Goldman Sachs announced the best quarter of its 140 year existence yesterday. Normally, this type of news would be viewed quite positively as a sign that the financial industry is turning around and the recovery is fast approaching. But how it made this money has a lot of observers worried that the street truly has not learned its lessons.
The obvious political furor is over the $11.4 billion set aside as employee bonuses (as a clarification from my original post this amount is for the whole year not just this quarter). From a populist perspective, Goldman Sachs has thrown an oil tanker on the fire. From an economic perspective, many worry that bonus envy may lead to imprudent risk taking from less skilled (or less lucky) peers, re-setting the cycle of chasing the highest-risk for highest reward on someone else’s money.
More worrisome is how Goldman Sachs achieved this result. It basically traded its way to massive profit. Net revenue from trading was up 93% year over year to $10.78 billion; having made $13.8 billion in total revenue in the last quarter, this is a huge dependency on a revenue source that is not exactly stable right now.
More specifically, financial analysts use a concept called value at risk (VaR). In plain English and on a very simple basis, VaR measure how much risk of loss a particular portfolio has. Goldman Sachs VaR increased 22% last quarter and its average daily VaR is estimated at approximately $245 million. In other words, this figure is its exposure to loss every day but if recent history teaches us anything it is that losses are not one-day events.
In and of itself, this is pretty risky but as Reuters reported Goldman Sachs is now the second largest derivatives trader in the U.S., adding a staggering $10 trillion in contracts in one quarter. Derivatives contracts carry with them counterparty risk which can be mitigated but the law of averages dictates that in massive quantities your risk management analysis in derivatives moves from “what if we loss” to “how much are we losing?”
Combine massive trading with Goldman Sachs becoming the new AIG and has the street learned anything? Probably not. Goldman Sachs employs some of the smartest people on the earth. No one can deny their talent and drive. But their willness to believe that the future means resorting to the very recent past, with the context having changed around them, is a worrisome trend which one hopes is an exception rather than the new/old rule.
July 15th, 2009 at 10:55 am
Leaving aside the question of whether these trades involve too much hidden risk (one quarter doesn’t tell us anything about their long-term success rate), I don’t find it too hard to believe that a company such as GS could potentially have an ability to trade more than it did in the past without going to losing trades. In that case the main problem would be that since current volatility gives a trader who knows the market well more opportunities to profit, these profits will tend to decline in the long run. However that sounds like excellent diversification – profit from volatility when times are bad, and from more stable business that pick up again when times are good.