Goldman bets courting risk is again a safe bet

The flags of the U.S. and China hang outside of 85 Broad Street, headquarters for the investment bank Goldman Sachs in New York, October 23, 2008.

NEW YORK (Reuters) - Goldman Sachs Group Inc (GS.N) is taking much more trading risk than rival Morgan Stanley (MS.N), and some analysts wonder if the largest investment bank could be making itself vulnerable to another downturn.

Goldman's supporters say the bank is keeping to a strategy that served it well during the financial meltdown: fund itself in bond markets and trade actively, both for clients and its own account.

But Goldman is also forgoing many of the safety measures that competitors like Morgan Stanley have embraced, such as building businesses less dependent on trading activity and finding reliable sources of cheap deposit funding.

If the economy deteriorates and bond markets seize up again, the bank could find itself posting big losses.

"There's no question, Goldman is taking a risk," said James Ellman, president of hedge fund Seacliff Capital in San Francisco.

Eight months ago, Morgan Stanley and Goldman Sachs were in a full-blown crisis, paralyzed by the credit crunch and watching some of their long-time competitors, like Lehman Brothers, disappear.

With their share prices sinking and investor confidence depleted, both banks in September agreed to become bank holding companies and each accepted $10 billion of bailout funds from the U.S. government.

In the months after those dark hours, Morgan Stanley Chief Executive John Mack began rethinking the bank's business. He encouraged the bank's retail brokers to sell certificates of deposit to decrease Morgan Stanley's reliance on fickle bond markets for funding.

Mack also began thinking about acquisitions, ultimately deciding to buy a controlling stake in Citigroup Inc's (C.N) Smith Barney retail brokerage business. That deal will allow Morgan Stanley to gather more deposits and reduce its reliance on sales and trading businesses

"Morgan Stanley experienced a near-death experience," said Bill Hackney, chief investment officer of Atlanta Capital Management Co, which owns Goldman and Morgan Stanley shares. "And as a result of that, the company was interested in pursuing a less risky model going forward."

Both companies seem to have recovered at least partly from their difficulties last year. The Treasury on Tuesday approved repayment of the money they borrowed under the Troubled Asset Relief Program.

Goldman and Morgan Stanley will benefit from less competition, as rivals like Lehman Brothers are no longer in business. Both have reaped fee bonanzas in recent months amid a boom in secondary offering activity, although M&A activity, another big traditional fee source, has been moribund.

GOLDMAN GOES BACK TO THE FUTURE

Morgan Stanley's increasing uneasiness with taking risk is evident from data it released last month.

The bank's "value at risk," a measure of the maximum possible losses the bank will face on 95 percent of its trading days, on average, was $115 million in the quarter ended March 31, up 12 percent from the first quarter a year earlier. Compare that with Goldman Sachs's 52 percent increase in value-at-risk (VaR) to $240 million.

Goldman spokesman Lucas van Praag said VaR is an imperfect measure of risk.

Lloyd Blankfein, the bank's chief executive, hinted on Wednesday that Goldman may be positioning itself for uncertain times ahead and questioned whether the economic recovery has begun.

"I think it is going to be a long protracted recession," Blankfein said at a conference in Tel Aviv, Israel.

Goldman's supporters see the bank as expert at managing risk, which they say means it can stay the course.

Goldman has a reputation for recruiting the elite of Wall Street's talent and its traders are famous for their sang-froid. Moments after planes crashed into the World Trade Center on September 11, 2001, its traders shed riskier assets and bought government bond options, steps that generated big profits.

"They are just Goldman. They are different. They are special," said Lawrence White, a professor at New York University's Stern School of Business.

Optimism about how both banks will perform with fewer competitors has helped lift their share prices. Morgan Stanley shares traded at $30.98 on Tuesday, up 362 percent from its 52-week low of $6.71 in mid-October. Goldman, at $149.31, is up 215 percent from its 52-week low.

But Goldman is also trading at a higher valuation, around 1.5 times its book value, compared with Morgan Stanley's 1.1 times, meaning it could have farther to fall if it takes a wrong step.

And it may. The bank has made some bad calls, as when it took profits on short positions in areas like mortgages last year earlier in the credit crunch.

Holding onto Goldman shares now demands faith that the bank's track record of strong risk management will allow it to navigate even the turbulent waters that may be ahead. And some investors are short on faith these days.

"They are vulnerable to a bad trade, that's just a fact," said Walter Todd, a portfolio manager at Greenwood Capital Associates who views the bank's risk as potentially affecting future earnings -- although not crippling the company.

(Additional reporting by Dan Wilchins; Editing by Steve Orlofsky)