Goldman Sachs: Still Arrogant and Unrepentant

Last week Goldman Sachs (GS) reported record profits for the April through June 2009 quarter. Quite a difference for a firm that was nearly insolvent less than a year earlier. But thanks to the TARP and favorable borrowing terms from the Federal Reserve, Goldman was able to use taxpayers' funds primarily for the benefit of its shareholders and employees.

In announcing its stellar quarterly earnings of $3.44 billion or $4.93 per share, Goldman stated that it was setting aside $11.36 billion for an employee bonus pool, or $386,489 per employee. According to the Wall Street Journal, Goldman is on track to set aside $20 billion for the year or $700,000 per employee. Under any circumstances, such bonus compensation would be considered sensational. But given the actual circumstances under which its profits were "earned", the projected bonuses are reprehensible and unjustified.

The justification for such bonuses should reflect the risk/reward undertaken to achieve them. Unfortunately, that is far from the case in this instance. Rather, Goldman's apparent success is a function of a confluence of events which had very little to do with the adeptness of its management or employees.

As alluded to above, Goldman was in severe financial stress last Fall as the U.S. financial system was under assault. First, Bear Stearns effectively failed and was sold off to J.P. Morgan Chase (JPM) for $10 a share. Second, Lehman Bros. was forced into bankruptcy after the federal government decided not to bail it out. Third, other financial institutions nearly collapsed and were forced to sell for a fraction of their value only months earlier. Consider Washington Mutual, Merrill Lynch and Wachovia for example.

After the Lehman failure, the financial woes of the U.S. financial system worsened rapidly. The Government enacted the TARP to prevent a further avalanche and in the process created a bailout nation mentality, as least among the largest financial institutions.

A huge beneficiary of TARP funds was AIG. As of today, AIG has received approximately $180 billion of government funds and guarantees for other substantial obligations on its books depending on the ultimate value received for the vast inventory of credit-default swaps and related derivatives on its books.

Of the AIG TARP funds, Goldman received nearly $13 billion. Without those funds, Goldman would likely have suffered a significant loss on the counter-party liability due from AIG. Although Goldman claims that it was really never at risk and was substantially collateralized, Goldman showed no hesitancy in accepting the AIG TARP funds as opposed to enforcing its contractual rights. Clearly, if AIG had gone out of business, it is far from certain as to the nature and extent of AIG's total liabilities and of those particularly due to Goldman, and how such obligations would be treated vis-á-vis other creditors of AIG.

Aside from those funds, Goldman also received $10 billion of TARP funds directly. Of course, this was only after Goldman received nearly instantaneous approval to change its status from an investment bank not regulated by the Federal Reserve to a bank holding company that is. Without the change in status, Goldman would not have qualified for TARP funds and it would have had to raise additional capital from private sources.

In fact, before becoming eligible for TARP funds, Warren Buffett invested $5 billion in preferred stock of Goldman in exchange for a cumulative annualdividend of 10% and warrants to purchase 43,478,260 shares of common stock bearing a strike price of $115. In contrast, thanks to Henry Paulson, the then-Treasury Secretary and former CEO of Goldman, the U.S. government only negotiated to receive a cumulative annual dividend of 10% on its preferred stock investment and warrants to purchase only 12,205,045 million share of common stock with a strike price of $122.90. In effect, Buffett received twice the dividend rate of return on his equity investment to that of the government (even though the situation was more dire when the government invested the TARP funds) and 31,273,215 more warrants than the government at a strike price almost $8 lower. Clearly, the government's below-market equity investment terms were a benefit to Goldman, which would have had to pay at least the same terms to a private investor as received by Buffett (which, given the government's investment, would have equated the right to purchase almost 87 million shares at a strike of $115) and likely much more, given the severity of the situation when the government made its TARP investment as the likelihood of repayment was even less certain at that time.

Besides the TARP, as a result of Goldman becoming a bank holding company, it was given access to the Fed Discount Window, meaning that it could borrow billions of dollars from the Fed at rates as low as .10% and then deploy those funds. Now, the original intent of such borrowings was to enable "banks" to make loans to creditworthy borrowers to spur stagnating economic growth. Such borrowings were not intended as a mechanism for Goldman or other banks borrowing such funds to either purchase other government instruments bearing a higher rate of return or to fund a bank's proprietary trading operations.

But that is exactly what Goldman did. They didn't make a single commercial loan, nor did they accept a single customer deposit. They used the funds to make money on the spread between the almost non-existent cost of borrowing from the Fed and government-guaranteed rates on return on U.S. bond instruments (i.e., bonds issued to fund the Fed borrowings and other government obligations) and related instruments and derivatives. Net net, the government loaned money to Goldman so that Goldman could buy the bonds/instruments being sold to loan money to it and other financial institutions.

Goldman profited handsomely as a result of all of this government assistance, TARP and Fed borrowings. They were literally guaranteed a substantial profit merely by borrowing as much money as possible and then buying government-backed securities bearing a higher rate of interest. Additionally, Goldman took advantage of its nearly monopolistic bond trading operations. With the departure of Bearn Stearn and Lehman Bros. and with Merrill Lynch becoming a shadow of itself due to its acquisition by Bank of America (BAC), there were only two of the principal bond trading operations existing from at least five only months earlier, the other being Morgan Stanley (MS).

While there were other firms trading bonds, Goldman had and retained a significant competitive advantage due to the loss of three of its principal bond trading competitors.

As a result of all this, Goldman posted record earnings. Was that due to Goldman's talent? The skill of its management and its employees? Or did Goldman benefit from the TARP and easy Fed money and fewer competitors in the marketplace? To put it bluntly, Goldman did benefit mightily and for its management to now seek to compensate itself and its employees as if its skill and expertise alone were the only or primary reason for its success is arrogant and condescending.

Yet, that is what Goldman appears to be doing. Other than a perfunctory acknowledgment of thanks to the U.S. government for its assistance, Goldman apparently hasn't learned a thing, certainly not about humility or avoiding ostentatiousness. Consequently, the outrage from the public and Congress has been strong. And even President Obama has counseled against payment of out-sized bonuses by those firms that benefitted from the TARP and other government assistance now that they have returned to profitability due in no small part to U.S. financial assistance.

If Goldman and other banks do not take this advice to heart, it is quite likely that new legislation will attempt to rectify this compensation issue or at least to prevent it from occurring again in the future.

Disclosure: Long BAC and no other positions.

The Case Against Bonuses For Citibank "Key Employee" Traders

Here we go again. Wall Street has yet to take any real economic responsibility for the financial crisis they created (with the government's "help"), but once again they are seeking excessive bonus compensation. Haven't we already seen this movie before with AIG. In that case, AIG was seeking to pay approximately $280 million in "stay" bonuses to a select group of employees -- employees without whom AIG could have functioned effectively for several months after it became an effective ward of the U.S. Government. However, in that situation, there was a contract in place that had been approved by Treasury and relied on by the employees. Whether or not the employees were legally entitled to bonuses was at least an issue in play. In the end, after the public hue and cry, a substantial portion of the intended recipients "voluntarily" agreed to forego all or a substantial portion of the bonus payments. But what the episode made very clear is that when the American taxpayer has bailed a company out from impending bankruptcy, don't come hat in hand expecting to be paid like business as usual.

Frankly, the outrage was justified on an economic basis, while legally perhaps less so. In the real world, when a company files for bankruptcy, it does not matter whether an individual was entitled to a bonus or not based on his individual performance; if the company doesn't have the money to pay the bonus, it doesn't get paid except to the extent other creditors eventually get paid. So, because the government bailed out AIG, Citibank and Bank of America and many others, they didn't technically go bankrupt even though they were insolvent and would have failed without government intervention for better or worse.

So here we have a group of traders at Citibank who, without regard to the fact that shareholders have been substantially wiped out due to their company's poor risk-management and performance, are demanding bonuses for the trading profits generated by Citibank in the first quarter of this year. I am not convinced. Due to Federal Reserve policies of lending billions to Citibank and others at almost 0% and guaranteeing billions more of Citibank obligations, their trading strategies were far from unique and apparently reasonably easy to replicate at other large institutions. To wit: Goldman Sachs, Wells Fargo and even Bank of America profited from substantially similar business tactics. Consequently, the traders at Citibank were merely meeting the benchmark achieved at other firms. In this sense, nothing extraordinary occurred. In fact, the profits at Goldman Sachs were substantially higher than those generated at Citibank.

The point is that the traders at Citibank, while generating substantial profits for the firm, did so under almost "lay-up" like conditions given the government actions to virtually guarantee the banks a highly profitable first quarter. And the traders at Citibank at best correlated with their peers. There is also a real argument as to whether these financial institutions actually even made a "GAAP" profit since the mark-to-market rules were only adopted after the quarter's end with permission thereafter given by FASB to apply those rules retroactively to first quarter results. Thus, if the prior GAAP rules had remained in effect, there is a serious question whether there would have been any profits to crow about. But never let the facts stand in the way of Wall Street greed.

This mentality of being compensated at obscene rates, after massive, unprecedented government bailouts and only peer equivalent performance is questionable at best and evidences a lack of understanding (i) that their bloated bonuses of the past probably really weren't earned given the mess that ensued from those "profitable years" in which they were "earned", and (ii) that they should never return to those levels especially based on short-term government-primed performance. If bonuses are to be paid, let these key employees receive common stock in Citibank vested over three years. Then we will truly see if their one-time juiced performance resulted in shareholder value for the long-term.

By the way, the one-time FASB rule change benefit was reflected in first quarter numbers. Let's see if these so-called "key employee" traders can replicate their performance without continual government intervention bolstering them and whether their performance exceeds peer performance at other institutions. If it does, maybe there is something to talk about bonus-wise. Are you listening Treasury Secretary Geithner?