Goldman Profits from the Downturn

With the economic outlook improving and bank stocks surging, the markets have bounced back a bit. If one company exemplifies the improving fortunes, it's Goldman Sachs (GS). Shares of the giant bank have almost doubled since March, adding $35 billion in market value.

But don't assume that a bet on Goldman is a bet that the "green shoots" of economic growth will soon turn into a bountiful harvest. Oddly enough, Goldman is in a position to collect the fattest profits if the recovery is slow and federal programs to shore up the banks falter—just the scenario many economists are predicting. The bank is "well positioned to capitalize on this new world" that's emerged since the collapse of Lehman Brothers, says David J. Winters, manager of the Wintergreen (WGRNX) fund and a Goldman shareholder.

How Goldman ended up in this advantageous spot is a study in foresight, shrewd maneuvering, and no small amount of luck. The question is whether CEO Lloyd Blankfein can keep it up.

For a sense of how sweet life is at Goldman, imagine you own the sole lumber yard that stayed dry in a town hit by a 100-year flood. Now as customers line up with fistfuls of money from relief programs, you can set prices at will. That's essentially Goldman's situation. Because it saw the subprime crisis coming and bet on the housing bust, it has emerged from the wreckage as arguably the strongest bond dealer in the world. It can mark up the prices on its inventory of bonds with impunity.

But Goldman also caught a break. Last September, in the heat of the market panic, investors and regulators began questioning whether Goldman (and rival Morgan Stanley (MS)) could survive. They thought Goldman would be safer as a commercial bank collecting deposits than as a freewheeling investment bank betting on the markets. With its stock plunging, Goldman converted itself from an investment bank under the purview of the Securities & Exchange Commission to a bank holding company under the Federal Reserve. Investors assumed Goldman would buy a big consumer bank to get deposits. They also assumed the Fed's tougher oversight would stop Goldman's traders from taking big risks. The firm's battered stock soon turned around.

And then nothing changed. By spring the panic had eased thanks to all the government money pouring into the markets. And Goldman found it could pretty much stick to its old ways. As revenues jumped in the first quarter, so did compensation—raising speculation that Goldman may pay out record bonuses this year. It still hasn't bought a consumer bank, and has no plans to do so. Why should it? The torpor has lifted so much that Goldman in April was able to sell $5.8 billion of stock and $2.1 billion of debt, proving it doesn't need to turn into an ordinary bank.


Spared from a dull future dependent on deposits, Goldman's traders have been risking more of the firm's money than ever before. Goldman's so-called value-at-risk, a measure of how much money the firm could lose in a single day, jumped 22% during the first quarter—a record high. The surge has raised suspicions that Goldman's swelling profits in recent months were attributable more to gambling than to a new, prudent style of trading. Colm Kelleher, the chief financial officer of rival Morgan Stanley, referred to Goldman's appetite for risk when he told analysts in April, "We did not see ... the sort of opportunities that others may or may not have seen."

Yet while Goldman was taking more risks behind the scenes, it was making public moves to restore the confidence of investors and regulators. The firm unloaded many of its troubled assets, including junk corporate loans and commercial real estate bonds. And much of what it didn't sell it wrote down in value, reassuring investors that the firm isn't hiding big losses.

In short, the bank has steered skillfully through the storm thus far, adding risk here, dialing it back there—and collecting big profits. "That's how you have to run these businesses," says Robert Lee, analyst at Keefe, Bruyette & Woods (KBW). "You have to be opportunistic, but you have to be careful."

Now Goldman is in the unusual position of benefiting from a slow recovery. A plodding economy will keep competitors weak and allow Goldman to book big bond-trading profits. For that reason it's better for Goldman if the U.S. rescue programs don't work and rivals remain hampered by bad assets, says analyst Roger A. Freeman of Barclays Capital (BCS). After all, zombie banks aren't much of a threat.

Eventually, of course, competitors will return, offering better bond prices and taking some of Goldman's market share. They'll also hasten to mimic Goldman's aggressive trading style, cutting into the firm's profits.

Even if that doesn't happen right away, there's the potential that Goldman's traders will become so overconfident that they'll blow the opportunity all by themselves. It has happened before. In 1998, Goldman was beaming over past success and preparing to go public when it suddenly suffered big trading losses and postponed the IPO. Goldman managing director Lucas van Praag says overconfidence isn't a problem. "We don't take anything for granted," he says. "This organization is populated by individuals who are obsessed about not screwing up."

If Goldman sticks to that way of thinking, it could pull off a rare trick for the industry: not only surviving but thriving during a tepid recovery.

    Before it's here, it's on the Bloomberg Terminal.