Streetwise Professor

July 14, 2009

Moral Hazard, Goldman Edition

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 8:41 pm

Many commentors were giddy with the news of Goldman’s large profits.  Not me.  By a long shot.  

For one thing, it is in large part a commentary on the weakness of the banking system, and the consequent erosion of the competition Goldman faces from other big dealers.  (JP Morgan-Chase is in a similar position.)  

More ominously, Goldman had this record quarter by dramatically increasing its risk exposure:

 Goldman Sachs Group Inc.  ratcheted up risk-taking to an all-time high in the second quarter, increasing equity bets 58 percent to amass record trading revenue and quarterly earnings.

Value-at-risk, a measure of how much money the firm could lose in a day’s trading, rose to $245 million from $240 million in the first quarter, the New York-based firm said yesterday. The figure stood at $184 million last May (see table, below). Most of the increase during the second quarter stemmed from equity-trading risk, which surged to an average of $60 million per day from $38 million in the previous three months.

Goldman Sachs’s  move to become a bank holding company in September to win the financial backing of the Federal Reserve didn’t curb the firm’s appetite for wagering its capital on trading, a formula that fueled Wall Street profit and compensation records in 2007. Second-quarter earnings and revenue also benefited from reduced competition, following the collapse of Bear Stearns Cos. and  Lehman Brothers Holdings Inc.

Goldman knows it is too big to fail.  How does it know this?  Well, the government bailed out AIG not so much for AIG’s sake, but for the sake of big AIG counterparties–most notably Goldman.  Moreover, given the conventional wisdom that the government’s primary error in the financial crisis was its failure to bail out Lehman–a piker compared to Goldman–it doesn’t take a rocket scientist to figure out that it won’t repeat that mistake in the future, and let Goldman go down.  So Goldman knows it can get bigger, and take more risk.  It is the classic heads Goldman wins, tails the sucker taxpayer eats the loss gambit.  If nobody steps in to rein in the firm, it will continue to add risk, thereby enhancing the value of the Treasury put hiding in the equity entry on its balance sheet.  

Somebody should be stepping in–but nobody is. Why not?  Partly, no doubt, it is Goldman’s political heft.  It is likely too that important policy makers don’t want to crack down on a major source of risk capital to the markets in the fear that this would impede a recovery.  Even though in reality, that risk capital is your money and mine, with the exception that we have no chance of capturing the upside, and are left with a good chunk of the downside.  This is a piece with the hair-of-the-dog strategy being pursued by Treasury and the Fed.

Too big to fail is extremely pernicious.  It is the biggest systemic risk, bar none.  The big Goldman profit, and the big Goldman risk, should raise serious concerns that TBTF is alive and well, and rather than roping it in, regulators are feeding it in the short-sighted belief that it is essential to a financial and economic recovery.  This is just laying the groundwork for bigger risks in the future.

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  1. As I see it Goldman’s exposure to risk is offset by their alumni being firmly entrenched in the halls of power and the deep pocket of their campaign contributions to the useless lemmings we have in Congress.

    What people aren’t getting is that Goldman is a hedge fund as well as a well placed lackey making a fortune processing government debt and gunning the indexes for the Feds with massive program trades so 401k folks won’t feel poorer.

    I’d love to see them blow up but they’ll never have to face the consequences.

    Comment by penny — July 15, 2009 @ 8:51 am

  2. […] Goldman-Sachs, Too Big to Fail? […]

    Pingback by US politics - Hamsterwheel - Page 205 - PPRuNe Forums — July 16, 2009 @ 12:29 pm

  3. Absolutely. 5.6 B revenues from trading compared to a puny 1.2 B from the traditional investment banking side. Asset management seems to be almost out of the door with around 800M. I am also interested in learning about any rumors from within the bank on this shift in power structure. Many an investment banker would be fuming at the loss of political heft inside the firm and the continued increase in the trader’s clout. That Blankefein is from the trading side just means this policy of gambling its way to glory is going to continue unabated. As regards to the daily Var – this could fluctuate substantially depending on the distribution employed. Using a genuine fat tailed distribution might render that figure even worse.

    Comment by Surya — July 16, 2009 @ 5:41 pm

  4. Surya–Re fat tails. Right on target. “Real” var is usually bigger than reported var due to the fat tail problem. Indeed, there is evidence of this–goldman had too many var limit breaches (most on the upside, admittedly).

    Also, would be interesting to know loss conditional on var breach.

    The ProfessorComment by The Professor — July 16, 2009 @ 6:58 pm

  5. Interesting. Where is the evidence published? Is this something that SEC catches? Or is it something released in the 10K statements?

    Comment by Surya — July 17, 2009 @ 6:37 am

  6. […] eye-popping $3.4 billion second-quarter earnings shouldn’t surprise anyone. As Craig Pirrong notes, these earnings reflect moral hazard, pure and simple, with Goldman exploiting its […]

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  7. […] eye-popping $3.4 billion second-quarter earnings shouldn’t surprise anyone; as Craig Pirrong notes, these earnings reflect good old-fashioned moral hazard, with Goldman exploiting its […]

    Pingback by Goldman Sachs, Best in the Business | The Beacon — July 17, 2009 @ 9:49 am

  8. […] eye-popping $3.4 billion second-quarter earnings shouldn’t surprise anyone; as Craig Pirrong notes, these earnings reflect good old-fashioned moral hazard, with Goldman exploiting its […]

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