By John W. Schoen Senior producer
msnbc.com
updated 7/27/2009 11:02:17 AM ET 2009-07-27T15:02:17

While the U.S. banking industry struggles to right itself, Goldman Sachs has figured out how to turn financial turmoil into gold. Here’s how.

Why has Goldman Sachs prospered in this recession-depression and most other banks have fallen out or are in real trouble? … Perhaps that is where all of our money has gone. ...
-Alan M., Oregon

The answer is that Goldman Sachs isn’t really a bank. It’s a gigantic investment company that offers very limited conventional banking services — like lending money — on the side. Because it’s one of the few investment banks left standing, it has the highly profitable field of trading and underwriting pretty much to itself.

The bulk of the $2.7 billion profit Goldman reported for the second quarter, and roughly three-quarters of its revenues, came from trading — making bets buying stocks and bonds. Though it officially became a regulated bank holding company last year when the financial crisis hit, Goldman still behaves like a traditional investment bank. Since the financial meltdown wiped out most of its major rivals — including Lehman Bros. and Bear Stearns — it has picked up investment banking business from former customers of those defunct companies.

Goldman’s chief financial officer David Viniar put it succinctly when explaining the surge in profits: "There's less competition out there."

Because there are fewer players left, each trade also becomes potentially more profitable. Here's why. When an individual stock, for example, is heavily traded, the difference — or spread — between the price a buyer is willing to bid and what a seller is asking usually is very narrow. Traders make their money on that spread: A nickel here, a dime there and soon you’re talking real money.

In Goldman’s case, the trades that proved so profitable were in securities that few other traders wanted to make, including dodgy bonds. With fewer buyers and sellers, the spreads on these trades are much wider. If you bet right, your payoff is much bigger.

Goldman also entered the financial crisis with a relatively strong cash cushion which allows it to make riskier bets than banks that are still trying to rebuild their battered balance sheets. Companies such as Morgan Stanley that played it safe during the quarter paid the price in the lost opportunity to make trading profits.

Goldman also profited from another line of business that used to be fiercely competitive: underwriting stocks. When companies want to raise cash by selling stock, they need a big investment banker to move large piles of it quickly at a good price. In the second quarter, Goldman’s equity underwriting business generated record revenues of $736 million. Ironically, it was a quarter when many of those raising money by selling stocks were other banks.

It didn’t hurt that Goldman — like other banks — had access to extremely cheap money, thanks to the Fed’s policy of keeping short-term interest rates near zero. This is not a bad time to be a banker, despite the colossal losses incurred by the ones who made terrible loans and bought bonds backed by mortgages that people could never repay. Any time you're in the business of lending money, it helps to be able to get your hands on what is essentially free cash.

The taxpayer-funded TARP bailout money really didn’t help Goldman all that much. For one thing, the government was charging Goldman and other bailed-out banks 5 percent interest. The government also took warrants — essentially the right to buy some of each bailed-out bank’s stock. Goldman is now negotiating to buy those warrants back, which will cost it more money.

But that’s not the only reason for getting out from under the government’s bank welfare program. Like all big banks, Goldman executives chafed at the government's efforts to limit bonuses at banks that took TARP money.

With the TARP money repaid, and the restrictions lifted, Goldman set aside $6.65 billion in the second quarter for salaries, bonuses and benefits. That’s up almost 50 percent from last year and works out to an average of about $900,000 per employee.

The top traders who made all those winning bets can expect to take home tens of millions of dollars each.

I keep hearing about toxic assets and how they’re pulling down banks or at least making them less amenable to lending money. Do these assets pay any money? Are they toxic when the asset pays nothing? Why don’t they just write them off?
- Paul A., Sturtevant, Wis.

What makes them toxic is that they are filled with bad loans. No one is really sure how many bad loans. Nor can they say just how bad those loans are.

Usually, this isn’t such a difficult problem for a banker. If you make a loan to a home buyer, you always run the risk that they won’t pay it back. When they reach the point where they can no longer pay, the bank takes the house and sells it, writes off any losses and everyone moves on.

There are billions of dollars of loans on the banking industry’s books that are still performing today but might not in the future if house prices keep falling and unemployment keeps rising. So how do you value those loans? As long as they’re performing, it’s not unreasonable to say they're worth 100 cents on the dollar. But if default rates start rising, it’s time to start marking them down to create a more realistic appraisal of the risk that more of them will go bad.

Ordinarily, when a bank has a loan that is at risk of default, it can seek a buyer who will buy it at a discount, gambling that the borrower eventually will pay it off in full.

But things change when you take those loans, mix them all into a big pot, slice the pot into pieces and sell the pieces to other banks. The resulting bonds may be backed by hundreds of mortgages — each with its own risk of defaulting. To make things even more complicated, mix some car loans, student loans and home equity loans into the pot before you slice it.

There is simply no way to know which loans, or how many, will default before the housing market and economy recover.

In the meantime, it’s like trying to buy a bottle of water when you have been warned that some on the shelf are full of poison.  You pretty much have to label the entire batch as toxic.

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