Blankfein Sees Parallels to 1994 Interest-Rate Increases

Goldman Sachs Group Inc. Chief Executive Officer Lloyd C. Blankfein warned that the interest-rate environment has parallels to 1994, when a sudden and sharp increase in rates caught many investors off-guard.

“I worry now -- I look out of the corner of my eye to the ‘94 period,’’ Blankfein, 58, said today at a conference in Washington sponsored by the Investment Company Institute. He recalled how investors got used to low interest rates and were shocked by losses when borrowing costs rose.

The Federal Reserve increased its benchmark rate 3 percentage points from February 1994 to February 1995, from a then record-low 3 percent to 6 percent. The yield on the 30-year U.S. Treasury bond surged above 8 percent in late 1994 from below 6 percent 12 months earlier. The rate increase and corresponding collapse in bond prices and stock markets caused losses for Wall Street trading desks and investors.

Goldman Sachs, which at the time was a private partnership, suffered a drop in its capital and raised $250 million by selling a stake in the firm to a Hawaiian trust. Partners exited the firm, including then-Chairman Stephen Friedman, who now serves on the company’s board.

The rate increase was something ‘‘you’d think in hindsight should have been expected,” Blankfein said, although it “really was stunning.”

Quantitative Easing

Since December 2008, the central bank has held its benchmark rate at between zero and 0.25 percent, a record. It has been buying Treasury debt and mortgage-backed securities to reduce the cost of longer term borrowing as part of a policy known as quantitative easing. Yesterday that Fed’s Open Market Committee said it is prepared to “increase or reduce” the pace of those purchases.

Blankfein said the Fed’s actions are “sensible” given the potential effects of deflation. While the risk of inflation in the longer term is more likely than deflation, deflation can be more devastating to the economy, he said.

“I’d be most afraid of the economy sliding back into a deflationary period,” Blankfein said. “Psychologically we are in a bit of a deflationary mindset,” as companies and investors hoard cash.

Gary Cohn, Goldman Sachs’s president and chief operating officer and a long-time deputy to Blankfein, said in February that he was concerned some investors don’t understand that bonds will lose value when interest rates eventually rise.

Inverse Correlation

“There is really only one way that interest rates can go,” Cohn, 52, said on Bloomberg Television’s “Market Makers” program on Feb. 11. “I’m concerned that the general public doesn’t quite understand the pricing of bonds and interest rates and the inverse correlation between the two.”

Charlie Himmelberg, head of Goldman Sachs’s credit and mortgage strategy teams, said in a research note last month that a repeat of the 1994 “bond massacre” is unlikely. He cited clearer Fed communication to the markets and reduced fears about the central bank’s ability to counter inflation.

“While the 1994 episode still usefully illustrates the dangers of becoming too complacent about rate risk, we think a policy surprise and resulting sell-off comparable to 1994 are much less likely in the current environment,” Himmelberg wrote. “And the lessons for risk markets are surprisingly benign.”

Falling VaR

Goldman Sachs’s value-at-risk related to interest-rates, a measure of the most it could lose on 95 percent of days, fell to $62 million in the first quarter, the lowest level in six years. Chief Financial Officer Harvey Schwartz said the overall decline in the firm’s VaR was largely because of lower market volatility.

Blankfein also said Goldman Sachs’s asset-management unit offers the potential for growth even if markets don’t improve, as the business tries to catch up to rivals four times its size. Building that division gets a “very, very high percentage” of his attention, he said.

“Asset management has the added advantage for us of being a business where we can still grow without just crossing our fingers and hoping the market itself gets bigger,” Blankfein said. “We try to grow our market share in investment banking, but how much are we going to grow our market share given we’re the No. 1 player, and the same thing in market making.”