Robbing Grandma to pay Goldman

There are plenty of galling things in the financial world today, but the theatrical performance of the US investment bank Goldman Sachs as it manages its way through the economic crisis creates a kind of vomit inducing nausea that is tough to top. Last week GS recorded "super" earnings in the 1st quarter of the new fiscal year, announcing Q1 earnings of $3.39 per share, well above the markets expectations. They used the occasion to claim the moral high-ground with US taxpayer by suggesting that they would be the first to repay the $10bn worth of loans they have received from the US government, via TARP funds.

Except, as so always seems to be the case with these guys, that's not exactly the full story. Buried in the small print of their financial statements, it appears that as the Easter Bunny was delivering chocolate to the worlds children, he also deposited a small, albeit well-hidden, turd in the GS income statement. This little ruse along with a litany of other legal, but morally bankrupt undertakings, puts GS into a class of their own. It appears to me that correcting this type of crony capitalism would be pretty important in the re-regulation of the financial world, but with well placed lobbyists and effective sleight of hand, GS is helping to take steady steps in the opposite direction.

Getting into the nitty-gritty: As a consequence of GS becoming a bank holding company last year so that it could access deposit markets, it switched its reporting period from its own fiscal year to the calendar year - in keeping with other bank holding companies. Previously Goldman's fiscal year had ended on November 30th and now it ends December 31st. As a result, December 2008 was not included in the wonderfully stage-managed 1st quarter 2009 numbers.

This "orphan month" as it turns out is where GS decided to place some very significant write-downs - they lost over $1bn, after writedowns related to "non-investment grade credit origination activities" - i.e. poor quality, and very leveraged, loans to companies. A further $625mm writedown was taken on their commercial real estate loans, which when balanced against some meagre profits elsewhere means that GS actually has lost $1.5bn in the last 7 months. That wasn't how the numbers were reported last Monday, which is typically convenient. In reality, instead of earnings of $3.39 per share, the real figure is closer to a loss of $2.15 per share. As the stock price rose sharply on Monday, how many market participants were wise to this cloak and dagger approach to financial reporting?

At its low point last November, GS's share price closed at $52, which was close to 80% below its high of around $250. At that stage, many of its chief competitors - Lehman Brothers, Bear Stearns, Merrill Lynch and UBS - were either dead or mortally wounded. Somehow, less than five months later, on the back of the "surprisingly profitable" first quarter of 2009, the share price is back up at $115 per share. Are they really that much better than the competition, or are they successfully playing a bad hand in the most Machiavellian of ways? The more I observe, the more I see the latter.

Aside from this recent example of GS pushing financial laws to their limits, many point to Goldman's expert "management" of the levers of power in Washington. Since Robert Rubin, GS's former chairman, joined the Clinton administration in 1993, initially as the director of the National Economic Council and then as Treasury secretary, Goldman Sachs has come to be known, as "Government Sachs". After a highly paid investment banking tenure, the graduation class from GS has moved from Wall Street into to the corridors of Washington - first you get the wealth, and then you need the power.

The conspiracy-theorists point to the crucial role that Henry Paulson (who succeeded Robert Rubin to the top at both GS and the US Treasury) played in the demise of Bear Stearns and Lehman Brothers, and his insistance that Bank of America buy Merrill Lynch at an inflated price. These machinations changed the competitive landscape for GS - a point which was acknowledged by their CFO, David Viniar on their recent 1Q results conference call. "Many of our traditional competitors have retreated from the marketplace, either due to financial distress, mergers or shift in strategic priorities."

Within the same conference call discussions about Goldman's relationship with the battered US insurance group AIG, were somewhat muted. As William Cohan in the NY Times puts it, this relationship "is the canvas upon which the bank and its alumni have painted their great masterpiece of self-interest". Days after Hank Paulson refused to save Lehman Brothers last September, at an estimated cost of $45 billion or so, he bailed out AIG, to the tune of $170 (and rising). He then installed Edward Liddy - another GS alumni - as AIGs chief executive. Since then GS has received some $13bn in cash, collateral and other payments from AIG - that is, direct from the US taxpayer.

In deciding to rescue AIG, the US government was understandably worried that if it did not bail out the company, its collapse could lead to a cascading chain reaction of losses, jeopardizing the stability of the worldwide financial system. Goldman Sachs could easily have become the next Lehman Brothers, if their capital base was eroded by the full expected loss on their counterparty exposure to AIG (i.e. the $12bn mentioned above). The flipside, however, is that they jeapordized the financial system by letting Lehman Brothers go bankrupt, and Lehman's creditors will be lucky to pennies back on their loans to that company. GS (and others) however have been "made-whole" - i.e. they have received full and complete compensation for their massive exposure to AIG.

In another conference call he held last month, the CFO David Viniar made the interesting claim that Goldman “had no material exposure to A.I.G.” because the firm had “collateral and market hedges in order to protect ourselves.” If so, then why did they need the government’s help in the first place?

The truth is that Goldman had paid for insurance against a default of AIG, totalling around $100mm, according to the head of public relations at GS, Lucas Van Praag. In a letter to the NY Times last week he wrote: "If AIG had failed, we would have had both the collateral and the proceeds from the credit default swaps and therefore would not have incurred any economic loss." He goes on: "In order to collect under a credit default swap, there has to be an event of default. No event of default means no payout. By supporting AIG, the government prevented the company from defaulting."

So effectively he's claiming that GS were indifferent between AIG defaulting or not - and that it would have been "unfair" of the government not to pay the monies that AIG owed GS, as the government prevented a default which would have seen an equivalent payout to Goldman on its hedging contracts. This is complete rubbish - they lost $100mm on hedging, but gained over $12 billion from Grandma, and the rest of the US taxpaying nation. They weren't fully hedged, and they messed up in a big way, but aren't paying the price.

As part of its busy day last Monday, GS also announced it was raising $5 billion of equity capital and that it intended to pay back the $10 billion from the Treasury’s Troubled Asset Relief Program that Hank Paulson "forced" on the bank last October. The media management of that news, no doubt raised GS up in the estimation of the average US taxpayer, which is a pretty amazing achievement. Furthermore, being free of the government will give Goldman yet another competitive advantage: the ability to pay its own talent and new recruits whatever it wants without government scrutiny. This is significant, since it is unlikely any of Goldman’s remaining competitors will be able to make a similar move anytime soon.

On a slightly more amusing note, I see GS is in the process of suing a blogger who set-up the demonising website www.goldmansachs666.com. Goldman Sachs has taken legal action against the site, alleging it infringes a trademark in the phrase “Goldman Sachs.” The owner of the site, an investment adviser called Mike Morgan of Jensen Beach, Florida, has promised to contest the litigation.

"Everyone is entitled to their opinions and to share views," GS's spokesman Lucas van Praag said in a interview, "...but this is blatant trademark infringement". In response to this Matthew Lynn, a Bloomberg news columnist, has just registered the website www.goldmansachsislovely.com.

As of yet he hasn't had any word from the GS legal eagles. He says: "I suspect that if I fill that site with examples of Goldman Sachs executives being kind to small animals and how the bank brings joy and happiness to the capital markets, I might even be offered a job in their marketing department." Now that is Machiavellian.