Goldman Model Championed by Blankfein Planted Seeds of Distress
The window shades were lowered to block out the sunlight soaking lower Manhattan on a Friday afternoon in June as 14 students in Eric H. Kessler’s executive MBA class gathered in a conference room to present their analyses of Goldman Sachs Group Inc. (GS)’s leadership.
The firm’s management shows “resistance to change” and is “doing business in a bubble,” one of the three student teams explained in a PowerPoint presentation. Another recommended creating an “ethics role” within Goldman Sachs’s securities division. Kessler, who teaches management at Pace University’s Lubin School of Business, peppered the students with questions. Could cohesive culture be a weakness as well as a strength?
Such critiques have been rare in Goldman Sachs’s 142-year history. The company’s status as Wall Street’s most powerful and profitable securities firm -- with a leadership that produced two U.S. Treasury secretaries -- has lured top students from Ivy League business schools. After financial markets collapsed in 2008, driving Goldman Sachs and rivals to accept taxpayer aid, the investment bank became the most vilified on Wall Street.
Bungled public relations and a thirst to find a scapegoat for the worst U.S. economic crisis since the Great Depression may explain some of the shift in the firm’s reputation under Chairman and Chief Executive Officer Lloyd C. Blankfein. The mistrust and waning investor faith in the company’s prospects are rooted in something more fundamental: Blankfein’s reliance on trading and investing the bank’s own capital to reap profits, even if that meant sometimes competing with clients.
“The idea that you can manage what is a tremendously conflicted array of relationships is ridiculous,” said Michael C. Aronstein, a 32-year Wall Street veteran and president of New York-based Marketfield Asset Management LLC. “That’s exactly at the heart of it.”
Blankfein’s business model was ideal for a period of high leverage and low regulation, producing average annual profits more than double those achieved under his predecessor, Henry M. Paulson. As new capital rules and limits on proprietary trading take effect, those profits will be harder to achieve, said analysts including Fiona Swaffield of RBC Capital Markets.
“Goldman Sachs’s business model faces significant challenges in a post-crisis world,” according to a June 13 investor note by RBC analysts led by Swaffield, who’s based in London and rates the stock “underperform.”
David Wells, a spokesman for Goldman Sachs, declined to comment or make Blankfein available for an interview.
Return on Equity
In the first half of 2011, as trading revenue dropped 25 percent, Goldman Sachs’s return on equity slumped to 8 percent, or 10 percent excluding the cost of repurchasing preferred stock from Warren Buffett’s Berkshire Hathaway Inc. That’s down from 13 percent in the first half of last year.
“Our normal desire is to get to 20 percent; I think it’s going to be very tough in this environment,” Chief Financial Officer David Viniar said on July 19 after the firm reported second-quarter net income that fell short of analysts’ estimates. “I’d be surprised if we did that this year.”
With its business practices under scrutiny by the U.S. Securities and Exchange Commission and the Senate Permanent Subcommittee on Investigations, Goldman Sachs is fighting to maintain the trust of clients. The firm paid $550 million last year to settle an SEC lawsuit alleging it duped buyers of a 2007 mortgage-linked investment. The Senate subcommittee’s bipartisan report on the crisis, under review by the SEC and Department of Justice, accused the bank of misleading customers.
While Goldman Sachs didn’t admit or deny wrongdoing under the SEC settlement, the largest ever by a Wall Street firm, the company said it made a “mistake” in its marketing materials about the investment.
‘Wall Street Shark’
After writing a history of Goldman Sachs that was published in April, William D. Cohan described the firm in a Bloomberg Television interview as “the perfect embodiment, the ultimate evolution, of the Wall Street shark.” A poll of Bloomberg subscribers in May found 54 percent had an unfavorable view of Goldman Sachs, more than any other major Wall Street firm.
Jay W. Lorsch, a Harvard Business School professor, said the bank’s focus has shifted toward “more immediate greed” from long-term gains because Blankfein and many of his deputies come from a trading background instead of investment banking. Lorsch, who helped run an education program for new Goldman Sachs partners in the late 1980s, is “probably the world’s expert on governance,” said his Harvard colleague and Goldman Sachs board member William W. George.
“Goldman now needs to be more thoughtful about how they are perceived,” Lorsch said. “Lloyd needs to be careful in public pronouncements and testifying before Congress. Lloyd is coming across looking pretty greedy himself.”
Goldman Sachs has dropped 7.4 percent to $135.58 from its closing price of $146.49 on June 28, 2006, the day Blankfein became CEO. Under Paulson, the stock almost tripled from an initial public offering price of $53. The Standard & Poor’s 500 Financials Index has fallen 51 percent during Blankfein’s tenure as CEO after rising 17 percent while Paulson led Goldman Sachs as a public company.
The firm also slipped to second place advising on announced corporate takeovers in 2009 and 2010 after eight years in the top spot, according to data compiled by Bloomberg. Goldman Sachs has regained the No. 1 position so far this year, the data show.
Shareholders have continued to back Blankfein, re-electing him to the board at the annual meeting on May 6 with 97 percent of the vote. Blankfein said at the meeting that he had no plans to step down, and the firm has declined to comment on his eventual successor.
East New York
Blankfein, 56, who grew up in a public-housing project in the East New York neighborhood of Brooklyn, was only 16 when he went to Harvard College. He later graduated from Harvard Law School and worked as a tax lawyer before beginning his Wall Street career in metals sales. From there, he ascended the ranks of Goldman Sachs’s trading division, which became the firm’s profit engine under Paulson.
Blankfein’s top deputy, President and Chief Operating Officer Gary D. Cohn, has worked with him since their days at Goldman Sachs’s commodities-trading division, J. Aron & Co.
That gives them a different approach to the business than some former leaders, such as John C. Whitehead or Paulson, whose focus was on persuading corporate executives to hire Goldman Sachs as an investment banker on takeovers or financings, Marketfield’s Aronstein said.
“The people who ran Goldman back in my early days had a banking background,” he said. “They built that business on the basis that if you hired them, you would be part of the team that won. The commodity business is completely different. You have to guess whether you’re somebody’s customer or their prey.”
As high-flying technology stocks crashed and the mega- mergers of the late 1990s faded away, Goldman Sachs’s investment-banking revenue plunged to $2.71 billion in 2003 from $5.37 billion in 2000. Meanwhile, revenue from trading and principal investments, which include the firm’s own stakes in companies and real estate, surged to $10.4 billion from $6.63 billion. On Dec. 18, 2003, Goldman Sachs said that Blankfein, the vice chairman who was responsible for trading and principal investing, would become chief operating officer, putting him in line to succeed Paulson.
By the end of fiscal 2005, trading and principal investments accounted for two-thirds of Goldman Sachs’s revenue. After Paulson left to become Treasury secretary under President George W. Bush, the company’s trading revenue and profit shattered Wall Street records in 2006 and 2007. Blankfein’s $67.9 million bonus for 2007 made him the highest-paid securities-firm CEO ever.
“They went to a model that said, ‘Look, we’re making money from all these people with all these different things we do, let’s start trading for ourselves and therefore we make more than just commissions and fees, we make capital gains,’” said Ted Kaufman, who stepped in for Vice President Joseph Biden as a Delaware senator and served on the investigations subcommittee.
In his 2008 book “The Partnership: The Making of Goldman Sachs,” Charles D. Ellis wrote that Paulson, not Blankfein, initiated the shift toward acting as a principal investor as well an agent for clients. Paulson countered resistance from clients and some senior partners by saying that Goldman Sachs would become a more effective adviser if it also invested its own money, Ellis wrote.
Revenue from Goldman Sachs’s principal investments, which include the firm’s direct stakes in companies and real estate as well as holdings in hedge funds and private-equity funds, surged to $2.23 billion in 2005 from $566 million two years earlier, company reports show.
‘Spank From Hank’
In April 2006, two months before leaving the firm, Paulson sounded a note of caution. He admonished senior managers at Goldman Sachs that they must keep in mind the “perception” of the firm’s actions, Lucas van Praag, a company spokesman, said at the time.
The warning followed an unsolicited approach by Goldman Sachs bankers to buy BAA Plc less than two months after they offered to help the U.K. airport operator fend off a takeover offer from Spain’s Grupo Ferrovial SA (FER), people familiar with the matter said. The “spank from Hank,” as it was dubbed in a Financial Times column, was an effort to remind bankers about the risks of perceived conflicts of interest.
“In addressing conflicts, there is another issue at play: public perception. Does it appear appropriate?” Paulson said in an April 2006 interview with the Wall Street Journal. “We are increasingly aware of that.”
Once Blankfein was CEO, he set about building Goldman Sachs’s private-equity and hedge funds, which sometimes got as much as 30 percent of their money from the firm and employees, as well as direct, principal investments. Revenue from principal investments hit records of $2.82 billion in 2006 and $3.76 billion in 2007.
Goldman Sachs’s January 2006 investment in Industrial & Commercial Bank of China Ltd., China’s largest bank by market value, produced a $949 million gain when ICBC went public nine months later. The company, which alongside its own private- equity funds paid $2.58 billion for a 7 percent stake in ICBC, reaped $3.5 billion in mostly paper profits in the ensuing four years. Goldman Sachs-managed funds and employees who invested in them also had gains.
In a November 2006 investor presentation, Blankfein explained how the bankers’ relationships were increasingly becoming the gateway to investment opportunities.
A slide accompanying his presentation provided examples of companies in which Goldman Sachs funds or the firm itself had made investments, including ICBC; South Korea’s Hana Bank; Aramark Corp., a Philadelphia-based provider of food services; German department-store owner KarstadtQuelle AG; Japan’s Sanyo Electric Co.; and Kinder Morgan Inc., then the biggest U.S. natural-gas pipeline operator by market value.
“While clients seek us out because they trust us as an adviser and they want our skills at managing complex transactions, they also value our long-term involvement as an investor,” Blankfein said. “Over the long term, principal investing has proven to be a successful and profitable business, benefiting in many ways from our investment-banking franchise.”
Blankfein illustrated the trend with the firm’s role in the $15 billion management buyout of Kinder Morgan. Goldman Sachs advised Kinder Morgan’s management on structuring the transaction, underwrote the debt financing, and its private- equity funds invested alongside management, he said.
Kinder Morgan investors, including Goldman Sachs and buyout firm Carlyle Group, raised $2.9 billion in February by selling to the public 95.5 million shares, or 13.5 percent of the company, at $30 apiece. The stock dropped to $28.51 yesterday in New York, giving the company a $23 billion market value.
In April 2007, less than a year after Paulson cautioned partners about the firm’s image, Goldman Sachs announced that its newest private-equity fund had raised $20 billion, including $9 billion from Goldman Sachs and its employees. The new fund was a record at the time, eclipsing buyout firms like Blackstone Group LP (BX), Carlyle and KKR & Co. Four months later, Blackstone overtook Goldman Sachs with its own $21.7 billion fund.
KKR co-founder Henry Kravis, after an April 2007 speech in New York, was asked how he felt about investment banks such as Goldman Sachs competing in the private-equity business.
“I had a problem with it because here we are giving them a lot of business, and they’re turning around and competing with their customer,” Kravis said. “It’s their prerogative, and it’s our prerogative, too, to give business or not to give business. So we said, ‘God bless you, if that’s what you want to do, that’s fine.’”
Goldman Sachs wasn’t among the banks chosen to lead Blackstone’s IPO that year and hasn’t managed offerings of KKR stock since 2006, according to data compiled by Bloomberg. The firm has invested in deals alongside both buyout firms and has also provided financing.
Along with private equity, Goldman Sachs’s ballooning trading risk and revenue contributed to record profits in 2006 and 2007. Value-at-risk, a measure of how much the firm estimated it could lose in a single day of trading, almost doubled to an average of $138 million in 2007 from $70 million in 2005, a steeper climb than the 53 percent rise in shareholder equity. Included in that were bets for the firm’s own account.
“Under Blankfein, they moved the model toward more of a proprietary-trading operation to improve returns,” said Charles Peabody, an analyst at Portales Partners LLC in New York, who has a “hold” recommendation on Goldman Sachs. “That’s where the conflicts come up, or the potential conflicts.”
Goldman Sachs’s Special Situations Group, which buys distressed debt and other assets with the company’s own money, was the largest source of revenue in the fixed-income, currencies and commodities division during 2006 and 2007, according to a Goldman Sachs document released by the U.S. Senate this year.
SSG produced $4.1 billion in 2007, or 9 percent of the firm’s revenue, and $3.79 billion in 2006, or 10 percent, the document shows. The unit produced more revenue than currency and interest-rate trading combined.
The firm was also making proprietary bets on at least two other desks -- the “global macro” team that speculated on currencies and interest rates and the principal-strategies team that focused primarily on equities. Goldman Sachs hasn’t disclosed revenue from those teams. Both were closed in the past year because of a new U.S. regulation known as the Volcker rule, which limits such proprietary trading by banks.
‘Don’t Trust Goldy’
With trading and principal investing contributing 68 percent of the company’s 2007 revenue, compared with 9 percent from advisory fees, some clients questioned whether they could count on Goldman Sachs to provide unbiased counsel.
“We always need to worry a little about Goldman because we need them more than they need us, and the firm is run by traders,” Todd Baker, then-executive vice president for corporate strategy and development at Washington Mutual Inc., wrote in an October 2007 e-mail to Kerry Killinger, CEO at the time. Killinger, in considering whether to hire Goldman Sachs for advice on transferring credit risk off of WaMu’s balance sheet, wrote back, “I don’t trust Goldy on this.”
WaMu hired Goldman Sachs after all, less than a year before the Seattle-based bank failed and was taken over by regulators, who sold it to JPMorgan Chase & Co. for $1.9 billion.
Before asset prices began plunging in 2008, this distrust was mostly expressed in private e-mail exchanges and conversations. After the meltdown, it came out in the open.
“There was an underlying suspicion that Goldman did play in the gray areas, and I’ve spoken to a number of clients who finally did leave Goldman or refuse to do business with Goldman because of that concern,” Peabody said, declining to name any.
Blankfein, at first admired for posting record profit in 2007 as rivals began losing money on subprime-mortgage bets, came under scrutiny after the financial system unraveled in 2008 and even Goldman Sachs received government support including Federal Reserve loans, debt guarantees and $10 billion of capital from Treasury that it later repaid.
While Morgan Stanley executives promised to reduce the firm’s proprietary trading and principal investing and refocus on lower-risk businesses such as wealth management, Blankfein stuck to his strategy.
“We are not forsaking our position as a pre-eminent adviser, financier and co-investor as we pursue additional opportunities as a bank holding company,” Blankfein told investors in New York in November 2008. “We won’t stop doing the things that made us a leading investment bank.”
Instead of cutting its bets, Goldman Sachs doubled down. In the first six months of 2009, the firm’s average value-at-risk and trading revenue soared to all-time highs. The company set aside a record $11.4 billion to pay workers in the first half of 2009, enough to give each $386,429 for six months’ work.
“Is it just going to be business as usual with Goldman Sachs and much of the rest of the financial industry?” Senator Sherrod Brown, an Ohio Democrat, said at the time.
A July 2009 article in Rolling Stone by Matt Taibbi struck a nerve when it labeled Goldman Sachs “a great vampire squid wrapped around the face of humanity” and accused the firm of profiting from creating asset bubbles over its history.
Blankfein has made changes. The firm reduced compensation and increased philanthropic giving in late 2009 in response to the negative reaction.
Viniar told analysts in March 2008 he didn’t agree with rivals who thought the collapse and sale of Bear Stearns Cos. meant Wall Street’s leverage had to drop. Within months, Goldman Sachs began reducing its ratio of assets to equity. Total assets fell to $849 billion at the end of 2009, or 12 times the firm’s $70.7 billion in shareholder equity. That was down from $1.12 trillion, or 26.2 times the $42.8 billion in equity at the end of November 2007.
Goldman Sachs shut two proprietary trading desks after the Dodd-Frank Act’s Volcker rule prohibited such activities. The rule, which also limits the firm’s investment in private-equity and hedge funds to no more than the 3 percent of the funds, will force Goldman Sachs to pull investments like the $9 billion it contributed to the $20 billion buyout fund raised in 2007.
Viniar downplayed the importance of proprietary trading and investments in January 2010, after President Barack Obama embraced the Volcker rule. He said proprietary trading that has no connection to clients contributed an average of 10 percent to revenue -- a figure one former partner said he never believed.
The SEC’s lawsuit in April 2010, which came as Congress was debating Dodd-Frank, focused attention on Goldman Sachs’s creation of the Abacus synthetic collateralized debt obligations that had enabled clients and Goldman Sachs to use derivatives to wager against subprime mortgages.
E-mails included in the SEC’s complaint showed Goldman Sachs Vice President Fabrice Tourre, a co-defendant, e-mailing a friend in January 2007 about “these complex, highly leveraged, exotic trades he created without necessarily understanding all the implications of those monstruosities!!!”
When Blankfein, Tourre and other employees and former employees tried to defend the CDOs and trading as providing an essential market-making service at a Senate hearing on April 27, 2010, senators said the firms’ activities looked more like gambling and duping their own clients.
“In hindsight I wish we had not done some of those things,” Blankfein said in a television interview with Charlie Rose three days later. He also said “the firm is guiltless.”
Kaufman, the former Delaware senator and a 1966 graduate of the University of Pennsylvania’s Wharton School of Business, said he knows people who work for Goldman Sachs and had always viewed the company as a “first-class operation.” He said he was “appalled” by Blankfein’s testimony and the information amassed by the subcommittee on how the firm treated customers.
“I couldn’t believe it was the same firm,” Kaufman said. “What they basically said, which was legal -- but as a customer, you’ve got to say I don’t want to touch these guys -- was that as a market-maker I can sell you a product at the same time I’m betting it’s going to go south.”
Blankfein established a business-standards committee composed of employees to investigate how it could improve its conduct. The feedback the committee received from clients surprised and disappointed some senior executives, including Blankfein, said a partner at the firm. The reason: Several investors who are clients of Goldman Sachs’s sales-and-trading division said they didn’t feel they could trust the firm to treat them fairly, the person said.
After eight months, the committee issued a report containing 39 recommendations. One was to provide clients with “plain language” explanations about how the firm manages conflicts of interest, “including describing activities we may continue to conduct while we are advising or financing a particular client.” The firm also changed the way it reports its financial results.
That change allowed investors to see for the first time how much revenue came from principal investments, proprietary trading and a smaller category of lending. While that so-called Investing & Lending segment contributed just 6 percent of revenue in 2009, it jumped to 19 percent in 2010.
Analysts and investors say that segment will shrink as Volcker rule restrictions are phased in. The Basel Committee on Banking Supervision will also require banks to hold more capital against the types of illiquid investments and high-yield loans that dominate the Investing & Lending unit’s assets, making it harder to achieve a worthwhile return.
In its 12 years as a public company, Goldman Sachs has promised investors a 20 percent return on tangible equity throughout the economic cycle. The firm stopped providing such a target late last year. In her note, RBC’s Swaffield said the stock price was consistent with an 11.8 percent return on tangible equity.
“Given the regulatory pressures facing investment banking, this is more appropriate,” the note said.
Revenue from trading fixed-income, currencies and commodities plunged 63 percent in the second quarter from the previous three-month period, more than double the decline at rivals like JPMorgan, Citigroup Inc. and Bank of America Corp. Viniar said the decline resulted from the firm’s decision to reduce risk-taking and wasn’t a sign that clients were executing fewer transactions with Goldman Sachs’s traders.
The company’s 2009 annual SEC filing added an item to the “risk factors” investors face. “We may be adversely affected by increased governmental and regulatory scrutiny or negative publicity,” the firm said.
Such adverse effects were evident at the start of this year, when Blankfein returned to the model he used in the Kinder Morgan and ICBC investments, putting $375 million of the firm’s own money in Facebook Inc. and pitching as much as $1.5 billion of stock in the closely held social-networking company to wealthy investors.
While the move was classic Blankfein, the reaction it received after the financial crisis couldn’t have been more different than four years earlier. After a flurry of positive coverage, media reports focused on conflicts inherent in the deal: Goldman Sachs’s investment had better terms than other investors would get; one of the company’s funds had rejected the deal; and the sale skirted securities rules forcing companies with more than 499 investors to meet SEC reporting requirements.
“Oh, Goldman, is there any regulation’s intent you can’t subvert?” comedian Jon Stewart said on “The Daily Show.”
‘Intense Media Attention’
On Jan. 17, two weeks after the New York Times reported details of the deal, Goldman Sachs stopped offering the stock to U.S. investors. The firm said in a statement that “intense media attention” may violate rules limiting marketing of private securities. The company completed the sale by offering the stock to non-U.S. clients.
“The reason that got so much attention was because they’re Goldman, and if you just look at it from the outside it looks like there are all sorts of conflicts,” said Roger Freeman, an analyst at Barclays Capital in New York. “So like a lot of things you wait until people start focusing on other stuff and then you go back about your business.”
In their recent presentations to investors, Goldman Sachs’s managers haven’t been emphasizing the advise-finance-invest model. Instead, they’re touting the firm’s technology investments and their efforts to be “Goldman Sachs in more places,” focusing on efforts to expand in developing countries such as Brazil, Russia, India and China.
The strategy in those countries doesn’t necessarily represent a change in the firm’s model. In Russia, for instance, Goldman Sachs has won business by spending $1 billion buying stakes in 15 companies since 2007, Christopher M. Barter, co- head of the firm’s Russian business, said in a May 12 interview.
Blankfein has put a positive spin on the Volcker rule, which requires Goldman Sachs to reduce its investment in private-equity funds to no more than 3 percent, down from 15 percent to 30 percent the firm has contributed previously.
While the bank will stop reaping the kinds of gains those investments produced in recent years, it will also be shielded from losses delivered in weak markets, making results less volatile, he said at an investor presentation in New York on Nov. 16. Instead of generating revenue by investing company capital, Goldman Sachs will get fees for managing the funds, improving the return on equity, he argued.
“These activities have more volatile revenue streams and are subject to higher capital requirements than many of our other businesses,” he said. “As a result, limiting these activities will likely reduce the firm’s capital requirements and revenue volatility.”
That means Goldman Sachs will depend more than ever on clients’ willingness to entrust their money to funds overseen by Goldman Sachs Asset Management, a division that has suffered from mediocre performance and client outflows. Management has made fixing that business a priority.
Clients pulled $15 billion from Goldman Sachs’s asset- management division in the first six months of 2011 after taking out $71 billion last year, company data show. Morgan Stanley’s asset-management business took in $17.1 billion from clients in the same period, after clients took out $5.7 billion in 2010, the New York-based bank reported.
Asset management is the one area that has suffered “collateral damage” from the investigations and reputational problems at Goldman Sachs, said Barclays Capital’s Freeman. Some pension funds are reluctant to invest in a company that’s being investigated by the Department of Justice and the Manhattan District Attorney, he said.
Other businesses have remained strong. In addition to regaining its No. 1 position advising on mergers this year, the firm has also climbed to the top worldwide position in managing equity and equity-linked offerings after dropping to second or third place in the past four years, according to Bloomberg data. Goldman Sachs’s strong showing in takeover advice and equity offerings is a sign the firm has kept its status within corporate boardrooms, Peabody noted.
“The fact that Goldman continues to do very well in those two product areas shows that CEOs value their intellectual capital very highly,” he said.
Still, investors may wonder whether Blankfein, who devised a strategy that helped make Goldman Sachs the most profitable and scrutinized firm on Wall Street, is the best leader to adapt to a new regulatory landscape.
Aronstein, who said he doesn’t own Goldman Sachs shares or do business with the firm because he lacks faith in its model, doubts Blankfein and his team will change their strategy.
“When people are in a position where conflicted relationships are extremely lucrative and have created a monumentally nice lifestyle, they don’t just give that up,” he said. “It’s very easy to write and it sounds great: ‘The customer’s always right.’ Until he gets in our way.”
That concern was reflected in some of the questions that Kessler, the business professor at Pace University, asked his students after their presentations in early June.
“You can be too cohesive, you can have too strong a culture and that’s this concept of groupthink,” Kessler said in an interview afterwards. “Groupthink kind of skews your judgment a bit, but at the same time makes you more confident in that skewed judgment.”
There was a glimmer of hope for Blankfein in the dark conference room after the last team of Kessler’s students finished their presentation. The five members agreed that current management would be able to undertake the changes needed at Goldman Sachs.
All of them said they’d love to work at Goldman Sachs.
To contact the reporter on this story: Christine Harper in New York at email@example.com