Why is Goldman allowed to game the system?

Submitted by Edward Harrison of Credit Writedowns.

Marshall Auerback sent me a link to a recent Simon Johnson missive about Goldman Sachs. I had already seen and liked this article, but his e-mail prompted me to write this post. My question is: Why is Goldman a bank holding company?

Goldman becomes a bank

The reason Goldman became a bank to begin with is because it was on the verge of collapse after the Lehman Brothers failure. Andrew Ross Sorkin has a good write up on this in Vanity Fair:

Due to disastrous bets on Lehman paper, the giant Reserve Primary Fund had broken the buck a day earlier, causing an investor run on the money-market funds. Between that, Geithner thought, and billions of dollars of investors’ money locked up inside the now bankrupt Lehman Brothers, that meant only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

Just in case it’s not obvious, Goldman Sachs was a major beneficiary of the government’s bailout of the financial services industry, not only through the bailout of AIG but also through its ability to fall under the regulatory umbrella as a bank holding company (technically Goldman became a financial holding company but the distinction is relatively minor. see definition here). – something which made it eligible for debt guarantees and other government backstops.

Late last year, every financial services company on earth wanted to become a bank and line up for the handouts coming from WashingtonAmerican Express (a credit card company), GE Capital (basically a hedge fund), GMAC (a car financing company), Genworth Financial (an insurance company), Aegon (a Dutch company), even Willem Buiter, a former central banker, wanted to become a bank.

This is why Goldman became a bank too. Now, Goldman was in a more precarious position than bank holding companies because of the vulnerabilities of being a broker-dealer. Nouriel Roubini warned repeatedly before Leman’s collapse that the large full services broker-dealer model was broken.  Here, just before Lehman failed, he talks about Goldman, Morgan Stanley and Merrill’s demise if Lehman collapses:

I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions. Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.

I happen to think Goldman is a well-run institution, but that is neither here nor there. They were vulnerable.

And, apparently, policy makers heeded Roubini’s words as all the broker-dealers were immediately made into banks.  Government went so far as to try and merge Goldman with the bankrupt Wachovia (now a problem for Wells Fargo), but thought better of it because of the conflicts of interest for Hank Paulson and Robert Steel:

In an excerpt from his forthcoming book, Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, Sorkin reports that the deal, which was nearly consummated, would have merged Goldman Sachs and Wachovia. Henry M. Paulson, the Treasury secretary and former C.E.O. of Goldman, was deeply involved in the process, contacting both Lloyd Blankfein, Goldman’s current C.E.O., and a Wachovia board member, and strongly urged both to consider it. Wachovia’s C.E.O., Robert Steel, was a former vice-chairman at Goldman Sachs and Paulson’s former number two at the Treasury Department.

Sorkin reports that Warren Buffett was also contacted about investing in the merged company, but told a banker at Goldman that it would never happen. “By tonight the government will realize they can’t provide capital to a deal that’s being done by the former firm of the Treasury secretary with the company of a former vice-chairman of Goldman Sachs and former deputy Treasury secretary,” Buffett said. “There is no way. They’ll all wake up and realize, even if it was the best deal in the world, they can’t do it.”

Goldman gets to game the system

These conflicts of interest has everyone up in arms about Goldman, dubbed “Government Sachs” by its haters (see here, here, and here). That is why the face-sucking squid polemic by Matt Taibbi was a zeitgeist piece.

I think eyes should be focused firmly on the government’s responsibility and not Goldman when it comes to these issues. Which is why the issues that Simon Johnson raises are important. They go to the core of the regulation of banks.

Here are four questions we should be asking regulators:

  1. Why is Goldman Sachs allowed to maintain leverage ratios significantly higher than the large legacy bank holding companies like Wells Fargo, Bank of America, JPMorgan and Citigroup?
  2. Why is Goldman allowed to operate like a private equity company, holding large stakes of foreign non-financial corporations? (I should note that Financial Holding Companies do have ten years in which to sell their stakes)
  3. Why is Goldman (and other large banks) allowed to operate like a hedge fund and take outsized risks with capital via large proprietary trading operations.  Most of Goldman’s profits are coming from this area. At least Deutsche Bank has offloaded these bets onto hedge funds in which it invests. Given the fact that the large too-bog-to-fail financial institutions have received a large backstop from the taxpayer, the fact that they are loading up in prop trading shows that regulation in the U.S.  is non-existent.
  4. Why is Goldman allowed to have an interest in the failure of other financial firms? We now hear that Goldman has an interest in the failure of CIT, a major lender to small-and medium-sized businesses. These perverse incentives are everywhere in the derivatives world and were an enabler of the financial meltdown and the principal reason AIG was bailed out with taxpayer money.

Clearly, regulators are not serious about regulating or they would correct these problems.  MarketWatch reported on this as far back as July and nothing has happened.

When Goldman switched to a bank holding company, such big profit seemed unlikely as analysts worried the firm would face stricter regulatory oversight from the Federal Reserve, with limits on risk-taking and higher capital requirements. See story Wall Street changes.

But almost 10 months later, nothing much appears to have changed, some analysts said in the wake of the firm’s second-quarter results.

After two quarters as a bank holding company, Goldman is still “not reporting like a bank and not acting like one either,” said David Hendler, Baylor Lancaster, Pri de Silva and Kristine Lanspa, analysts at CreditSights, an independent fixed-income research firm.

Given Goldman’s spectacular results so far this year, “the company has basically been given a green light to continue operating in a ‘business as usual’ fashion,” they wrote in a note to investors after Goldman’s latest earnings report. “Bank regulators have their hands full with other deteriorating bank situations and, for the time being, seem content to let Goldman do what it’s always done.”

Tier 1

Goldman still doesn’t report quarterly results like other large bank holding companies. For instance, the firm doesn’t disclose a full balance sheet in its earnings release or provide detailed information on revenue and valuation marks on exposures, the analysts noted…

“Our sense is that Goldman’s switch to bank holding company status was basically a security blanket in the worst of last fall’s troubles, and the company would be happier today if it could let it go,” they added. “We also sense that Goldman Sachs many not yet have the same level of regulatory scrutiny that many banks routinely live with.”

And CreditSights is right. Goldman have no intention of changing anything at all.

“Our model really never changed,” Goldman Sachs Chief Financial Officer David Viniar said yesterday in an interview. “We’ve said very consistently that our business model remained the same.”

Plus ça change.

The excerpt in this article from the RGE Monitor is copyrighted and re-published with the express permission of Roubini Global Economics LLC.

Update: Chris Whalen is apoplectic that Goldman is upgrading the too-big-to-fail banks and has given his own downbeat assessment, a view I shared on Credit Writedowns just yesterday. See his comments and video here.

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward http://www.creditwritedowns.com


    1. Edward Harrison Post author

      I have added this to address your comment:
      (technically Goldman became a financial holding company but the distinction is relatively minor. see definition here).

    2. Edward Harrison Post author

      again bb, you are the one who is unprepared as a financial holding company is a subset of bank holding company types which was created specifically to allow the Travelers-Citcorp merger in Gramm-Leach-Biley.

      Here is a reference from 2000 at the FTC:


      The statute creates a new “financial holding company” category under section 4(k) of the Bank Holding Company Act (“BHCA”). Such holding companies can engage in a statutorily provided list of financial activities, including insurance and securities underwriting and agency activities, merchant banking and insurance company portfolio investment activities.

      By the way, Bank of America is…drumroll please… a financial holding company as are the other large banks

      1. Michael

        Goldman first became a BHC in the initial rush to safety. It was granted waivers that allowed it to continue operating as a Financial Holding Company until the formal FHC designation was completed (recently, some time this summer)
        The FHC distinction is not trivial, as you seem to suggest, since most of the businesses Goldman engages in are not permitted to a Bank Holding Company.

        The waivers were enormously beneficial to GS and supported the fiction that Goldman had converted to a nice safe banking model subject to full regulatory constraints imposed on banks. That wasn’t the case at all.

        Ironically, the full package of moral hazard risks transferred to the taxpayers through the repeal of Glass Steegal are on full display here in one handy package for anyone who cares to look. The package of waivers GS enjoyed during the interim period when it was a BHC to the date it was granted FHC status nicely illustrates the cynical gaming of the current state of the banking system.

        1. Edward Harrison Post author

          Michael, all of the too big to fail institutions are financial holding companies and bank holding companies. The point is that Goldman is no different than the others in this regard. There is nothing about its designation that sets it apart from other TBTF companies.

          1. Michael

            Mp point is that CITI, JPM, BOA were already FHCs going into the crisis. Allowing GS to become a BHC overnight to obtain FDIC guarantees, while at the same time allowing it to operate as an FHC was extraordinary and unneccessary.

            By allowing GS to operates as a FHC in the interim the gov’t forfeited leverage they could have exploited to rein in, rather than expand, the population of TBTF institutions.

            Granting the FHC status cemented GS fate as another TBTF inistitution and makes the task of any type of Gramm-Leach repeal/modification that much harder.

            Consider. If eventual (within a year) FHC status for GS (or MS for that matter) wasn’t a sure thing, we would have been having a serious debate during the last year about how to dismantle the US universal banks, rather than how to guarantee the survival of these dinosaurs.

      2. bb

        as Michael points out to you, GS became BHC with a few waivers while it can convert to a FHC (presumably the process was more elaborate).
        the difference between a BHC and a FHC is not subtle as you suggest. even less so a FHC is a subset of a BHC, as per your suggestion: a FHC can engage in a much wider range of activities. it is like saying: some mammals are animals, then all animals are mammals.

        on top of that, on Oct 4, Yves posted a link on the same subject where someone else engaged in the same musings, and was pointed to the same problem in his flawed argument.

        plagiarism and ad hominem attacks seem your style of play, reasoning is always your weakness.

        i really wonder why Yves is still cross posting your musings, you have your own blog, whoever is interested in reading your stuff can do so there.

        1. Claire

          “i really wonder why Yves is still cross posting your musings, you have your own blog, whoever is interested in reading your stuff can do so there.”

          Jeeze, not another one. As somebody who’s still somewhat annoyed that, from what I can tell, Leo got booted because of comments like this one, could I please ask you to tone down on such remarks? Ed’s posted some great stuff, and if you don’t like it, you could just avoid reading it instead of harassing yet another contributor. It’s less effort on your part, too.

  1. Hugh

    As I keep saying, there is no reason or rationale for Goldman Sachs to exist. I would put this up there with a return of Glass-Steagall. We will know that government is serious about financial reform when we see re-imposition of Glass-Steagall and when Goldman and the other IBs (in their various incarnations) are regulated out of existence. They are systemic risk creators, responsible for great misallocations of resources and even greater wealth destruction.

    The AIG, Lehman, and Merrill decisions all came down on the weekend of Sept. 13-14, 2008. The AIG deal was structured to bailout and save Goldman, Blankfein being the only banker allowed in on the negotiations. The Lehman bustup on the 15th overwhelmed (but also helped cover up the Goldman friendly details) of the AIG deal announced on the 16th. The Lehman debacle also placed Goldman’s survival in jeopardy again. Paulson’s demand for $700 billion, the famous blackmail note, came out the following Saturday, the 20th. It had much the same effect of the events earlier in the week, taking the focus off Goldman, and the Fed’s announcement of the 21st that it had accepted GS and MS applications to become bank holding companies.

    For me, it is laughable, given how the AIG deal went down or the non-conversion conversion of Goldman to a bankholding company, that conflicts of interest scuttled a Wachovia-Goldman merger. I think it was far more likely that Goldman didn’t want its action crimped by a partnership with a real, but very troubled, bank. The bankholding company route gave them the credit lines without the hassles. Of course they went that way. What is obscene is that it was allowed to.

    We have very different ideas about what a well run company is. For me any business that needs to be bailed out twice in one week to survive, that relies on its crony connections to government to make good all of its godawful mistakes –to the tune of tens of billions of dollars, is not. well. run.

    As for Roubini, what happened to him? That piece you cite is from August 2008 and is some fine, clear writing. Most of what he writes now is mealymouthed drivel.

  2. anarkst

    Goldman Sachs does what it does because it can. If you allow the most unbalanced among us, free reign, what can you possibly expect? Remember, these are not normal people.

    It would be like allowing a bunch of severely hyperactive children free access to the candy store and wondering why the outcome was not real good.

  3. Nik Kondratieff

    Ed, You’re on a roll with another great article exposing the massive economic fleecing and fraud that is the US financial system.

    What is it going to take for Americans to wake up from their stupor and realize the culture of greed is destroying the US? Nothing, I fear.


  4. ex-lehman employee

    From an ex-lehman unemployed “still today” employee (software technician)… When I see Goldman paying 16 billion in bonus’s I can’t help to feel it is my money. Why did they turn down Lehman’s request to become a bank holding company but grant the privilege to Goldman and Morgan? Can Goldman employees really walk away with billions and not feel any remorse? Do they really feel they deserve all of it while there are so many financial services employees especially in the “support” area out of work? The money Goldman is making should be put in a fund for the unemployed Bear and Lehman employees..


    “Lehman asked the Federal Reserve for help, but it didn’t get much, Fuld said. But days after the firm filed for bankruptcy, on Sept. 15, the Fed and other regulators rushed to save Goldman and Morgan Stanley by granting them many of the things that Lehman hadn’t gotten, he argued.

    Lehman asked the Fed to let it become a bank holding company, which could have given the firm more access to deposits, considered a more stable source of funding.”

    1. Ex-IB Employee

      “The money Goldman is making should be put in a fund for the unemployed Bear and Lehman employees..”

      You made your bet by joining Lehman. You lost.

      While employed you would have made (relatively) good money with the associated risk that when the market goes bad you will get screwed. EVERYONE working on the street knows and accepts this. Yes, GS may have played the game more successfully than others when the mother load of crap hit the fan, but this does not mean that a communist system of profit distribution should be imposed where profitable companies pay for failures. I doubt those companies would remain profitable for long if all the profit headed out the door to ex-employees of failed companies.

      1. charcad

        this does not mean that a communist system of profit distribution should be imposed where profitable companies pay for failures.

        Well said. A viewpoint I hope is adopted by Middle America, greatly expanded and used to evaluate the sum performance of “Wall Street” in aggregate.

        It’s too precious a view to remain narrowly confined to a few blocks of lower (in all senses) Manhattan.

      2. RueTheDay

        “Yes, GS may have played the game more successfully than others when the mother load of crap hit the fan, but this does not mean that a communist system of profit distribution should be imposed where profitable companies pay for failures.”

        Oh, puuullllease. Goldman went crying to the government for help like a little baby when TSHTF. They didn’t “play the game more successfully”, they got bailed out by the government. Your invocation of the dreaded “communism” word is just laughable.

  5. kevinearick

    to be fair:

    our equation is (I – C) / G.

    When the legacy families short the agreement, the US Constitution in this case, we eliminate our C & G, to roll out a new economy.

    They are giving Goldman complete efficiency to keep the dead pump in the old economy “primed” for as long as possible.

    The motivation behind anonymous posts is irrelevant. The point is price disclosure. The sooner we get full price disclosure, the sooner we can roll out the next economy.

      1. kevinearick

        this is my longer version:

        The old clunker economy is not worth $1
        let alone $100 Trillion. The kids are not going
        to pay one dime of that debt. Denying them
        access, parents, and a decent education
        was counterproductive. As usual, the kids
        were out building tomorrow, while the older
        generations were busy fighting over yesterday.

        The sooner the legacy families agree to
        cancel out all the debts, the less it’s going
        to cost them. They are so far behind the
        learning curve at this point, all they can be
        in the new economy is passengers. At their
        age, that’s the best seat anyway.

        The geography is saturated. The older
        generations can’t go anywhere, and the kids
        own the virtual space in which expansion
        must occur. The universe cannot be remade
        so that all roads are straight, flat, and smooth.
        That violates the laws of physics. Sooner or
        later, the law of revision comes into play, and
        everyone racing down the old road gets farther
        and farther behind.

        Physical property(local) and oil(global) can no
        longer serve as economic hubs.

        just to be fair.

        happy trails

  6. Dave Raithel

    I’m a literal cripple. I read this:

    I also read the linked definitions provided in the original post.

    Will GS let me open a checking account / savings account? If not GS – literally as Goldman Sachs – then where is the bank they own that accepts deposits, lets me take out a personal note with a CD as collateral, so I can replace my driveway, etc?

    “The Bank intends to provide deposit and loan products to high net-worth clients and employees of Goldman Sachs.” Is that the language (pulled from the link above) that excludes me?

    Really, I just don’t get it.

  7. sam farkus

    GS needs full-time access to the fed window in case it wants to gamble on some stuff with printing press $$.

    It’s just the US slush fund/sovereign fund. Fighting the other sovereign funds out there which are explicitly owned by the government. Fulfills a purpose. But it’s making a mockery of the entire financial system. People are losing faith in it completely. It is going to devolve into a printing/devaluation war. Why invade a country when you can just print up infinite dollars through an off-balance sheet slush fund and trick them into giving it to you?

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