Goldman, where are the shareholders' and taxpayers' yacht

Thu Jul 16, 2009 10:19am EDT

--James Saft is a Reuters columnist. The opinions expressed are his own--

By James Saft

HUNTSVILLE, Alabama (Reuters) - As much as bonus-eligible employers may rejoice, the government, taxpayers and shareholders have real reasons to be concerned about Goldman Sachs' huge surge in profits and how they are being generated and allocated.

Goldman this week notched up its largest ever profit as a public company - $3.44 billion for the second quarter - but did it while taking on considerably more risk by a key measure.

Furthermore, Goldman set aside 48 percent of its total revenue, or $6.65 billion, to fund employee compensation, an amount that is not only titanic for a company that only recently was in receipt of direct government support but is, even more astonishingly, the same percentage as was doled out to employees in 2007, in the supposedly bad old pre-crisis days.

"Our model never really changed," Goldman Sachs Chief Financial Officer David Viniar told Bloomberg News. "We've said very consistently that our business model remained the same." I'll say.

We have just lived through the biggest financial markets blowup in several generations, one in which a catastrophic mixture of bad policy, lax regulation, failed risk management and perverse incentives combined to throw the world into recession and put taxpayers in the position of having to bail out the financial sector.

But yet, Goldman is taking on more risk than before the deluge, and, when it makes more money, allocating the same amount to the no-doubt brilliant employees who helped produce it.

If I were a politician who might need to underwrite the next bailout if Goldman's bets go bad, I'd be a bit worried.

If I were a Goldman shareholder who had seen Lehman and Bear Stearns fall, I'd be wondering why, given the risks they exemplify, I don't get a bigger share of the pie.

It all puts me very much in mind of the old and doubtless apocryphal joke about the out of town J.P. Morgan client a century ago who, when his salesman sought to impress him by pointing out the yachts of Mr. Morgan and his executive lying at anchor at the foot of Wall Street quipped, "Where are the customer's yachts?"

Where, indeed, are the shareholders' yachts, and, if the taxpayers can't get yachts, where are their harbor fees to help clean up the oil slicks when the yachts sink?

A CREATURE OF GOVERNMENT

Goldman's value-at-risk (VAR), a calculation which attempts to measure potential daily losses, increased to $245 million in the quarter, up from $185 million last May and just $127 million in the palmy days of February, 2007.

Shareholder equity has also increased, so you could argue that there is a bigger cushion to buffer losses, but even so Goldman is taking on nearly 15 percent more VAR as compared to shareholder equity than in February 2007.

To be fair, leverage, the ratio of assets to shareholders equity, at the bank is falling and stands at 14.2 percent.

VAR has been widely criticized, not least because of claims it is poor at discounting the kinds of very rare events which ruin firms, but I think it is fair to use it as a proxy for changes in the direction of risk taking.

Goldman may well be better, smarter and even safer than all of the competition, and I am sure they will argue persuasively that they are never going to need to have recourse to the public purse, but a lesson of the past year is that if private risk taking at a big enough institution goes wrong, the government will have to pick up the pieces.

Goldman and virtually every other bank and investment bank around the world are creatures of government. They exist, whether they want to or not, only by grace of the taxpayers who, it has been demonstrated, stand ready to pick up the pieces when risk management fails.

Even if all the government equity and FDIC-insured bonds are paid back, that is still true and is understood by Goldman and everyone else's clients, lenders and counterparties. This gives regulators the right to do what they think is needed to control risk taking, and compensation too, given the strong relationship between incentives and foolish risk taking.

It may be that Goldman's stonking profits and increase in risk are an anomaly, as Goldman was strong enough to be the firm best able to function and take on more risk in the aftermath of last autumn's blowup, and it may also be that regulators become more effective and better at limiting and controlling risk-taking.

A mooted plan to impose fees on activities like proprietary trading is promising and seems both more elegant and easier to manage than outright controls on compensation.

One thing is certain: if regulators don't act there will be a lot of competitors gunning to make Goldman-like profits and not all of them will be as well managed or successful.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on )

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