The financial crisis of 2008 was exacerbated by the banking industry's trillion dollar bet on the housing sector. Leading up to the crisis investment banks like Bear Stearns, Lehman, Goldman Sachs (GS), and Morgan Stanley (MS) managed proprietary-trading portfolios of approximately $138 billion, $270 billion, $400 billion and $380 billion, respectively. Instead of funding these portfolios through retained earnings, these firms borrowed commercial paper and other indebtedness that led to gross leverage ratios ranging from 32.8x (Bear) to 23.4x (Goldman). When those proprietary-trading portfolios turned sour, Bear was acquired by JP Morgan Chase (JPM) in a transaction backstopped by $29 billion in government funds; Lehman filed the largest bankruptcy in U.S. history ($691 billion), and Goldman and Morgan Stanley were spared a "run on the bank" via injections of tens of billions in TARP funds.
Skirting The "Volcker Rule?
In 2009 Federal Reserve Chairman Paul Volcker suggested that Goldman and other firms that focused on short-term trading should be denied access to future taxpayer funds. The "Volcker Rule" which was designed to prevent banks from taking excessive risks from trading their own capital, later became a section of the 2010 Dodd-Frank Act. According to the Shock Exchange book, "How Inner-City Kids From Brooklyn Predicted the great Recession and the Pain Ahead":
Goldman shut down its proprietary trading desk in response to the Dodd-Frank Act. KKR then hired a nine-person team from Goldman's former proprietary trading unit, led by Bob Howard; KKR expected to raise money from outside investors for a hedge fund to be run by the new unit. If banks were to lend to such a hedge fund, it would still expose its depositors to the whims of speculators and create the same risk within the financial system that Goldman did.
As late as July 2012 Goldman CEO Lloyd Blankfein gave public assurances that its proprietary trading activities had indeed been shuttered. However, a new report from Bloomberg News states that Goldman is still engaging in proprietary trading via a "secretive" group called Multi-Strategy or MSI.
"We shut off that activity," the chief executive officer told more than 400 people at a lunch organized by the Economic Club of Washington, D.C., slicing the air with his hand. The bank no longer had proprietary traders who "just put on risks that they wanted" and didn't interact with clients, he said ... That may come as a surprise to people working in a secretive Goldman Sachs group called Multi-Strategy Investing, or MSI. It wagers about $1 billion of the New York-based firm's own funds on the stocks and bonds of companies, including a mortgage servicer and a cement producer, according to interviews with more than 20 people who worked for and with the group, some as recently as last year. The unit, headed by two 1999 Princeton University classmates, has no clients ... The team's survival shows how Goldman Sachs has worked around regulations curbing proprietary bets at banks.
The red herring in the Volcker Rule is that it prohibits banks from making "short-term" investments with its own capital; it does not prohibit banks from making "long-term" wagers. According to current and former Goldman employees, though MSI acts much like a hedge fund, its investments are designed to last months; the long-term nature of its investments may keep the unit in compliance with the Volcker Rule. Yet as we learned from JP Morgan Chase's whale trade which lost upwards of $6 billion, the risks to our financial system are still the same. The question remains, in the event Goldman does experience an exceptional loss, what is to prevent it from walking away from its obligations like any other hedge fund, or causing a systemic risk to the financial system like it did in 2008?
For the avoidance of doubt, I am bearish on the U.S. economy and the market as a whole. Goldman has proven that it is addicted to proprietary trading and will openly defy regulators in order to do it. I expect its core business of capital raising and M&A advisory to decline in lockstep with the U.S. economy. Meanwhile, its continued risk-taking obfuscates its true business operations and adds volatility to its revenue stream. That said, I recommend avoiding the stock long-term.