policy at the White House (2001 to

2003), Director of the Office of Management and Budget (2003 to 2006), and

White House Chief of Staff (2006 to 2009). (Wikipedia - Joshua Bolten, 2009)

o John Whitehead: Goldman Sachs (1947 to 1984), U.S. Deputy Secretary of State

(1985 to 1989), Chairman of the Board of the Federal Reserve Bank of New York

(Wikipedia - John Whitehead, 2009).

Business Segments

Goldman Sachs separates its principal operating activities into three separate business

segments: Investment Banking, Trading and Principle Investments, and Asset Management and

Securities Services. The following graph shows the net revenues of the operating activities from

2006 to 2008.

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Investment Banking

Goldman Sachs, although not exclusively an investment bank, is a leader in the investment

banking industry, ranking number one in global Mergers and Acquisitions (M&A) and in

worldwide public common stock issuances (Wetfeet, Inc., 2009). Goldman’s investment banking

segment assists corporations and financial institutions plan and execute financial strategies in

the capital markets. Through its investment banking segment, Goldman offers clients a wide

range of advisory, structuring, and underwriting services, including debt and equity financing,

mergers and acquisitions, and project financing. Over the past three fiscal years, the investment

banking segment of Goldman’s operations has been the smallest of its business segments by

net revenues, but is still fundamental to Goldman’s consistent profitability. Investment banking

operations provided net revenues of $5,185 million, $7,555 million, and $5,629 million for the

Net Revenues by Segment

(in millions) (2)

-

10,000

20,000

30,000

40,000

2008 2007 2006

Investment Banking Trading and Principal Investments

Asset Management and Securities Services

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years ended December 2008, 2007, and 2006, respectively (The Goldman Sachs Group Inc.,

2008). The investment banking segment of Goldman Sachs is divided into two components:

Financial Advisory and Underwriting. Goldman also divides the investment banking into

functional groups including:

Communications, media, and entertainment

Corporate finance

Energy and power

Equity capital markets

Financial institutions

Health care

High technology

Investment banking services

Leveraged finance

Mergers and acquisitions

Principal investment area (merchant banking)

Real estate

Real estate principal investment area

Risk markets group

Special execution

The following graph indicates the net revenues earned in millions in financial advisory and

underwriting.

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Financial Advisory

Included in the financial advisory component of Goldman’s investment banking segment are

advisory services related to mergers and acquisitions, restructurings and spin-offs, divestitures,

and corporate defense activities. Net revenues from financial advisory services were $2,656

million, $4,222 million, and $2,580 million for the years ended 2008, 2007, and 2006

respectively (The Goldman Sachs Group Inc., 2008).

Underwriting

Underwriting of both debt and equity securities is the second component of the Investment

Banking segment of Goldman Sachs. The underwriting component at Goldman focuses on

assisting corporations and financial institutions with public offerings as well as private

placements of debt and equity instruments. Net revenues from underwriting services for the

Investment Banking Net Revenues

(in millions) (2)

-

1,000

2,000

3,000

4,000

5,000

2008 2007 2006

Financial Advisory Underw riting

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years ended 2008, 2007, and 2006 were $2,529 million, $3,333 million, and $3,049 million

respectively (The Goldman Sachs Group Inc., 2008).

Trading and Principal Investments

Goldman Sachs’ largest business segment is its Trading and Principal Investments with net

revenues of $9,063 million, $31,226 million, and $25,562 million for the years ended 2008,

2007, and 2006, respectively, as shown in the graph below (The Goldman Sachs Group Inc.,

2008). The trading and principal investments segment focuses on executing transactions for

customers with wide variety of individuals, corporations, financial institutions, and

governments. In addition, it engages in floor-based and electronic market-making as a specialist

in U.S. equities and option exchanges and clears customer transactions on major stock, options,

and futures exchanges worldwide. In connection with Goldman’s merchant banking and other

investment activities, it makes principal investments both directly and indirectly through funds

that it raises and manages. Goldman’s trading and principal investments segment is divided into

three components: Fixed Income, Currency and Commodities, Equities, and Principal

Investments.

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Fixed Income, Currency and Commodities (FICC)

Under the fixed income, currency and commodities component of operations, Goldman focuses

on the marketing and trading of fixed income and derivative securities. These securities include:

interest rate and credit products, mortgage-backed securities and loan products, other asset-

backed products, currencies, and commodities. Risk management is a strong focus in this

business component, especially in the areas of interest rates, liquidity, commodities, credit, and

currencies. Net revenues from the fixed income, currency and commodities component for

2008, 2007, and 2006 were $3,713 million, $16,165 million, and $14,262 million (The Goldman

Sachs Group Inc., 2008). The fixed income, currency and commodities component is also further

divided into the following functional groups:

Capital markets

Corporate securities

Trading and Principal Investments Net Revenues

(in millions) (2)

(5,000)

-

5,000

10,000

15,000

20,000

2008 2007 2006

FICC Equities Principal Investments

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Dealer sales

Futures services

Government securities

High-yield securities

Industry resource groups

Money market instruments

Mortgage- and asset-backed securities

Municipal securities

Currency and commodities strategies

Energy

Foreign exchange

Metals

Equities

The equities component of Goldman’s trading and principal investments business segment

brought in net revenues of $9,206 million, $11,304 million, and $8,483 million for fiscal years

2008, 2007, and 2006, respectively (The Goldman Sachs Group Inc., 2008). This component

focuses on the trading of equities and equity-related products, structuring and executing equity

derivative transactions, proprietary trading. The equities component also executes and clears

customer transactions on major exchanges around the world. Profits in this component are

generated primarily from commissions made from trading activities for others and from gains

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on proprietary investments. The following functional groups comprise the equities component

of the trading and principal investments business segment at Goldman:

Equities arbitrage

Equity capital markets

Equities management

Global securities services

Institutional sales

Private client services

Trading

Principal Investments

The principal investments component of Goldman’s equity division deals primarily with its

merchant banking investments. These investments are generally made in the areas of real

estate and corporate principal investments. Income is generated on these investments from

gains made when the returns on merchant banking funds exceed certain thresholds and on the

returns from these investments. Net revenues for 2008, 2007, and 2006 from Goldman’s

principal investments were ($3,856 million), $3,757 million, and $2,817 million, respectively

(The Goldman Sachs Group Inc., 2008).

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Asset Management and Securities Services

Goldman’s third business segment is its asset management and securities services division,

which brought in net revenues of $7,974 million, 7,206 million, and $6,474 million for the years

ended 2008, 2007, and 2006, respectively, as shown in the graph below (The Goldman Sachs

Group Inc., 2008). Asset management services are separated from securities services as

individual components. Collectively, this business segment offers investment advice, planning,

and strategies for all major asset types to Goldman’s individual and institutional investors. This

segment also provides finance, brokerage, and securities service to funds, endowments,

foundations, and high-net-worth individuals.

Asset Management

This component is responsible for both financial planning and investment advisory services for

individual and institutional investors. Net revenues produced from the asset management

component for the years ended 2008, 2007, and 2006 were $4,552 million, $4,490 million, and

$4,294 million (The Goldman Sachs Group Inc., 2008). Revenues are generated from

management and incentive fees generated as a result of these services. Assets under

management include alternative investments, equity, fixed income, and money market

products. Total assets under management were $779 billion, $868 billion, and $676 billion for

2008, 2007, and 2006 (The Goldman Sachs Group Inc., 2008).

Securities Services

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The securities services component at Goldman provides prime brokerage services, financing

services and securities lending services to institutional clients, including hedge funds, mutual

funds, pension funds and foundations, and to high-net-worth individuals across the globe.

Revenues are primarily generated from these services in the form of fees or interest rate

spreads.

TARP and Goldman Sachs

TARP allows the United States Department of the Treasury to purchase or insure up to $700

billion of "troubled" assets. "Troubled assets" are defined as "(A) residential or commercial

mortgages and any securities, obligations, or other instruments that are based on or related to

such mortgages, that in each case was originated or issued on or before March 14, 2008, the

purchase of which the Secretary determines promotes financial market stability; and (B) any

other financial instrument that the Secretary, after consultation with the Chairman of the Board

Asset Managment and Securities Services Net Revenues

(in millions) (2)

-

1,000

2,000

3,000

4,000

5,000

2008 2007 2006

Asset Management Securities Services

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of Governors of the Federal Reserve System, determines the purchase of which is necessary to

promote financial market stability, but only upon transmittal of such determination, in writing,

to the appropriate committees of Congress.” (The Troubled Asset Relief Program: Report of

Transactions Through December 31, 2008, 2009)

In short, this allows the Treasury to purchase illiquid, difficult-to-value assets from banks and

other financial institutions. The targeted assets can be collateralized debt obligations, which

were sold in a booming market until 2007 when they were hit by widespread foreclosures on

the underlying loans. TARP is intended to improve the liquidity of these assets by purchasing

them using secondary market mechanisms, thus allowing participating institutions to stabilize

their balance sheets and avoid further losses.

TARP does not allow banks to recoup losses already incurred on troubled assets, but officials

hope that once trading of these assets resumes, their prices will stabilize and ultimately

increase in value, resulting in gains to both participating banks and the Treasury itself. The

concept of future gains from troubled assets comes from the hypothesis in the financial

industry that these assets are oversold, as only a small percentage of all mortgages are in

default, while the relative fall in prices represents losses from a much higher default rate.

The Act requires financial institutions selling assets to TARP to issue equity warrants (a type of

security that entitles its holder to purchase shares in the company issuing the security for a

specific price), or equity or senior debt securities (for non-publicly listed companies) to the

Treasury. In the case of warrants, the Treasury will only receive warrants for non-voting shares,

or will agree not to vote the stock. This measure is designed to protect taxpayers by giving the

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Treasury the possibility of profiting through its new ownership stakes in these institutions.

Ideally, if the financial institutions benefit from government assistance and recover their former

strength, the government will also be able to profit from their recovery.

Another important goal of TARP is to encourage banks to resume lending again at levels seen

before the crisis, both to each other and to consumers and businesses. If TARP can stabilize

bank capital ratios, it should theoretically allow them to increase lending instead of hoarding

cash to cushion against future unforeseen losses from troubled assets. Increased lending

equates to "loosening" of credit, which the government hopes will restore order to the financial

markets and improve investor confidence in financial institutions and the markets. As banks

gain increased lending confidence, the interbank lending interest rates (the rates at which the

banks lend to each other on a short term basis) should decrease, further facilitating lending.

(Nothwehr, 2008)

The TARP will operate as a “revolving purchase facility.” The Treasury will have a set spending

limit, $250 billion at the start of the program, with which it will purchase the assets and then

either sell them or hold the assets and collect the 'coupons'. The money received from sales

and coupons will go back into the pool, facilitating the purchase of more assets. The initial $250

billion can be increased to $350 billion upon the President’s certification to Congress that such

an increase is necessary (Summary of the Emergency Economic Stabilization Act of 2008, 2008).

The remaining $350 billion may be released to the Treasury upon a written report to Congress

from the Treasury with details of its plan for the money. Congress then has 15 days to vote to

disapprove the increase before the money will be automatically released. The first $350 billion

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was released on October 3, 2008, and Congress voted to approve the release of the second

$350 billion on January 15, 2009. One way that TARP money is being spent is to support the

"Making Homes Affordable" plan, which was implemented on March 4, 2009, using TARP

money by the Department of Treasury. Because "at risk" mortgages are defined as "troubled

assets" under TARP, the Treasury has the power to implement the plan. Generally, it provides

refinancing for mortgages held by Fannie Mae or Freddie Mac. Privately held mortgages will be

eligible for other incentives, including a favorable loan modification for five years (MHA

Guidelines).

The authority of the United States Department of the Treasury to establish and manage TARP

under a newly created Office of Financial Stability became law October 3, 2008, the result of an

initial proposal that ultimately was passed by Congress as H.R. 1424, enacting the Emergency

Economic Stabilization Act of 2008 and several other acts (Gross, 2008).

As this relates to Goldman Sachs, they gave taxpayers their due in September. Goldman Sachs

said it paid the government $1.1 billion to redeem the stock-purchase warrants it issued

Treasury last fall. The payment marks the first time taxpayers have recovered the full value of

warrants issued to a major institution under TARP. The Goldman Sachs TARP warrant deal is the

best deal that taxpayers have got to date. Since at least April 2009, representatives from

Goldman Sachs have said that taxpayers deserve a fair return for their investments. Taxpayers

received a 23% annualized return for their $10 billion investment last fall in Goldman.

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Warren Buffet’s Investment in Goldman Sachs

Warren Buffett's ride to the rescue of Goldman Sachs with a $5 billion cash infusion at the

height of the Wall Street panic is an opportunity to examine what the terms of his deal might

tell us about the future of capital in the financial sector.

Buffett didn’t buy Goldman common stock. Instead, he privately negotiated a very special

preferred stock deal that made the capital very expensive for Goldman. He took taking $5

billion worth of perpetual preferred stock that promised him a 10% dividend and warrants to

buy $5 billion of common stock with a strike price of $115 a share.

In many ways, Goldman operates for Buffett the way a profitable hedge fund does for its

limited partners. The general partner of a hedge fund usually makes very little unless the firm’s

earnings cross a specified hurdle. Similarly, Buffett’s 10% dividend means he gets the first cut of

Goldman’s revenues, before the Goldman partnership itself. If they don't earn enough to pay

Buffett, there's nothing left to pay the partnership (Carney, 2009).

Perhaps surprisingly, the perpetual preferred shares mean that Buffett’s interests are very

closely aligned with those of the Goldman partnership. He has a concentrated interest in

Goldman and little interest in having the firm pursue short term gains. Similarly, the Goldman

partners have their fortunes tied to the profits of a single firm, both through their interests in

the firm continuing to pay them and their large holdings of its stock. Both have an interest in

the firm being cautiously “long-term greedy” (Brand, 2009).

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Compare that to an ordinary investor in Goldman’s common stock. Those folks are happy if just

20 percent of the firm’s revenue goes to equity. They stand behind Goldman’s partners,

employees and overhead when it comes to seeing a cut of the revenues. Their capital is in a far

riskier position. What’s more, ordinary shareholders tend to hold Goldman as part of a

diversified portfolio and don’t much care about the fate of a single firm. They want more risk

than Goldman’s partners want. The structure of Buffett’s investment also resolves some of the

dangers of Goldman’s partners becoming too cautious if they are forced to lower their

leverage. Ordinarily, a combination of debt load and stock options helps encourage the

management of corporations to overcome the excessive risk aversion that comes from their

undiversified interest in their company. Their interests become aligned with their shareholders

since they need to achieve enough returns to be profitable after the fixed costs of debt

payments. In short, the guys in charge need to make sure the firm makes enough money that

they can get paid after the lenders get paid (Haruni, 2008).

As firms lower their debt, the barrier between revenue and the bosses paycheck lowers. This

lowers the appetite for risk. But Buffett’s guaranteed 10% puts that barrier back in place, re-

creating the role of debt to incentivize risk taking.

As firms and regulators attempt to reduce leverage and risk in the financial sector, we wouldn’t

be surprised if the capital structure of many Wall Street firms began to shift in this direction.

The problem of excessive risk is solved by a fixed return, and the problem of excessive risk

aversion is addressed by forcing managers to make distributions.

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Goldman Commercial Bank Conversion

On September 21, 2008, Goldman Sachs received Federal Reserve approval to transition from

an investment bank to a bank holding company. As part of the credit and banking turmoil, the

nation’s three largest investment banks, Goldman Sachs, Morgan Stanley, and Merrill Lynch

have become “banks.” They come from a rough-and-tumble, hard-charging business where

Goldman Sachs in particular has thrived on disruptive change. Not always nice, they are here to

stay and will strive to bring change that works to their advantage.

Corporate executives and directors, particularly those who rely on banking organizations for

access to capital, will be wise to anticipate the impact on the credit markets and on financial

relationships that will develop with the new contenders acting as bank holding companies. The

banking industry is being joined by companies that have been living and winning by very

different rules. They’ve been in a rougher business with more risk-taking and faster change and

they have thrived on it. They have no intention of becoming “normal” commercial banks (Ellis,

2009).

Clearly the change was not voluntary. Goldman Sachs, Morgan Stanley, and Merrill Lynch (now

part of Bank of America) got caught in a capital-market tsunami. As public companies with

enormous leverage and funding requirements plus mark-to-market accounting, they were

compelled to accept the change to regulated bank-holding-company status when the

plummeting market prices of many of their assets decimated their capital. While Goldman

Sachs was the least distressed of the three, it was given only one choice. The other choice for

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Goldman was to opt for a state charter rather than becoming a national bank, so it’s regulated

by New York State rather than the federal government. The state could be more

accommodating.

During the intense market turmoil at the height of the October storm, Goldman Sachs severely

threatened by an inability to roll over short-term credits like commercial paper and losing

substantial prime-brokerage assets held for hedge funds was nearly forced to merge itself into

a giant commercial bank, reportedly Citigroup. But no transaction materialized, and Goldman

Sachs moved ahead with its own strategy. Goldman Sachs is certainly not a “beginner” bank. As

soon as it became a full-service New York State-chartered bank as Goldman Sachs Bank USA, it

ranked as one of the 10 largest banks in America, with assets of $150 billion (Reynolds, 2008).

A few important financial changes will come with the transition to bank-holding-company

status: lower leverage ratios, higher capital ratios, more liquidity, and “cushion” capacity to

absorb short-term losses. Also, three or four dozen bank regulators will be on the firm’s

premises, as they are at all large bank holding companies. Further expected consequences

include slower growth in profits most likely partly offset by more consistent earnings growth

and therefore somewhat higher price-earnings ratios on its stock. So in some ways, Goldman

Sachs will be changed by its new bank status. But odds are that this won’t be the major change.

Goldman Sachs Bank will alter corporate banking more than corporate banking status will alter

Goldman Sachs. First, consider how much the businesses of Goldman Sachs have changed in

past years while the essence of what makes Goldman Sachs Goldman Sachs has changed so

little. In a single generation, it has absorbed, and adapted to exploit profitably, such major

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changes as brokerage commissions’ plunging by more than 90%––from 40 cents a share to less

than 4 cents––and the transformation of bond dealing, foreign exchange, and commodities

trading from commission-based agency-service businesses to gigantic, complex, capital-at-risk

principal businesses. During that same time, the firm has gone from being almost entirely

domestic and losing money in Europe to earning a majority of its profits overseas, and from a

U.S. partnership with 2,000 employees to a global, publicly owned corporation with some

30,000 employees and a balance sheet over $1 trillion. It has built a major private equity

business, a major investment-management business, and a major prime-brokerage business

serving hedge funds. In these and dozens of other businesses, Goldman Sachs has embraced

and capitalized on change.

Corporate executives and directors will like most of the surprises still to come from the firm’s

transformation into a regulated bank holding company. While projecting the future of free

competitive markets is notoriously risky––and the market for corporate financial services is

notoriously free and competitive––corporations can confidently anticipate that Goldman Sachs

will combine its old strengths with its new strengths in ways that are innovative and assertively

entrepreneurial. As a major bank, Goldman Sachs will be able to combine credit—swiftly and on

a large scale—with any of the firm’s current strengths in real estate, mergers and acquisitions,

private equity, commodities, foreign exchange, and other areas. Some of the combinations will

be fairly conventional, but if history teaches one thing about Goldman Sachs, the lesson is that

its people will conceive of and create strongly profitable new ways of meeting the objectives of

the thousands of corporations and dozens of governments with which it already has major

working relationships (Montia, 2009).

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Information technology has become a core strategic force in banking strategies. The ability to

syndicate large loans swiftly is now the norm and has already changed the basic business model

of banking. Managing lending risks by hedging with sophisticated analytical models and

derivatives continues to change the traditional concepts of loan portfolio management. Balance

sheets and loan syndications are still important, but access to the world’s enormous capital

markets is becoming more important. These are areas where Goldman Sachs excels.

The “universal bank” business model, already dominant in Europe and Asia, has in recent years

become increasingly important to America’s major corporate banks as they have sought to

muscle in on the more profitable business enjoyed by securities dealers and investment banks.

Suddenly the major investment banks have become universal banks at least they’re now

regulated bank holding companies. They got there for defensive reasons, but they won’t stay

on the defensive for long; they will go over to the offense soon.

The critical advantage of universal banks is that they accept deposits and therefore have access

to much more capital than investment banks do. Clients of Goldman Sachs have increasingly

asked it for substantial financing, with the firm acting as financing principal, to help them

convert advice into action. This was central to Goldman Sachs’ consideration less than a decade

ago of acquiring JPMorgan––and its declining to do so. When the firm decided not to make that

acquisition, it was because Henry Paulson, then CEO, was convinced Goldman Sachs would

soon meet or beat what was arguably the best corporate bank in each area of capability. There

was also a cultural gulf. Taking just one factor in isolation, the culture of Goldman Sachs

included being at work before 7 a.m. and often working well into the night and on most

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weekends, largely because the work was so interesting and compelling and the rewards so

great. Goldman Sachs people could not relate to bankers who worked only from nine to five or

even eight to six (Montia, 2009).

What already makes Goldman Sachs “different” embraces many attributes. A few are crucial:

exceptional recruiting, risk management, teamwork, intensity of commitment, and distributed,

driven leadership. All these are energized by the entrepreneurial imperative to create, discover,

and develop profitable businesses—and make them grow by capitalizing on the organization’s

many strong corporate relationships, its power in many markets, advanced technology, and an

extraordinary communications network that links thousands of professionals into one

interconnected team that is flexible, adaptable, and, to any and all competitors, dangerous.

Only a few universal banks have as much competitive strength as Goldman Sachs, and no bank

of any kind has such formidable strength in service after service in market after market or the

speed and intensity of internal communication or the number of action-taking leaders well over

1,000 distributed with action authority into parts all over the world.

Corporations will need to decide how they will work with the new Goldman Sachs. Will they

want to compete with rivals in their industry to be one of the firm’s particularly important

clients? How crucial might it be to get the first call with new ideas? At what executive level will

they locate their relationship––CEO, CFO, or AT (assistant treasurer)? Goldman Sachs

traditionally builds its principal relationships with CEOs and CFOs. Will companies concentrate

their corporate finance business with one or two banks like Goldman Sachs or distribute their

business more widely to achieve supplier diversification? Managers and directors will want to

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answer such long-term “strategic supplier” questions early, because having the right partners in

corporate finance is clearly becoming more important, and powerful strategic partnerships take

time and care to develop (Westfall, 2009).

No organization has to want to be as hard-driving as Goldman Sachs, but it is important for

customers and competitors to understand and respect what such a firm has accomplished and

how quickly it adapts to change and profit opportunity. Consider how it changed the

investment banking business in the ’60s, the stockbrokerage business in the ’70s, commodities

in the ’80s, and investment management in the ’90s. Goldman Sachs is a merchant of change in

area after area of corporate finance. Initiating and driving disruptive change is in its culture.

Sure, the firm has changed to a bank holding company, but the substance of what makes

Goldman Sachs Goldman Sachs the culture has changed very little in 50 years, while almost

every aspect of its form has changed greatly. So welcome your new kind of banker, but don’t

expect Goldman Sachs to be your conventional banker.

Regulation of Goldman and the Financial Markets

Enforcement

The main lesson learned from the financial crisis is the need for more effective systemic

regulation. Again, more effective regulation is needed, not necessarily more regulation.

Government and financial leaders realize that the task of a systemic regulator would be

impossible without the much needed transparency and regulatory tools to instill market

discipline. Lately there has been a focus on who should be in charge and exercise this enormous

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responsibility. There was a fundamental problem with the old system in that it was far too easy

for financial institutions to flat out deny and ignore problems that allow systemic risks to

infiltrate the market. Whoever is in charge of exercising regulation needs to be able to first

determine risk areas early to prevent them from becoming so large that they soon infect and

threaten the entire financial system. If systemic problems do begin to arise, these regulators

need to take immediate action to limit their overall impact and protect the overall safety of the

system.

In order to protect the system, the regulator must be able to first recognize all of the risks

which may be exposed to an institution and require that those risks be recognized. However,

it’s not enough to just recognize and identify risk exposure. Many firms, including Goldman

Sachs, have argued that their assets must be valued at their fair market value price and not at

the historic value (The Trouble with Wall Street Regulation, 2009). It could be argued that if

institutions had been able to recognize their daily risk exposures and value them appropriately,

they may have been able to abbreviate or reduce the worst risk. Because these positions

weren’t monitored, value changes were often ignored until the firm’s losses grew to a point

where their overall solvency became an issue.

In an Op-Ed piece in the Financial Times, Goldman CEO Lloyd Blankfein stated that regulators

really need to encourage a culture whereby financial firms are required to share their concerns

about overall system risks with regulators. “I remember being told by my mentors we do not

fire people for losses or mistakes that were honestly made,” said Blankfein. “But if anyone

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conceals or fails to escalate a problem, they must be held accountable immediately. The same

principle should inform regulatory oversight” (Blankfein, 2009). One suggestion is that

regulators could establish a committee in charge of examining certain issues such as

underwriting standards and risk assessment. If practices ever slip and risk starts to become

uncontrollable, regulators should be the first to know. These committees would need the

authority to quickly address any massive capital deficits by reducing risk or raising capital. Of

course, raising the capital requirements of holding companies would reduce systemic risk but

it’s important not to overlook liquidity concerns. Leverage ratios need to be closely examined,

but these ratios really tell you nothing about banks liquidity. If a large amount of a financial

institutions assets are illiquid, low leverage ratios wouldn’t matter much. Once liquidity begins

to dry up in the market, these institutions begin to face significant life-threatening problems.

This is why the regulators need to really put an emphasis on the care and need for institutions

to focus on keeping a large amount of liquidity reserve at all times which would prevent

extreme events. A set of broad regulatory proposals which were recently discussed by the G20

and their effects on Goldman Sachs are presented below.

Banking Reform

Transparency

In order to flow freely, the money system has to be trusted by everyone around the world. We

have lost that trust and a lack of transparency led us to our current situation. Infosys CEO, Kris

Gopalakrishnan, recently stated:

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“Many of the economic challenges we face are the function of a global crisis in

confidence. Investors… and analysts have good reason to pause and consider

where their efforts and investments will be safe. This lack of confidence is

preventing basic, sound business from thriving and is ultimately prolonging the

downturn… A lack of transparency hid the true exposure of giants like AIG and to

the detriment of international stakeholders and the American public

(Gopalakrishnan, 2009). ”

Greater transparency is obviously highly desirable not only for financial institutions, but for

governments and credit agencies as well. The issue is far more complex than just simply

requesting for more transparency. Most of the requests from governments and the public have

been for greater clarity of their ‘toxic asset’ portfolio and mark-to-market valuations (O'Neil,

2009). It is not easy to do this, partly because valuations are constantly changing under mark-

to-market accounting. What makes this financial crisis so different from others in the past, are

the difficulties of estimating fair-value of derivatives which have been deemed worthless and in

some cases, the market for which has dried up.

Goldman Sachs has produced countless reports to Congress regarding different avenues to

achieve a transparent market. They publicly state they support regulatory oversight but

continue to play on both sides of the fence. Regulatory decay has spurred countless

unregulated and unregistered market exchanges - some of which are run primarily by Goldman

Sachs. Their GSTrUE (Goldman Sachs Tradable Unregistered Equity OTC Market) program is the

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new game in town. This type of market is particularly attractive for firms who place a significant

value on keeping their operations confidential and staying out of the public limelight

(Ehrenberg, 2007). Below are some recent excerpts from a Wall Street Journal story that

mentioned this type of market:

Oaktree Capital Management LLC, a Los Angeles "alternative investment" firm,

plans to raise almost $700 million by selling a stake in itself. But unlike rival firms

selling shares -- such as Fortress Investment Group LLC, which has done so, and

Blackstone Group, which plans to -- Oaktree won't trade publicly. Instead, it will

trade on a new private market being developed by Wall Street firm Goldman

Sachs Group Inc. Not only does the maneuver enable Oaktree to avoid most

regulatory requirements of a traditional share offering, the deal is structured so

shareholders will have practically no say in how Oaktree is run (Sender, 2009).

The only reason this opportunity exists is because of the broken regulatory system in the U.S.

This type of market does not seem to fit into the regulatory and transparency guidelines that

Goldman has been preaching since it received TARP money last year.

Credit Rating Agencies

As was mentioned earlier, the credit rating agencies appear to have played a very significant

role in the crisis by providing investment grade ratings for packaged securities which were not

of high quality. There is a popular view that investors should do their due diligence before

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investing in securities, however, many investors who do not have the resources to conduct

strong due diligence and often rely on rating agencies when purchasing these securities. Now it

is clear that they may as well use their own research and regard market prices as a better and

more significant ‘rating’ for a security. These agencies were not truly independent, given that

the financial services industry is the source of their fees. This creates a serious conflict of

interest and a new structure of independence needs to be proposed.

Mark-to-Market Accounting

As we dug further into this crisis, there has been increased opposition to mark-to-market

accounting. In the Global Economics Weekly of July 2009, Chief Accounting Officer Sarah Smith

presented her views on why Goldman Sachs regards mark-to market accounting as more fair

and more sensible than the alternatives (Smith, 2009). The parties who oppose mark-to-market

accounting argue that as the prices of assets decline, mark-to-market accounting calls attention

to significant problems in the balance sheets of financial institutions. By having to report these

unrealized losses, banks are forced to reduce leverage which accelerates the process.

In a report in the Huffington Post in April, Goldman Sachs publicly stated their major problems

with the above view.

We see two major problems with this view. First, it is not very credible for

financial institutions to argue that marking to market is inappropriate only during

downturns. Second, if the underlying assets are worth more than institutions are

being ‘forced’ to value them at, presumably there will be an increase in the

number of value-driven buyers of these undervalued assets. Moreover, financial

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institutions will see mark-to-market gains when and if the assets appreciate

(Nazareth, 2009).

Clearly, Goldman Sachs wants mark-to-market accounting to stay put. Furthering their view,

they believed that policy markets could instead choose to broaden their ‘lender of last resort’

activities and require financial institutions to raise more capital. They could also relax capital

ratios in certain circumstances. CEO Lloyd Blankfein made reference to his views on the subject

in the Financial Times (Blankfein, Do Not Destroy the Essential Catalyst of Risk, 2009). He

disagreed with those who suggest that fair value accounting is one of the main factors

exacerbating the credit crisis. “If more institutions had properly valued their positions and

commitments at the outset, they would have been in a much better position to reduce their

exposures,” he stated. “For the industry, we cannot let our ability to innovate exceed our

capacity to manage.”

Bank Compensation

Most recently, the crisis has scrutinized the compensation structure of the banking industry. In

an interview published in the Wall Street Journal, Goldman Sachs expressed three points in

terms of what they deemed appropriate in compensation practice (Dauer, 2009).

Bonus compensation should be more closely tied to the long-term performance of

companies…A system of rewarding immediate apparent profit with cash bonuses is not

appropriate.

Non-executive directors need to be allowed to play and be capable of playing a stronger

role.

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It is important that policymakers and regulators do not place artificial ceilings on

compensation. Forces of supply and demand for skilled labor need to be allowed to

function. Controls will be circumnavigated (as they were in the 1970s and 1980s through

generous free car schemes, etc). If it is the case that financial services employees do not

constitute ‘skilled’ labor, then the demand for their services will wane.

The recent executive pay limits imposed by President Obama and his administration are

pointed at companies that take bailout money and will affect companies getting ‘exceptional

assistance.’ This does not include Goldman Sachs.

Bank Capital and Pro-Cyclicality

Basel II is a set of banking regulations which regulates both finance and banking internationally.

It attempts to integrate capital standards with regulations by setting minimum capital

requirements of financial institutions with the goal of ensuring liquidity of the institution (Basel

II). One concern about Basel II’s risk-sensitive bank capital requirements is that they could

amplify business cycle fluctuations. In boom times, everything looks good – asset prices rise and

credit expands in the system. In recession, everything seems very bad – banks stop lending,

asset prices diminish, and this makes the macro environment and their own problems worse.

There have been a variety of recommendations to deal with this problem by the Issuing

Commission. One simple guideline to combat pro-cyclicality has been developed by Rafael

Repullo, Jesus Saurina, and Carlos Truchart – three well respected economists. They argue that

the best way to correct pro-cyclicality is to use a business cycle multiplier of the Basel II capital

requirements that is increasing in the rate of growth of the GDP. Under this scheme, more risky

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banks would face higher capital requirements without regulation intensifying credit bubbles

and crunches (Rafael, 2009).

Using the experience of Spain, the simple multiplier of the Basel II requirements depends on

the deviation of the rate of growth of GDP compared with its long-term average. Based on their

results, they recommend that the multiplier be increased in expansion phases or decreased in

recessions by 7.2% for each standard deviation in GDP growth, i.e., 7.2% more capital needs to

be raised when GDP is 1% above trend, and vice versa. The below chart which was obtained

from Goldman Sachs shows how the cycle would be smoothed when using this approach. It

may be difficult for an international regulator to enforce this rule, but it would be sensible for

them to impose something similar.

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Recapitalization of the Banking System

Many questions still need to be asked. How can we somehow find enough capital to support

and refuel our banking systems? In the first of three series on effective regulation, Goldman

Sachs brings up three reasons which they believe it will be unlikely that we solve these

problems globally (O'Neil, Avoiding Another Meltdown, 2009):

It is ultimately the preserve of domestic regulators and policymakers to find capital to

support the banks. While an international agreement would be desirable, in reality is it

realistic or enforceable? Can we really expect all countries in the G20 to share the same

belief about how much capital their banking system needs?

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For cross-border purposes, some commonly used capital requirements are necessary

but to implement a globally agreed upon banking plan isn’t likely.

Despite this, it is necessary and urgent that all local governments continue with their currently

implemented plans to help recapitalize their banking systems further.

Local Rules, Global Markets

Early in 2009, Timothy Geithner was hopeful that the leaders from the world’s 20 largest

economies would lay out a plan for regulation reform which would stop banks from transferring

risk to less regulated markets and security domains. He mentioned that it was extremely

important that the United States work with Europe in developing a global infrastructure which

has global oversight in order to prevent a global crisis. “Risk does not respect international

borders,” he stated. “Rules must be enforced fairly between major financial powers (Quinn,

2009).” Governments around the world are attempting to strengthen markets and regulations

to ensure that these same mistakes are not bound to repeat in the future. It must be

recognized that global economic growth can only resume with well-functioning financial and

capital markets. Effectively regulated markets can enable new capital to be put to use in

effective areas.

Capital is Global, Regulation is Local

Capital is not local – it is cross-border. But regulation is local, and that identifies a clear

mismatch which has increased many of the problems facing the global financial system. One

way to fix this mismatch of capital location and regulation is to have one global financial

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regulator, or at least consistent rules and regulations in financial markets. It could be helpful to

have coordination amongst national regulators, but many do not think a single regulatory

system is viable. It would be far too difficult for a single global regulator to monitor each

country and its laws separately while enforcing standard rules. With that in mind, it would

probably be best if governments focused on controlling risk in their country or jurisdictions. If

this were the case, governments could set their own standards and monitor risk-taking very

closely. This would not hinder cross-border financial activity and trading. Instead governments

should attract financial activity to their jurisdiction in order to control it more effectively. The

most effective long-term solution is for countries to contain risk in institutions which oversight

and regulation can be best applied.

Exceptional Regulatory Systems Promote and Encourage

Financial Activity

All parties in a financial transaction have an interest in maintaining a trading environment that

is clear and operates under effective and sensible rules. Regulatory systems which have been

proven to be exceptional attract large amounts of financial activity. Governments of those

geographic areas should focus on regulations that make those markets function well and avoid

regulations which cause financial activity to flee. The key to all effective global regulations

include some form of transparency: legal clarity in bankruptcy and the treatment of creditors,

reliable accounting standards, and regulators which have a large desire to help and the

experience to provide a successful market. Factors which tend to cause a drop in market

activity include legal uncertainty, politically-motivated regulators, and harsh tax treatment. The

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question then becomes, what factors support a growth of market activity? A recent report from

Sandra Lawson of Goldman Sachs International gave a list of a few principles which encourage

effective capital markets (Lawson, 2009). They include:

The enforceability of financial contracts, even (and especially) under bankruptcy;

The consistent application of regulations and bankruptcy provisions;

Respect for liquidity, which allows for faster resolutions to disputes;

Fair treatment of financial counterparties (including non-residents); and

Supportive tax policy

Regulatory Approach

When looking at global regulation, recent years have seen two separate approaches to

regulation: a rules-based approach, as in the United States, or a principles-based approach as in

the United Kingdom. In general:

The rules-based approach is proscriptive, offering an extensive list of what is allowed

and how it must be done, with compliance focused solely on the letter of the law.

Advocates of this approach argue that “bright-line” rules are simple to understand and

to follow, and that this clarity removes much of the subjectivity from enforcement

(Regulatory Reform for the US Financial Markets, 2009).

The principles-based approach lays out broad principles and standards but does not

offer detailed guidelines. Compliance and oversight lean toward meeting the spirit of

the law rather than the (less detailed) letter. Supporters of this argue that it gives firms

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more flexibility and is better suited to fast-changing markets (Principles Based

Regulation on the Outcomes that Matter, 2007).

Given these two approaches, it is important to note there is no strict line dividing the two. In

the end, there is no perfect regulatory approach that fits all markets or societies. Instead other

factors matter more in determining the effectiveness of regulation and the attractiveness of the

market to issuers and investors.

Financial Analysis

Goldman Sachs has been a staple in the financial industry for years. With a market

capitalization of $87.73 billion it is among the largest financial institutions in the country. It

makes up approximately 6.6% of the financial sector and is held by over 2,500 institutions. The

company boasts 31,700 employees, with revenue of nearly $2 million per employee.

Goldman Sachs displayed a very favorable Return on Equity (ROE) in the years leading up to the

financial crisis of 2008. The table below displays Goldman Sachs’ ROE in relation to the

commercial banking industry and several competitors from the year 2000 through 2008.

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Source: SEC 10-k filings and FDIC Statistics on Depository Institutions reports

Goldman Sachs’ increasing use of financial leverage through these years enabled the firm to

realize such high levels. Restructuring in the latter part of 2008 caused Goldman’s leverage to

fall from a high of 26.16 at the end of 2007 to 13.5 on their most recent quarterly report filed

November 4, 2009. The company’s ROE for the quarter ending September 2009 was 4.87%,

showing some improvement over the year end of 2008, but far from nearly 35% at the end of

2007.

Goldman Sachs’ Return on Assets (ROA) has been historically lower than the commercial

banking industry as a whole. The table below displays Goldman Sachs’ ROA in relation to the

commercial banking industry and several competitors form the year 2000 through 2008.

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

RO

E

Year

Comparative ROE

Industry

GS

JPM

MS

BAC

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Source: SEC 10-k filings and FDIC Statistics on Depository Institutions Reports

Goldman Sachs’ ROA has been lower than the commercial banking industry largely because of

its narrow net interest margin. Compared with other financial institutions with a broader array

of services, Goldman’s ROA is fairly in line hovering steadily around .35%. Goldman historically

made up for this narrow margin by engaging in non-interest income producing activities such as

trading and financial advisement that give the company a typically negative burden, raising

total ROA (2008 was the first time that Goldman Sachs experienced a positive burden based on

its non-interest income and expenses).

Goldman Sachs is currently comprised of three business segments, which may also be broken

down into separate components as follows:

Investment Banking

o Financial Advisory

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

RO

A

Year

Comparative ROA

Industry

GS

JPM

MS

BAC

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o Underwriting

Trading and Principal Investments

o FICC

o Equities

o Principal Investments

Asset Management and Securities Services

o Asset Management

o Securities Services

Trading and Principal Investments has significantly more earnings than either of the other two.

Goldman Sachs has wisely increased this line of their business as it is also the most profitable

with a net operating margin of 40.23% compared to 16.38% and 17.14% for Investment Banking

and Asset Management, respectively. Below is a chart displaying the breakdown of Goldman

Sachs’ business segments.

Investment Banking

9%

Trading & Princ. Investments

79%

Asset Management

12%

Business Segment MakeupPercent of Revenue

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Source: November 4, 2009 10-Q SEC filings

In the third quarter of 2009 the Trading and Principal Investments segment earned $4.5 billion

in operating income.

Goldman Sachs’ interest income has declined dramatically since the 2008 financial crisis, largely

due to a steep decline in interest rates. The company has lost significant interest revenue

particularly in their securities borrowed category, falling from $2.917 billion in the third quarter

of 2008 to just $122 million in the similar quarter, 2009. Likewise, their interest expense has

dropped in a related category: securities loaned with interest expenses falling from $1.639

billion in 2008 to $246 million in 2009. The result is that Goldman Sachs’ net interest margin has

narrowed to just .19% in the third quarter of 2009, but gains in non-interest income have offset

this, creating once again a negative non-interest related income and expenses burden.

Goldman Sachs’ balance sheet reveals a strong financial company that is becoming more

financially sound. Because the company is de-leveraging (largely caused by Goldman Sachs’

shift to a bank holding company) they have been forced in recent months to shift the focus of

their business ever more towards Trading and Principal Investments. Because the company’s

thin interest margins necessitated utilizing leverage to increase ROE, their focus must now shift

to the more profitable area of their business. While Goldman Sachs has decreased their risk by

reducing their leverage, they are now engaging in more risky investment opportunities with a

higher rate of return to make up the difference. Below is a graph showing Goldman Sachs’

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operating income over time from FICC-the riskiest part of the Trading and Principal Investments

segment.

The company’s employees enjoy some of the highest compensation to be found, with

$168,801.26 in compensation per employee in the third quarter of 2009 alone. This allows the

company to recruit some of the best talent available, but cuts into their returns by increasing

the financial burden. Employee compensation makes up over 70% of Goldman Sachs’ non-

interest expenses. The company has come under scrutiny recently for its high compensation.

Indeed with new restrictions on the company’s leverage they may have to decrease

compensation to keep their ROA positive and reduce their burden.

$-

$5,000.00

$10,000.00

$15,000.00

$20,000.00

$25,000.00

$30,000.00

Mill

ion

s o

f D

olla

rs

FICC Operating Results

FICC Operating Results

48 | P a g e

Goldman Sachs employs an above average amount of off-balance sheet trading as well. The

company holds off-balance sheet items totaling 927.56% of total assets, or $1.11 trillion worth.

These are primarily composed of credit derivatives totaling $1.04 trillion, split roughly evenly

between derivatives purchased and those that the bank has written. The company has been

reducing its off-balance sheet holdings in recent months, reducing total items by 30% since the

year-end 2008. Below is a graph showing the off-balance sheet items held by Goldman Sachs’

competitors as a percentage of total assets.

Source: FFIEC Uniform Bank Report: 6/30/2009

While it appears that Goldman Sachs is using off-balance sheet derivatives responsibly, their

presence increases the company’s overall risk. The average daily value at risk has increased in

0.00%

100.00%

200.00%

300.00%

400.00%

500.00%

600.00%

700.00%

800.00%

900.00%

1000.00%

GS MS JPM BAC

Off-balance-sheet Percent of Total Assets

Off-balance-sheet Percent of Total Assets

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2009 from 2008 to $231 million due to the company’s more aggressive trading strategies.

Goldman Sachs is heavily exposed to shocks to the financial system due to its heavy volume of

trading activities. If securities prices are over-inflated and the company is not adequately

hedged then it could suffer significant blows to its bottom line.

Competitive Analysis

As the banking system continues to stabilize in 2009, markets are rising and consumer

confidence is returning. Although a weaker than expected consumer spending report at the

end of October, 2008 sent stocks fleeing, there is a general consensus that the economy is

stabilizing. GDP is showing positive growth and the banking industry has taken advantage of

improving market conditions. Risks remain, however, as the depths of commercial credit losses

have yet to be discovered, and while consumer debt shows signs of improving, provisions for

commercial real estate losses may not cover the actual costs of these loans. It is in this climate

that Goldman Sachs is operating. With few consumer loans on hand, Goldman Sachs must

tread carefully in their portfolio of loans written to companies holding risky assets. If the

company can successfully walk the tight rope it may have a competitive advantage against

some of its staunchest competitors, such as JP Morgan, Bank of America and Morgan Stanley.

JP Morgan is has a market capitalization of $168.18 billion, which is nearly twice the weight size

of Goldman Sachs. They have been able to buy assets including Bear-Stearns and Washington

Mutual at extreme discounts through the financial crisis of the past year. Though they engage

in retail banking to a greater degree than Goldman Sachs, their investment banking potential is

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nothing to scoff at. The company’s ROA is roughly even with Goldman Sachs’ while JP Morgan

has a more diversified business.

Bank of America has also weighs against Goldman Sachs in the financial services sector. With a

market capitalization of $128.02 billion it also holds more of the sector than Goldman. Bank of

America, however, lies in much worse shape than JP Morgan and poses less of a threat to

Goldman Sachs. By overpaying for Merrill Lynch during the financial crisis and keeping billions

in bad commercial real estate loans on its books, Bank of America does not fare as well against

some of the more well-placed financial companies. Bank of America has also seen its debt to

equity ratio rise in the past year and its financial leverage fall, reflecting an increase in debt and

a decrease in assets.

Morgan Stanley is another brokerage firm in direct competition with much of Goldman Sachs’

business. With a market capitalization of $43.68 billion it is roughly half the size of Goldman

Sachs. Much like Goldman Sachs, Morgan Stanley reclassified itself as a bank holding company

coming out of the economic crisis. Also similar is the fact that Morgan Stanley is required to

reduce leverage and look for high return business opportunities to bolster its returns. Below

are various comparisons for the companies.

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Valuation Ratios

P/E P/Book P/Cash Flow

Div. Yield

GS 37.9 1.5 40.8 0.90% JPM 74.6 1.1 1.6 1.20% MS 20.4 1 0.5 1.30% BAC 12.5 0.6 1.5 2.40% Industry 58.1 1.5 2.2 1.60% S&P 19.1 2.1 6.5 2.20%

Goldman Sachs appears to be the most overpriced stock, trading at 40.8 times cash flows and

37.9 times earnings. While JP Morgan’s Price-Earnings (P/E) ratio appears inflated as well, their

price to cash flow ratio is much more in line with the norm. Each company’s price to tangible

book value appears to value the stock similarly.

ROE

Industry GS JPM MS BAC 2008 1.35% 3.60% 4.91% 2.60% 3.04% 2007 9.12% 34.20% 13.08% 14.10% 12.95% 2006 13.02% 25.17% 11.32% 27.00% 16.86% 2005 12.87% 17.30% 6.37% 18.17% 14.47% 2004 13.71% 11.83% 3.29% 15.49% 10.07% 2003 15.33% 6.34% 7.54% 11.58% 10.89%

Goldman Sachs’ return on equity has been one of the highest over the last few years while JP

Morgan has typically trailed, though this trend appears to be changing. The sharp decline in

ROE seen in 2008 comes from one of two sources: in the case of Goldman Sachs and Morgan

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Stanley, quick de-leveraging pulled back their returns while JP Morgan saw their burden sharply

increase from -.22% to 1.01% from 2007 to 2008 causing ROA to fall. Bank of America had a

similar problem, though their situation was exacerbated by a decrease in the net interest

margin from 1.93% to 1.37% after allowing for losses on loans.

ROA

Industry GS JPM MS BAC 2008 0.13% 0.26% 0.19% 0.27% 0.33% 2007 0.93% 1.98% 1.53% 0.40% 1.55% 2006 1.33% 1.64% 1.34% 0.98% 2.36% 2005 1.30% 0.98% 0.82% 0.87% 1.73% 2004 1.30% 0.80% 0.42% 0.80% 1.42% 2003 1.40% 0.50% 0.67% 0.72% 1.10%

Similar to ROE, each company saw a sharp decline in ROA from 2007 to 2008. While conditions

are improving in 2009, companies are being forced to find more profitable lines of business to

give a boost to ROA.

Net Interest Margins

GS JPM MS BAC 2008 0.48% 2.60% 0.38% 3.35% 2007 0.45% 1.77% 0.33% 2.55% 2006 0.39% 1.43% 0.22% 2.56% 2005 0.35% 1.33% 0.44% 2.27% 2004 0.34% 1.13% 0.46% 2.07% 2003 0.36% 0.87% 0.36% 1.52%

Goldman Sachs and Morgan Stanley, as brokerage firms, have the tightest Net Interest Margins

(NIM) due to the amount of non-interest income and expenses they have. They are able to

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make up profits in securities trading and wealth management. JP Morgan, as an institution

leaning more on the commercial bank side, shows higher NIM than either Goldman or Morgan

Stanley while Bank of America, which leans mostly upon its commercial banking business, has

the highest net interest margins. This all makes sense and when comparing the two brokerage

firms, Goldman Sachs shows the most promise in its net interest margin.

$-

$5.00

$10.00

$15.00

$20.00

$25.00

$30.00

2002 2003 2004 2005 2006 2007 2008 2009

Eari

nin

g P

er

Shar

e

Historical Earning Per Share

GS

JPM

MS

BAC

54 | P a g e

The stock price and earnings data charts give a visual representation of volatility risks involved

with these stocks. The stock’s betas are displayed as follows:

Though Goldman Sachs appears to be the most volatile stock in the graph

above, the beta chart shows that Bank of America has historically deviated

more from the market than any of the other three stocks. Goldman Sachs

does have the most volatility if Bank of America is excluded, and according to this measure, is

riskier than the other two stocks. In addition, Goldman Sachs market exposure subjects it to

risks of market fluctuations to a greater degree than any of the other three stocks. Though

Morgan Stanley is a brokerage firm as well, it has followed the path of wealth management

rather than trading activities to bolster its returns. JP Morgan’s business is diversified to a

$-

$50.00

$100.00

$150.00

$200.00

$250.00

1/6/2003 1/6/2004 1/6/2005 1/6/2006 1/6/2007 1/6/2008 1/6/2009

Sto

ck P

rice

Stock Prices from 1/6/03 through 11/2/09

GS JPM MS BAC

Beta

GS 1.48 JPM 1.2 MS 1.37 BAC 2.66

55 | P a g e

degree that it is much less exposed to market fluctuations than Goldman Sachs. Bank of

America’s investments in Countrywide and Merrill Lynch cause its risk profile to increase with

regards to both market exposure and fixed income securities. This is likely why its volatility is

so high because a change in any number of economic factors could cause a loss for Bank of

America.

Goldman Sachs holds off-balance sheet derivatives far in excess of any of the three competitors

examined. This additional exposure to market risks should cause investors to pause. Although

many of the off-balance sheet liabilities are offset by assets, they are dependent on timing and

the direction of the markets. These items total $1.11 trillion in notional value and represent a

real risk hidden within Goldman Sachs’ books. As a percentage of total assets, this amount is

much higher than any other competitor, the next closest being JP Morgan with 472.12% of total

assets in off-balance sheet items.

Because of off-balance sheet items, higher securities trading volumes (particularly in the FICC

segment), and higher stock price volatility Goldman Sachs does have a higher risk profile than

Morgan Stanley or JP Morgan, though Bank of America’s purchase of Merrill Lynch and

Countrywide combined with its high beta likely make it the riskiest out of the bunch. That

being said, Goldman Sachs does have higher earnings potential per share than either of the

other competitors though the valuation analysis shows that this has likely already been priced

into the stock.

56 | P a g e

Conclusion

From a very auspicious beginning to a near-death during the Depression; from the IPO of an

automobile giant to a bleak future in the new century; Goldman Sachs has been able to prevail.

Goldman Sachs was able to take its volatility and high earnings per share and remain a steadfast

icon in the financial world while many firms were collapsing all around. The setbacks

experienced during the Financial Crisis of 2008 may have forced Goldman Sachs to make some

changes, but from almost every perspective, the firm has come out in a better position than

most others. Warren Buffett’s investment and the payback from AIG has only helped to secure

a better perception for the firm. Goldman Sachs is now poised to continue on to great things in

the future due to the determination of the current senior management team.

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