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Goldman Sachs After Lloyd Blankfein

San Diego | Reports last week that Goldman Sachs (NYSE:GS) CEO Lloyd Blankfein was planning to retire by the end of 2018 caused a bit of a fuss. We spoke about the prospect of a change on CNBC’s Closing Bell on Friday. And yes, we do hope Mr. Blankfein goes to Washington, a city where adult supervision is badly needed.

As Blankfein prepares to declare victory and hand the leader’s baton to another GS banker, it is worth considering how the investment bank has changed under his tenure and its competitive prospects going forward. While Blankfein did an admirable job stewarding GS through the financial crisis, the bank’s future has never been less certain.

When GS was founded by German immigrants in 1869, the tiny non-bank made its way in a marketplace dominated by large commercial banks. Marcus Goldman built his firm by providing credit to small businesses in New York, what is today known as commercial paper. By the turn of the century, GS was venturing into the world of equity underwriting, leading offering for businesses like General Cigar and Sears Roebuck.

You can divide the history of GS into two major periods: the first half, which includes the firm’s early years and the 40-year tenure of Sidney Weinberg; and the second half, which begins with the ascension of Gus Levy as senior partner in 1969. Levy grew the trading business which became the primary source of revenue for GS by the 1970s.

Weinberg, who was known as “Mr. Wall Street,” focused on building the firm’s corporate finance business after the 1930s. Under his direction, GS recovered from the Great Depression and became a leader on Wall Street in such areas as real estate and mergers & acquisitions. And yet despite the success of GS, the firm still operated in the shadow of the large Wall Street commercial banks and investment houses.

Sidney James Weinberg

For example, when the Ford clan wanted to save their business from the Internal Revenue Service after the death of Henry Ford in 1947, the family of Edsel Ford consulted Sidney Weinberg. The result of those efforts was the novel creation of the Ford Foundation, as described in “Ford Men: From Inspiration to Enterprise.” But when Ford Motor Co (NYSE:F) went public in 1956, Blyth, Eastman Dillon & Co. got the mandate. GS was the number four underwriter in the deal. Even with Weinberg’s relationship with the Ford family, another firm got the underwriting business.

Going back 12 years to when Blankfein took over as CEO, GS was in some respect little changed from the firm created by Gus Levy. It was a large broker dealer with no bank deposit base and a business that rested on two legs, investment banking and trading. A third leg could be added to include the internal funds managed by GS for its partners and clients, a dimension that made the bank part advisor and part private equity investor. With the 2008 financial crisis, however, GS was forced to become a bank – in name, at least – in order to gain access to liquidity and support from the Federal Reserve.

While other firms such as Lehman Brothers and Bear, Stearns & Co. were annihilated during the 2008 financial crisis, GS survived, albeit in a different form. With the passage of Dodd Frank in 2010, the major banks were forced to shed their internal funds and principal activities because of the Volcker Rule, which rightly identified the principal activities of banks as a fundamental conflict of interest with the bank’s clients. So today the house build by Marcus Goldman really rests upon just two legs, leaving GS vulnerable to changes in the trading environment.

By becoming a bank, GS reassured its clients and came under the regulation (and protection) of the Federal Reserve Board. But in one of the many ironies of this period, the Fed’s purchase of securities as part of “Quantitative Easing” badly diminished the trading business of GS and the other major Wall Street banks. As we described earlier (“Banks and the Fed’s Duration Trap”), by taking $4 trillion worth of securities out of the private marketplace, the Federal Open Market Committee not only distorted credit spreads and juiced asset prices, but also suppressed volatility and trading in the secondary markets.

Today at just shy of $1 trillion in total assets, GS is one of the smallest of the global universal banks. Compared to other large US banks, GS has among the lowest asset returns and net operating income as a percentage of total assets, but boasts non-interest income as a percentage of its balance sheet that is three times that of larger peers. At year-end 2017, net loans and leases at Goldman’s single subsidiary bank were just 12% of the firm’s consolidated assets vs 70% for most large banks.

These metrics illustrate how the GS business model is very different from that of JPMorgan (NYSE:JPM) and Citigroup (NYSE:C) and remains dependent upon transactional income and volatile sources of funding. Let’s compare GS with Morgan Stanley (NYSE:MS), a slightly smaller bank holding company with two subsidiary banks that generates significantly more net interest income as a percentage of its balance sheet. The MS bank units have total assets of nearly $200 billion while the Goldman Sachs Bank USA had total assets of $160 billion at year end.

Net loans and leases at MS were almost one fifth of the group’s total assets at the end of 2017 vs about 15% for the GS bank unit. Significantly, Goldman’s dependence upon non-core funding is twice that of JPM and C and roughly four times that of MS. The double leverage of GS (equity investment in subs / equity capital) was 116% at year end vs 101% for larger banks and just 85% for MS. Of note, the double leverage of GS was just 102% at the end of 2014. Credit rating agencies tend to get nervous when double leverage in a bank holding company is above 115%.

One of the key measures of financial strength for a universal bank in the post-Dodd Frank world is assets under management (AUM), in part because so many universal banks have de-emphasized trading and focused instead on the regular cash flows of wealth management.

At MS, assets under management were $438 billion at the end of 2017 generating an average of 46bp of fee income of $2.1 billion in 2017. Total fee based client assets at MS were $1 trillion at year-end earning 76bp on average or over $13 billion in pretax income. Of the $37 billion in net revenues for MS at year end 2017, 50% came from sales and trading, 44% came from wealth management and the remainder from investment management.

By comparison, GS had $32 billion in net revenues at December 31, 2017, with less than a third coming from wealth and investment management and the largest portion from traditional trading and investment banking activities. GS has $1 trillion plus in assets under supervision, plus another $300 billion in liquidity products, yet the Investment Management segment generated half the net revenues of the comparable business at MS.

In the half century since Gus Levy became the leader of GS, investment bank and trading remain the two largest segments at the firm. As and when new leadership takes over GS from Lloyd Blankfein, the key issue that confronts the firm is how to grow its current business model into a more balanced and less volatile franchise.

Each time that GS has stumbled in terms of earnings from trading, for example, the firm has spent a great deal of time talking about growing the Goldman Sachs Bank into consumer deposit taking and lending. But these are low return businesses that offer more risk than reward. Trading cryptocurrencies was another suggestion advanced by Mr. Blankfein after a disappointing earnings report, a decidedly bad idea whose time hopefully has come and gone.

As we discussed on CNBC last week, the opportunity for GS is to go where the larger banks are not. GS, for example, went into real estate finance, M&A and risk arbitrage long before the larger bulge bracket firms. In the wake of the 2008 financial crisis, many of the larger US banks have backed away from consumer finance and instead focused on lower risk wealth management and business lending.

If GS chooses to remain a commercial bank, then it might consider acquiring another depository with a real retail deposit base and an established lending operation, hopefully one focused on business lending where spreads are higher and risks considerable lower. Construction lending, for example, is a short duration asset business that many commercial banks have fled, but it can be a very lucrative and low-risk business if managed properly. It also leads to other types of lending and asset securitization opportunities in real estate that GS knows very well.

But if GS is to survive and prosper in the 21st Century, it needs to rely upon its legendary ability to see and execute on new opportunities b