“There are some things so dear, some things so precious, some things so eternally true, that they are worth dying for. And I submit to you that if a man has not discovered something that he will die for, he isn’t fit to live.”
January 16, 2023 | Over the Martin Luther King holiday, in between playoff football games and the latest bomb from the pasta queen, we examined the most recent corporate reorganization and earnings restatement from Goldman Sachs (GS). We also pondered the earlier debacle at JPMorgan (JPM) involving a supposed startup known as “Frank.” In celebration of MLK, our thoughts follow below for the readers of The Institutional Risk Analyst.
Over the past few years of QE, credit did appear to have no cost – to be free of consequences or pain. But it seems that the reckoning was merely delayed. JPM invested in a company that allegedly created millions of fake user accounts. Sad to say, large banks led by Wells Fargo & Co (WFC) own the fake account thing.
Maybe our friend Mike Mayo was right to berate Jamie Dimon, CEO of JPMorgan Chase (JPM), about sloppy portfolio investments during the earnings call last week. In the lawsuit filed at the end of 2022, JPM states:
“Defendant Charlie Javice founded a small start-up business known as Frank that seemingly had the potential to grow and become a successful enterprise in the future, and appeared to have had had early proven success.1 But to cash in, Javice decided to lie, including lying about Frank’s success, Frank’s size, and the depth of Frank’s market penetration in order to induce JPMC to purchase Frank for $175 million. Specifically, Javice represented in documents placed in the acquisition data room, in pitch materials, and through verbal presentations…”
Apparently 4 million of Frank’s 4.6 million claimed users were nonexistent. “When JPMC specifically requested proof of that claim during due diligence, Javice used ‘synthetic data’ techniques to create a list of 4.265 million fake customers,” states the complaint – “a list of names, addresses, dates of birth, and other personal information for 4.265 million “students” who did not actually exist. In reality, Frank was nearly 4 million short of its representations to JPMC.”
But here’s the question: Did the managers at JPM ever even look at anything other than the documents in the “data room” or the pitch materials provided by Charlie Javice? How many deals, fellow bankers, have we seen in the past decade where diligence followed the close? Truth is, what passes for due diligence and assurance in the hyperbolic, post-COVID world of quantitative easing and tightening will shock even the most jaded market cynic.
But size is also a problem, that is, asset inflation illustrated by large banks. In Q1 2009, the total assets of the US banking industry was a tad of $13 trillion. Today it is over $20 trillion. Inflation? When assets at JPM or the other money centers total into the trillions and 20% of the book rolls off every year, you got to do a lot of deals to feed the beast. This reduction in the quality of assets is another hidden cost of inflation and QE.
With a balance sheet over $2 trillion, the $175 million lost by Jamie Dimon in the Frank fraud is arguably not material to investors. Indeed, there is more risk than reward in this stinky deal. Why did JPM even consider a PE investment this small? Perhaps it was the fact of a female entrepreneur? But whatever the rationale, this deal did not seem to rise to a level of significance where the Morgan bankers would actually perform due diligence prior to the close. Really?
Leaving aside the tawdry details of this transaction, the Frank episode illustrates how the Fed’s de facto embrace of inflation encourages misallocation of economic resources on a grand scale, not just in the US but globally. And this is nothing new. Instead, the scope and size of the Fed’s manipulation of risk appetites has increased astronomically as the size of the federal debt has grown. Consider the judgment of Roger W. Garrison in 1994 ("The Federal Reserve: Then and Now"):
“There are significant parallels between the Roaring 1920s and the Bullish 1980s. Both decades were characterized by a policy-induced artificial boom that ended with an inevitable bust. The Federal Reserve had a hand in both episodes, keeping the interest rate artificially low in the first one and keeping Treasury bills artificially risk-free in the second. Comparing the two episodes in terms of Federal Reserve policy, federal government borrowing, and the regulatory environment faced by the banking community accounts for both similarities and differences between the economic realities of the 1990s and those of the 1930s.”
Notice that Garrison pays explicit attention to the key aspect of the Fed’s massive open market operations, namely subsidizing the debt costs (and liquidity) for the U.S. Treasury. Some thirty years later, observers in today’s markets barely mention that the real point of QE is subsidizing part of the Treasury’s debt issuance. If we actually performed a summation of the risks and rewards of QE to the private sector, would the balance be as positive?
Risk vs reward, one of the key themes of The Institutional Risk Analyst, brings us next to the growing disarray at Goldman Sachs. Last week, the bank pre-announced a corporate restructuring and restatement of its business. This is the latest exercise in rearranging the lawn furniture in terms of presentation, but not really making any substantive changes in how the business is operated. The chart below shows the new corporate org chart for Goldman Sachs.
The implicit message in the latest GS restructuring: the portions of Marcus that face wealth management clients is good, corporate banking and other stuff is a loss-leader. GS has labeled the "bad bank" Platform Solutions. We can think of some other names. Our Ukrainian babusya called it "schmatta" -- rags. Question for Mayo to ask David Solomon on Tuesday: Is Platform Solutions to be discontinued?
The corporate reorganization, announced just days before the release of Q4 2022 earnings, represents the most audacious attempt at changing the subject in the storied history of Goldman Sachs. The restatement of earnings shows a $3 billion loss to date on the “build-a-bank” project known as Marcus.
The organic banking strategy build has been underway at GS since it converted into a bank holding company a decade ago. These belated disclosures now answer some of the questions about Marcus and the inability of the leadership of the firm to actually run a commercial bank. Below are the restated earnings into the three new buckets.
We’ve argued for years now that GS needs to combine forces with a good-sized commercial bank, Key Corp (KEY) on the small side has a strong focus on commercial real estate, a favorite asset class for GS bankers. Or perhaps PNC Financial (PNC) or even U.S. Bancorp (USB) on the high end. Why? One word: Funding.
As we wrote for our Premium Service readers in December (“Outliers: CapitalOne, Goldman Sachs & Citigroup”), GS is leading the large banks higher in terms of cost of funds, even compared to subprime lenders like Citigroup (C) or CapitalOne (COF). That is bad. JPM and other larger banks, of note, are down at or below the average funding costs for Peer Group 1.
Notice not just the funding costs of GS, but also the outsized credit losses coming from both the Marcus bank focused on wealth management clients and also the corporate bank in the tables above. Even though GS has a smaller loan book than its asset peers, it manages to lose 2.5x as much money than JPM and Peer Group 1? How does this latest corporate reshuffling address this performance deficit in terms of credit risk management?
There are three legs to the universal bank model perfected by Morgan Stanley (MS), UBS AG (UBS) and Charles Schwab (SCHW): 1) banker, 2) trader and 3) advisor. GS is missing a leg. On Tuesday AM, GS CEO David Solomon needs to lay out his strategy for getting GS big enough and efficient enough in an operational sense to be credible as a large universal bank. The Street has GS revenue down double digits in Q4 2022, but the bigger question is about the next five years.
We are scheduled on CNBC Worldwide Exchange 5:30 ET Tuesday
January 17th to talk bank earnings with Brian Sullivan.
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