Goldman Sachs's Director Conveniently Misses the Point

Jan. 8.10 | About: Goldman Sachs (GS)

Goldman Sachs (NYSE:GS) director Bill George was recently discussed in the Guardian for his assertion that GS employees are similar to star athletes and thus deserve to be compensated accordingly. This assertion demonstrates that George has no true understanding of the benefit GS and other Too Big to Fail ("TBTF") institutions have over other participants in the industry. GS, in particular, due to its reliance on trading, may benefit the most of TBTF institutions.

George conveniently ignores the fact that GS is deemed TBTF and is thus backed by tax payers, whereby the company can aggressively gamble with no significant consequence. This can be of particular benefit to GS because its financing costs are cheaper than comparable financial institutions. In addition, because GS relies significantly on its principal trading, the benefit of being a TBTF institution exceeds that of other TBTF competitors. GS may enjoy a 1-2% benefit compared to non-TBTF financial institutions for financing costs.

For example, assume GS and a non-TBTF trading firm both have $1B in equity that they intend to deploy on a leveraged basis. GS, due to tax payer largesse, can obtain financing for this capital at 4% while the non-TBTF must pay 200 basis points more or 6%. This means that the non-TBTF firm can leverage that $1B in equity by about 9.0x or $9B, working with a total of $10B in capital with funding costs of $540MM ($9B x 6%). In contrast, GS can lever their equity by a factor of 13.5x, raising 50% more in financing simply due to its status as TBTF as its funding costs would be identical ($13.5B x 4%) due to GS's TBTF status.

Now assume both firms have similarly skilled traders and deploy their raised capital and both earn 15% on it in one year. For GS, the value of its total capital would be $16.7B while the non-TBTF firm would have a capital account value of $11.5B. Both firms pay back the debt, with GS repaying the $13.5B it raised and the non-TBTF repaying the $9B it raised along with the same funding costs of $540MM for both institutions. GS's equity account has increased from $1B to $2.64B ($16.7B - $13.5B - $0.54) while the non-TBTF firm has an equity value of $1.96B ($11.5B - $9B - $0.54).

The non-TBTF firm generated the same return as GS yet due to GS enjoying TBTF status, its lower funding costs allow it to obtain much cheaper financing. Consequently, GS traders have generated a 164% return off their firm equity while the same skilled non-TBTF traders generated a 96% return. GS directors and apologists want us to believe that this spread is due to talent but it's clearly due to tax payer largess represented by lower funding costs. At year-end, when outsized compensation is distributed to GS traders, a good portion is simply due to the TBTF status whereby US taxpayers backed GS trades.

For some reason George thinks this equates to talent when it clearly equates to "favored status." GS not only employs some smart people but has benefited from a number of former executives employed across a variety of government institutions. For example, during the market meltdown in fall of 2008, then-Treasury secretary Hank Paulson was reported to have spoken frequently with GS CEO Lloyd Blankfein. Additionally, former GS Chairman Stephen Friedman served as Chairman of the NY Federal Reserve when key discussions were held regarding how to address counter party payments related to AIG and related parties such as GS (Friedman also bought stock in GS at this time).

If George wishes to compare GS employees to athletes, he should draw the comparison in a more accurate light. For example, would Manny Pacquiao be considered that much better if every opponent he faced had to tie their hands behind their back? Would Roger Federer be considered much more talented if he was allowed to use the entire tennis court (doubles alleys) while opponents couldn't? Essentially, GS's level of talent is the equivalent of allowing Tiger Woods to play every hole on a golf course 100 yards away while opponents must play each hole from the official tee off location and then pay Tiger 50% more than his opponents when he wins a rigged game.