The stunning quarterly results achieved by Goldman Sachs tell us almost nothing about the financial health of Goldman, and less than nothing about the health of the banking sector. Goldman, even more so than many of its competitors, still remains basically opaque. We don’t know the source of its profits, except in a general way, and the outdated types of financial disclosures it makes only further obscures its financial health.
The problem is not, as some of the more frothing Goldman haters believe, that Goldman is fudging the numbers or lying about earnings. The problem is that the numbers are problematic even if we assume 100 per cent veracity. Many of the troubling dynamics that have helped destroy Wall Street are embodied in Goldman’s latest earnings report.
- I-Banking, Still Dead. The lack of profits from the basic, traditional financial businesses encouraged Goldman to take on ever-greater risk. Their internal measures of the daily risk at the bank ballooned.
- Cheap Money=Profits. Much of Goldman’s profitability last quarter seems to have resulted from the availability of cheap government funding that could be put to work against a steep yeild curve. This is a recipe for windfall profits that is no more sustainable than those made from CDOs in the housing boom.
- Accounting Noise. The accounting earnings at banks have long been meaningless, reflecting write-downs and write-up of assets based on accounting rules that often poorly reflect the risk involved. Goldman said today it had written up some of the assets it had written down last quarter. All of this is mostly noise signifying nothing.
- Dumb Legacy Capital Measures. Discussion of earnings and capital allocations absent quality risk measurement is basically useless. All the talk about capital ratios, Tier 1 versus Tier 2 versus Teir 3, hybrid preferred stocks versus common, arguments about misclassification of capital, are left-overs from an legacy regulatory regime. Do we need to remind you that the legacy regulatory structure has proved to be completely disfunctional and unable to accurately predict a potential insolvency, much less future profitability?
- Too Much Leverage. There’s still too much leverage at Goldman Sachs. Although Goldman reduced the leverage ratio of money owed to outside creditors compared to its equity, it increased its internal leverage by ramping up the amount it pays its employees as a percentage of revenues. Make no mistake, this internal leverage ratio is just as important to predicting any investment bank’s future performance as external leverage. When faced with hard times, dependence on internal leverage for earnings can cripple a bank by sparking a flight of talent–an internal run on the bank–that can be just as damaging to performance as a creditor initiated liquidity crisis.
- Lack of Transparency. Goldman continued its long tradition of reporting earnings that keep investors in the dark about its business model. This lack of transparency makes it almost impossible to conduct an outside assessment of risk, and is probably an indicator that even within Goldman there is no real knowledge of risk and therefore no effective risk management.
Let’s put it differently. The performance of Goldman Sachs last quarter does nothing to resolve the long-standing debate about the viability of the business models of independent investment banks. It remains largely undiversified and highly leveraged, putting in question whether it is equipped to survive a major systemic financial crisis.
This is not to say that we don’t applaud Goldman for its plans to repay the TARP or are convinced that Goldman cannot continue to outperform by traditional measures. But we’d caution against jumping to the conclusion that Goldman has emerged as a new model investment bank just because it has become the first of its rivals to reach for life beyond government aid.