Submitted by Edward Harrison of Credit Writedowns.

Marshall Auerback sent me a link to a recent Simon Johnson missive about Goldman Sachs. I had already seen and liked this article, but his e-mail prompted me to write this post. My question is: Why is Goldman a bank holding company?

Goldman becomes a bank

The reason Goldman became a bank to begin with is because it was on the verge of collapse after the Lehman Brothers failure. Andrew Ross Sorkin has a good write up on this in Vanity Fair:

Due to disastrous bets on Lehman paper, the giant Reserve Primary Fund had broken the buck a day earlier, causing an investor run on the money-market funds. Between that, Geithner thought, and billions of dollars of investors’ money locked up inside the now bankrupt Lehman Brothers, that meant only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

Just in case it’s not obvious, Goldman Sachs was a major beneficiary of the government’s bailout of the financial services industry, not only through the bailout of AIG but also through its ability to fall under the regulatory umbrella as a bank holding company (technically Goldman became a financial holding company but the distinction is relatively minor. see definition here). – something which made it eligible for debt guarantees and other government backstops.

Late last year, every financial services company on earth wanted to become a bank and line up for the handouts coming from Washington – American Express (a credit card company), GE Capital (basically a hedge fund), GMAC (a car financing company), Genworth Financial (an insurance company), Aegon (a Dutch company), even Willem Buiter, a former central banker, wanted to become a bank.

This is why Goldman became a bank too. Now, Goldman was in a more precarious position than bank holding companies because of the vulnerabilities of being a broker-dealer. Nouriel Roubini warned repeatedly before Leman’s collapse that the large full services broker-dealer model was broken. Here, just before Lehman failed, he talks about Goldman, Morgan Stanley and Merrill’s demise if Lehman collapses:

I also argued in follow-up pieces that, in a matter of two years, no one of the remaining independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley and Goldman Sachs) would survive as: 1. their business model is now impaired (securitization is semi-dead); 2. they will need to be regulated like banks given the PDCF support and thus have lower leverage, higher liquidity and more capital that will erode their profitability; 3. Their severe maturity mismatch – borrowing very short term and liquid, leveraging a lot and lending and investing in more long term and illiquid ways – makes them very fragile – in the absence of deposit insurance and in the presence of only limited LOLR support by a central bank – to bank like run that are destructive even of illiquid but otherwise solvent institutions. Thus all such broker dealers need to merge with larger financial institutions that have a commercial banking arm and thus access to stable and insured deposits and to true LOLR Fed support. That process of unraveling of independent broker dealers started with Bear Stearns; now it is moved to Lehman; tomorrow Merrill Lynch will be on line; and Morgan Stanley and Goldman Sachs will be next. No one of them can and will survive as independent entities. So, the Fed and Treasury should advise them all to start finding a large international partner (international as almost no domestic partner is now sound to take them over) and merge with such partner before we get another Bear or Lehman disaster.

I happen to think Goldman is a well-run institution, but that is neither here nor there. They were vulnerable.

And, apparently, policy makers heeded Roubini’s words as all the broker-dealers were immediately made into banks. Government went so far as to try and merge Goldman with the bankrupt Wachovia (now a problem for Wells Fargo), but thought better of it because of the conflicts of interest for Hank Paulson and Robert Steel:

In an excerpt from his forthcoming book, Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, Sorkin reports that the deal, which was nearly consummated, would have merged Goldman Sachs and Wachovia. Henry M. Paulson, the Treasury secretary and former C.E.O. of Goldman, was deeply involved in the process, contacting both Lloyd Blankfein, Goldman’s current C.E.O., and a Wachovia board member, and strongly urged both to consider it. Wachovia’s C.E.O., Robert Steel, was a former vice-chairman at Goldman Sachs and Paulson’s former number two at the Treasury Department. Sorkin reports that Warren Buffett was also contacted about investing in the merged company, but told a banker at Goldman that it would never happen. “By tonight the government will realize they can’t provide capital to a deal that’s being done by the former firm of the Treasury secretary with the company of a former vice-chairman of Goldman Sachs and former deputy Treasury secretary,” Buffett said. “There is no way. They’ll all wake up and realize, even if it was the best deal in the world, they can’t do it.”

Goldman gets to game the system

These conflicts of interest has everyone up in arms about Goldman, dubbed “Government Sachs” by its haters (see here, here, and here). That is why the face-sucking squid polemic by Matt Taibbi was a zeitgeist piece.

I think eyes should be focused firmly on the government’s responsibility and not Goldman when it comes to these issues. Which is why the issues that Simon Johnson raises are important. They go to the core of the regulation of banks.

Here are four questions we should be asking regulators:

Why is Goldman Sachs allowed to maintain leverage ratios significantly higher than the large legacy bank holding companies like Wells Fargo, Bank of America, JPMorgan and Citigroup? Why is Goldman allowed to operate like a private equity company, holding large stakes of foreign non-financial corporations? (I should note that Financial Holding Companies do have ten years in which to sell their stakes) Why is Goldman (and other large banks) allowed to operate like a hedge fund and take outsized risks with capital via large proprietary trading operations. Most of Goldman’s profits are coming from this area. At least Deutsche Bank has offloaded these bets onto hedge funds in which it invests. Given the fact that the large too-bog-to-fail financial institutions have received a large backstop from the taxpayer, the fact that they are loading up in prop trading shows that regulation in the U.S. is non-existent. Why is Goldman allowed to have an interest in the failure of other financial firms? We now hear that Goldman has an interest in the failure of CIT, a major lender to small-and medium-sized businesses. These perverse incentives are everywhere in the derivatives world and were an enabler of the financial meltdown and the principal reason AIG was bailed out with taxpayer money.

Clearly, regulators are not serious about regulating or they would correct these problems. MarketWatch reported on this as far back as July and nothing has happened.

When Goldman switched to a bank holding company, such big profit seemed unlikely as analysts worried the firm would face stricter regulatory oversight from the Federal Reserve, with limits on risk-taking and higher capital requirements. See story Wall Street changes. But almost 10 months later, nothing much appears to have changed, some analysts said in the wake of the firm’s second-quarter results. After two quarters as a bank holding company, Goldman is still “not reporting like a bank and not acting like one either,” said David Hendler, Baylor Lancaster, Pri de Silva and Kristine Lanspa, analysts at CreditSights, an independent fixed-income research firm. Given Goldman’s spectacular results so far this year, “the company has basically been given a green light to continue operating in a ‘business as usual’ fashion,” they wrote in a note to investors after Goldman’s latest earnings report. “Bank regulators have their hands full with other deteriorating bank situations and, for the time being, seem content to let Goldman do what it’s always done.” Tier 1 Goldman still doesn’t report quarterly results like other large bank holding companies. For instance, the firm doesn’t disclose a full balance sheet in its earnings release or provide detailed information on revenue and valuation marks on exposures, the analysts noted… “Our sense is that Goldman’s switch to bank holding company status was basically a security blanket in the worst of last fall’s troubles, and the company would be happier today if it could let it go,” they added. “We also sense that Goldman Sachs many not yet have the same level of regulatory scrutiny that many banks routinely live with.”

And CreditSights is right. Goldman have no intention of changing anything at all.

“Our model really never changed,” Goldman Sachs Chief Financial Officer David Viniar said yesterday in an interview. “We’ve said very consistently that our business model remained the same.”

Plus ça change.

The excerpt in this article from the RGE Monitor is copyrighted and re-published with the express permission of Roubini Global Economics LLC.

Update: Chris Whalen is apoplectic that Goldman is upgrading the too-big-to-fail banks and has given his own downbeat assessment, a view I shared on Credit Writedowns just yesterday. See his comments and video here.