Critics say capital cushions at firms like Goldman are a drag on profits, and healthy banks need more leverage
Barely a year after Lehman Brothers toppled under the weight of its own debt, Wall Street is calling for some players to load up again. Analysts say Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan Chase (JPM), and other relatively healthy firms are holding too much capital—an overly cautious stance that's costing shareholders billions of dollars in profits.
It's a tricky balancing act. Banks, which set money aside to protect against losses, have more capital than regulators require. They would love to use some of that extra cushion to boost dividends, buy back shares, or borrow more money to invest. But the economy and credit markets remain fragile. And the Obama Administration wants to raise the capital requirements. "You've got two opposing forces: the regulator turning the screws, and investors saying you need more leverage," says a financial lobbyist.
How this tension between Washington and Wall Street plays out will influence whether the financial system takes on too much or too little risk, a critical factor in a recovery. If the pendulum swings too far in the risky direction, the banks may not be able to withstand another round of losses, a shock that could send the economy into a downward spiral. If it swings too far in the other direction, the banks may starve the economy of the credit it needs to grow.
The tension is most palpable at Goldman. Critics have slammed Goldman's aggressive trading style, which produced outsize profits in recent quarters. But when it comes to capital and leverage, Goldman has actually been quite prudent. And in the firm's latest conference call, 7 out of 17 analysts pushed management to bolster risk on the balance sheet. "There's a broad belief among investors that they are running with higher levels of capital than they need," says Roger A. Freeman, an analyst at Barclays Capital (BCS). Goldman declined to comment.
The conservative posture crimps profits. Consider Goldman's mix of assets. The firm has $171 billion, 19% of assets, in cash and highly liquid investments. The pile protects the firm in case of a panic but yields next to nothing. And it's double the stash that Goldman has had in the past. If the firm moves just $70 billion into securities earning 2%, it could boost annual profits by 5%, or $500 million, according to a report by Guy Moszkowski, an analyst at Bank of America Merrill Lynch (BAC).
Then there's the firm's leverage. By loading up on short-term debt and investing the proceeds in higher-yielding securities, banks can amplify their profits. Goldman currently owns $14 of assets for every $1 of capital, or 14 times its capital—roughly in line with peers. Nobody is saying Goldman and others should borrow to the max the way they did during the boom, when assets topped 25 times capital. But during more typical years, the figure has hovered around 20 for Goldman. Moszkowski figures the firm could add $2 a share to profits with an extra dose of leverage.
Despite its recent strong showing, Goldman needs to pump up profits. The firm has committed to delivering a 20% return on equity (a measure of profitability) over each business cycle. Historically, it has been able to meet the target, ensuring a lofty share price and loyalty from employees, who receive a lot of their pay in stock. But earnings sank in 2008, and Goldman fell way short of its goal. To offset the weak performance, it needs some bonanza years. The easiest way? Ramp up risk.
But Goldman may be constrained by the credit markets. The bank, like its peers, can't easily borrow unless creditors have faith in its ability to repay the money. Those banks, debt investors, and other creditors can be capricious, willing to lend one moment and reluctant the next. For example, the price of Goldman's credit default swaps, essentially insurance policies against default, shot up in August after falling for five months. It's a sign, says Tim Backshall of Credit Derivatives Research, that creditors may be spooked about the prospect of rising leverage.
Washington is another big obstacle. In a June report, the Treasury Dept. called for stronger "capital and other prudential standards." A committee is expected to recommend changes by January. The biggest banks will have "to meet stronger capital and liquidity requirements so that they're more resilient and less likely to fail," President Barack Obama said at the time.
Goldman doesn't seem willing to provoke the ire of Washington. In the July conference call, Goldman Chief Financial Officer David A. Viniar told analysts: "We don't know what the [new regulations] will be, so we'll have to wait and see." It's a sentiment echoed across the industry. Michael J. Cavanagh, CFO at JPMorgan, lamented in a call that the bank didn't need the $5 billion the government forced it to raise as a condition of repaying the bailout funds. Morgan Stanley CFO Colm Kelleher told analysts: "We have internal targets [for leverage], but I can't give [them] because I'm really subject to what my regulators would like me to do."
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The Fed's Problem
The Federal Reserve is on a spending spree, reports Heidi N. Moore, a contributor at The Big Money, a Web site. In the past four weeks alone, the central bank has purchased $67 billion in mortgage securities, helping create demand in the market. But with so much bad debt on its books, the Fed "may be in over its head."
To read the full column, go to http://bx.businessweek.com/federal-reserve/reference