New York | Last week we almost welcomed the news that the Securities and Exchange Commission had accused Tesla Motors (TSLA) founder Elon Musk of securities fraud. This is not because we hold any ill will towards Mr. Musk, but rather because news of the SEC action provided some relief from the political spectacle that dominated the past week. Speaking of real news, we were on CNBC Monday to talk financials with Brian Sullivan (below).
Fortunately Mr. Musk was smart enough to cut a deal to settle the SEC charges on the following day, but that changes little for the hapless shareholders of TSLA. After years of false promises and worse, TSLA seems headed for a reckoning as a dearth of liquidity forces more difficult decisions. Access to liquidity provides time and protects control. As we said on Twitter over the weekend, the bond holders of Tesla own the company — regardless of whether Musk is an officer of the company or not.
But moving on to more promising considerations, we return to the question of the evolution of Goldman Sachs (GS) from securities dealer to commercial bank as the firm prepares to go through a leadership change. The leadership transition process at Goldman is not unlike a reptile shedding its skin. The century old firm gains a glossy veneer, a new outer shell, but inside the operational machinery of financial chicanery remains unchanged. Does it matter whether Lloyd Blankfein or David Solomon sit at the top of the house built by Marcus Goldman or Samuel Sachs? Not really. After all, the culture of Goldman Sachs is bigger than any single person.
Goldman has always been a firm that seeks unique opportunities at the edge of propriety and often at the expense of clients and counterparties. Between July 2004 and May 2007, according to the Financial Crisis Inquiry Commission, GS packaged and sold $73 billion in synthetic collateralized debt obligations (CDOs) that referenced subprime mortgages. When the subprime loan market and related derivatives began to collapse, Goldman deliberately sought to shift its exposure to its clients.
“Despite the first of Goldman’s business principles—that ‘our clients’ interests always come first’—documents indicate that the firm targeted less-sophisticated customers in its efforts to reduce subprime exposure,” the FCIC concluded with considerable understatement. In the Abacus 2004-1 CDO, the FCIC reported, GS earned nearly $1 billion while “long investors lost just about all of their investments.”
As we’ve noted previously in The Institutional Risk Analyst (“Is Goldman Sachs Really a Bank? Really?”), GS is not so much a commercial bank as much as a large broker dealer with a small depository attached. In the decade since GS involuntarily converted its Utah non-bank industrial loan company into a commercial bank, and thereby came under the supervision of the Federal Reserve Board, the firm has become less innovative, if that is the right word. But the core competency of the firm remains informational arbitrage combined with all of the magic of derivatives and structured finance.
For example, GS makes half the interest income of other large banks on its almost $1 trillion in total assets, just shy of 2% vs over 4% for the 119 members of Peer Group 1. GS is in the 90th percentile in terms of interest expense vs earning assets, a reflection of the bank’s tiny deposit base and dependence upon costly market funding. Of note, GS saw its cost of funds rise 68% year over year as of June 30, 2018, according to the latest FFIEC performance report, following the disturbing trend in the US banking industry of rising funding costs that we have highlighted previously.
Indeed, when pondering the future under incoming CEO Solomon, ask yourself how much is Goldman Sachs willing or able to change its culture. To us, the first question facing Solomon and his colleagues on the board of GS is whether the company ought to reverse the 2008 decision to become a bank holding company and return to being a broker dealer that owns an industrial bank domiciled in Utah. If Goldman is to remain a trading firm, rather than a full service depository, then this would be the logical course of action.
For many years, there has been a lot of talk at GS about growing the existing bank’s business, but this has not materialized in assets, revenue and earnings. Just as Elon Musk has promised electric cars for his clients, GS has promised banking revenue for its shareholders. The bank was even given a name – Marcus – after firm co-founder, Marcus Goldman.
GS has always been better at formulating investment schemes to deprive the less astute of their hard earned savings than lending them money for some productive purpose. Consider the Shenandoah and Blue Ridge investment trusts of 1928, a precursor of the derivatives mess at American International Group (AIG) in 2008.
John Kenneth Galbraith in his essential book “The Great Crash 1929” wrote that Goldman’s nearly simultaneous promotion of Shenandoah and Blue Ridge in 1928 “was to stand as the pinnacle of new era finance. It is difficult not to marvel at the imagination implicit in this gargantuan insanity.”
Galbraith immortalized the subsequent 1932 exchange between Senator James Couzens of Michigan and Samuel Goldman, the co-founder of the firm, during hearings on the market crash:
Senator Couzens: Did Goldman Sachs organize the Goldman Sachs Trading Corporation?
Mr. Sachs: Yes, sir.
Senator Couzens: And it sold stock to the public?
Mr. Sachs: A portion of it. The firms invested originally in ten percent of the entire issue for the sum of $10,000,000.
Senator Couzens: And the remaining 90 percent was sold to the public?
Mr. Sachs: Yes, sir.
Senator Couzens: And at what price?
Mr. Sachs: At $104. That is the old stock… the stock was spit two for one.
Senator Couzens: And what is the price of the stock now?
Mr. Sachs: Approximately $1¾.
The fraud perpetrated by GS with respect to Shenandoah and Blue Ridge was monumental, but none of the firm’s principals did any jail time. Yet it took the great Goldman Sachs managing partner Sidney Weinberg decades of labor in corporate boardrooms and the salons of Washington to redeem the sins Goldman Sachs committed in the 1920s.
By the time that Lloyd Blankfein took over as CEO in 2006, Goldman was as respectable as any investment bank – admittedly not much of a statement. But then as now, the business today is about arbitrage and sales, not the lending and credit management of commercial banking.
If GS really has no intention of growing a commercial banking business, then why not save millions of dollars a year and simplify the firm’s regulatory structure by de-banking? The same comment goes for Morgan Stanley (MS), of note. If GS is really not serious about building a large depository business to go alongside the investment bank, then there is no point in dealing with the Fed and several other federal regulators.
If, on the other hand, GS does truly want to become a full service bank, then Solomon and company need to consider a combination with an established regional depository, a bank that has core deposits and also has a commercial lending business. A wealth management business would be desirable as well. There are a number of possibilities including:
Keycorp: With $138 billion in consolidated assets, Keycorp (KEY) is a solid regional bank headquartered in Cleveland, OH. The stock trades at 1.5x book on a beta of 0.9, so below market volatility for a stable business. But more than just a retail business and a $100 billion core deposit base, KEY is a significant national lender and has a strong position in financing and servicing commercial real estate – a sector that GS knows well.
First Republic Bank: At $88 billion in total assets, this San Francisco based state-chartered unitary bank has carved out a profitable niche in wealth management and prime mortgage originations. First Republic Bank (FRC) has $66 billion in core deposits, $5 billion in fiduciary assets and another $12 billion in custody and safekeeping assets, and $21 billion in off balance sheet securitizations. And FRC competes head-to-head with Wells Fargo (WFC), JPMorgan (JPM) and Bank of America (BAC) in the prime jumbo channel, another asset class that Goldman knows and loves. At over 2x book value, FRC is not cheap – but then again, neither is GS at 1.1x book.
Now of course the big question is whether the Fed and other regulators actually would allow the folks at GS to acquire a real bank with retail deposits. Some would argue that a decade after the financial crisis, GS has already lost much of the recklessness and “innovative” vision that characterized the firm’s market actions prior to 2008. Acquiring a large depository might help Goldman finally leave behind the bad old days and complete the transition to true mediocrity under the vigilant gaze of federal bank regulators.
But somehow we think that GS under its new leadership will continue to focus on trading and investments, not commercial banking. Banking is about patience, prudence and care. Leaving aside the fact that GS resides at the bottom decile of Peer Group 1 when it comes to Tier One Capital, the idea of the masters of the universe making loans to consumers and managing credit seems too far fetched.
Just as the Guardians of the Galaxy would never forsake their heritage as ravagers, the traders and bankers at Goldman are all about being smarter than everyone else. Better for Goldman to stay true to the proud legacy of Blue Ridge and Shenandoah, Penn Central and AIG Financial Products, ABACUS and Timber Wolf. In those glorious transactions, where the firm put its own interests ahead of those of its customers and counterparties, it proved that they will never really be bankers.
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