Goldman: Better Risk Process or Just Better Outcome?

Since the bloodbath on Wall Street began, almost every major piece in the press has mentioned Goldman Sachs (GS) as the shining example of great risk management. All these articles imply that other firms do not have practices, people, or a risk management culture that apparently Goldman possesses. However, no one has come out and said what exactly Goldman does that differentiates it in risk management.

Two recent articles got the Prince thinking about this omission, specifically Portfolio’s article about John Thain where they constantly talk about Goldman’s risk prowess and then Dealbook’s comment on the portfolio profile referencing what the editors call "The Goldman Effect."

So, does Goldman really have superior risk management processes or is the financial press just inferring this from the outcome - i.e. Goldman didn’t lose money on mortgages? Do they have the better risk metrics and strategies that current financial media heartthrob, Nassim "the Dream" Taleb, says Wall Street needs to create (by the way, the Prince thinks Mssr Taleb is long complaints but short solutions on risk management, but more on that later in the week when the Prince takes a look at Fortune’s, Bloomberg Markets magazine’s, and Bloomberg’s coverage of Taleb and his 2007 book, The Black Swan)?

The Prince doubts that Goldman does risk management better than other firms or they have a secret edge.  Yes, they were right last Spring and Summer when others were wrong, but that may be nothing more than a great call - not an active choice to rein in risk.  Yet nothing about a large short various tranches of the ABX trade necessarily screams that they have a risk management edge over other firms. Maybe the Prince is way off base, but he would love to hear from anyone who can answer his questions with anything more than pointing to Goldman’s recent performance.  

Other firms may have had risk management processes just as good or even better than Goldman but were on the wrong side of this one.  Also, the Prince is operating under the assumption that risk managers move from firm to firm.  How would Goldman be able to maintain an edge in risk management with its people moving to its competitors continuously?  The revolving door at top Wall Street firms for talented and/or lucky individuals makes it difficult to keep any advantage a secret for long.

Anecdotally, if you really want a glimpse into Goldman’s risk management or the culture of risk management they eschew, ask Gary Cohn, current GS President and COO, about his famous aluminum trade. That position made his name at the firm when he made millions for the bank right around the time of the IPO.  I think you will hear a story that doesn’t display Goldman’s risk management in a positive light.  This was a highly concentrated position that was trying to corner the world aluminum market in London, and it was deeply in the red.  Cohn refused to listen to his superiors and risk officers who told him to close the position.  After avoiding disaster by bluffing his way out of proposed higher rental rates on aluminum storage by his landlord in London, the aluminum market began to respond to a lack of supply and his position skyrocketed.  He was rewarded, his legend grew, and he advanced up the firm. 

Sounds like the risk management team at Goldman really reined him in. Hmmm.  Goldman got to show strong profits right around the time of the IPO, which were materially increased by the out-performance of Cohn’s proprietary position that the risk managers and senior firm leaders had insisted he close because it was large, deeply in the red, and had it went public would have portrayed Goldman in a negative light right as it became a publicly traded company. 

Albeit this is just an antidote, and things have become more sophisticated in risk management since that time.  However, it is a good example of where the risk management process was wrong and disregarded, the eventual outcome looked great, and no one focused on why the risk managers had been wrong.  Had the trade been a huge failure then the risk management process would have drawn critics amongst the first investors in Goldman Sachs - at their first earnings meetings after becoming a public company.

Goldman and all the other banks still have balance sheet problems and their earnings power has been greatly diminished, as the Prince has pointed out in recent posts.  If we want to continue to judge Goldman’s risk management by the performance of the firm then the press may be crying foul if Goldman struggles comparatively in the year ahead as a result of not delevering like its competitors in this volatile environment.  Maybe the press a year from now will be touting some other firms risk management practices based on outcome based evidence only.  The Prince thinks it is highly likely.

Also, stay tuned this week as the Prince deconstructs Fortune's special on how to fix Wall Street. Not only does the piece convey a naïve understanding of the crisis and Wall Street in general but in Fortune’s rush to dumb down the crisis for the average Joe they get a number of facts and practices just flat wrong. I will also lay off Goldman for awhile, to lay some grief on some other firms, but Goldman has been taking such a different course than its competitors lately that it demanded the Prince’s comment.

Comments

[john1940]

Well, that's not my definition of risk management. You can't isolate individual wins or losses and claim great risk control or lack thereof. Risk management refers to how you contain your overall risks so that an adverse event won't materially affect performance overall or over time. Materially means little chance of loss for different investing objectives. It would be different between long bond funds and leveraged commodity investing.

[RajshreeLaturia]

I found this article interesting as I have been wondering since this crisis started as to what is different in Goldman that led it to such heights... Is the case that Goldman was plain lucky this time as opposed to LTCM and Dotcom or it has really excellent risk management.. This still remains an open question.!!!

[just a treeguy]

Prince .. I'm a little short on your propensity (yes I had to look this up to make sure I used the correct word) for words, but in the tree trimming business some say "its better to lucky than good". perhaps this applies to GS