Goldman Sachs's SSG: Lending or Trading?

For Goldman Sachs's (GS) Special Situations Group, corporate disasters can be a source of some of the bank's biggest profits. Now the secretive operation, which invests in the debt and equity of troubled companies and in loans to high-risk borrowers, faces its own potential calamity. The group, known as SSG, could be put out of business by new rules in the Dodd-Frank financial reform law that seek to curb proprietary trading by banks.

Goldman Sachs has already shut two units that made bets with the firm's money because such trading by banks will be prohibited under the Volcker rule, named after former Federal Reserve Chairman Paul A. Volcker. Even so, SSG continues to make investments and named a new global head last month. Executives at the New York-based bank, including Chief Financial Officer David A. Viniar, have argued that SSG shouldn't be affected because it's more of a lending than a trading business. "It is proprietary trading, but the business can also be modified if you had to," says Brad Hintz, an analyst at Sanford C. Bernstein in New York. The question, he says, is "Where will the regulators draw the line?"

While SSG's results aren't published, the unit has been a major profit contributor at Goldman Sachs—the biggest in some periods, according to former SSG executives who asked not to be identified because they don't want to speak publicly about their former employer. Investing and lending, which includes SSG, proprietary trading businesses, and investments in hedge funds and private equity, generated 32 percent of Goldman's 2010 pretax profit, almost twice the profit from investment banking and money management combined, according to company reports.

Created during the late 1990s, SSG bought distressed assets in the aftermath of Asia's financial crisis and profited in the Enron bankruptcy, one former employee says. A gain on an investment in Accordia Golf, Japan's largest golf course operator, contributed about $500 million of revenue in the fourth quarter of 2006. Without SSG's profits, analysts say, Goldman Sachs would find it hard to match its historical returns. The bank's annualized return on average common shareholders' equity was 13.1 percent in the fourth quarter of 2010, down from 41.5 percent in the same period in 2006, company reports show.

Few of SSG's investments are public, making it tough to know what the division is doing. SSG is almost never mentioned in Goldman Sachs's regulatory filings or publications, and Viniar doesn't talk about it on quarterly conference calls unless asked. "Well, that's a group that you talk about more than we do," Viniar said on Dec. 16, 2008, in response to a query from Glenn Schorr, then an analyst at UBS (UBS).

Special Situations Investing Group, a legal entity that holds debt investments made by SSG, was included among creditors on a Jan. 5 forbearance agreement with lenders filed by Sbarro, a pizza chain based in Melville, N.Y., and owned by private equity firm MidOcean Partners. The bank wasn't an original lender to Sbarro, according to two members of the lenders' syndicate who asked not to be identified because they weren't authorized to speak. While Goldman Sachs didn't appear among creditors on two more recent agreements, including a Mar. 3 filing, a person at the firm familiar with SSG's investments says the unit still owns Sbarro debt. Michael DuVally, a spokesman for Goldman Sachs, says he can't comment on SSG's investments.

Richard M. Ruzika, 51, a former Goldman Sachs commodities trading chief and onetime New York Jets recruit, has run SSG since 2007. He is retiring from the firm at the end of April, according to a Feb. 17 memo obtained by Bloomberg News. Jason M. Brown, a Briton who has led SSG in Asia since 2007, will replace him and remain in Hong Kong, a separate memo said.

The future of Brown's unit will depend on how strictly the Volcker rule is interpreted. The provision aims to constrain banks that receive government backing, such as deposit insurance and access to Fed funds, from making bets that could produce significant losses. It would also limit the companies' investments in private equity and hedge funds. The Fed and other banking regulators must put the Volcker rule into effect by October.

There are unanswered questions that could leave an opening for SSG, say analysts and legal experts, including Roberta Karmel, a former member of the Securities and Exchange Commission who now teaches at Brooklyn Law School in New York. Can Goldman Sachs claim that purchasing debt makes the division a lender rather than a trader? If the unit holds its investments for months or years, do they cease to qualify as proprietary trading because the firm isn't seeking to "profit from near-term price movements," as the regulatory guidelines say? "These laws are too complicated, and they can find loopholes," says Karmel. "I don't know how strictly the regulators will be able to define proprietary trading."

Viniar said on an Oct. 19 call with analysts that the Volcker rule might not affect SSG because "the predominant part of that business is actually a lending business, which we think is not only O.K. under the rules but is actually something that's encouraged, because it obviously helps the economy grow."

Buying debt in the secondary market doesn't sound like lending to James D. Cox, a professor at Duke University School of Law in Durham, N.C. "I find it hard to think that they're just like the corner bank lending money to somebody in financial distress," Cox says. "This looks more like trading than it does any other activity, and it ought to be subject to Volcker requirements."

The bottom line: The survival of Goldman Sachs's Special Situations Group depends on how strictly regulators interpret the Volcker rule.

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