The Goldman Sachs Group, Inc. (GS) is an American-based giant multinational investment bank and securities company. Its services include investment banking, securities and investment management, and prime brokerage. Clients include corporations, high-net-worth individuals, governments, and financial institutions. The corporation was founded in New York in 1869 by Marcus Goldman, and underwent its IPO in 1999.

Goldman Sachs has long been the gold standard by which every other large investment bank is measured. For years the company has ranked either number 1 or 2 on investment banking. This was due in large part to the corporation’s management and culture. Goldman Sachs University has long been training recruits to think with a group mindset, asking each employee to put the bank’s above one's own goals. Such a culture has helped Goldman avoid the internal power struggles some of its competitors faced.

Gradually, Goldman Sachs began to shift away from the classical, low-risk, relationship-building model of investment banking to a high risk, proprietary trading model. Such a shift resulted in more than 70% of the corporation’s revenues coming from “Trading and Principal Investments” of its own accounts, and more important, more profits for the its shareholders in 2010. Where exactly did Goldman place its bets?

Near the turn of the last century, the U.S. Government contributed in two ways to not only Goldman's trading profits, but also to those of its competitors. One of the President's primary goals was to “make sure that hardworking Americans realize the dream of home ownership.” He asked that interest rates be kept low in order to allow for affordable mortgages. Second, Congress repealed the Glass Steagall Act in 1999, finally allowing commercial lenders to underwrite and trade securities, including mortgage-backed securities.

The frenzy of the housing bubble fueled mortgage securitization and trading. All the banks were recording massive profits. However in 2006, Goldman started seeing flaws in the MBS trading model. With the belief that housing prices weren't sustainable and, therefore, would lead to an increased number of defaults, the bank started to hedge its risk. The best way to get rid of a risk is to sell it. The second best way is to buy insurance for it. With the invention of the credit default swap, essentially a way to ensure the value of a debt security, Goldman was able to do both. As usual, Goldman was ahead of the curve and made record profits. So what's wrong?

By selling MBSs, Goldman was telling its clients to go long on the security. At the same time, by buying CDSs, Goldman was going short. There is nothing wrong with this, as Goldman exhibited excellent risk management. In addition, clients going long were knowledgeable investors seeking the risk of the MBS for its potential rewards. The issue lies in the fact that much of Goldman's record profits came at the expense of taxpayers in the form of TARP. AIG was on the other side of Goldman's CDSs, but was unable to pay the bank due to its own massive losses after the housing collapse. The government bailed AIG out, resulting in AIG delivering $12.9 billion to Goldman.

Since the financial crisis in this country, much has changed for Goldman and the investment banking industry. The Volcker Rule and other regulations have restricted leverage ratios and eliminated proprietary trading, all of which will lead to decreasing profits. But more important, at least for Goldman, is that the investment bank's public image has taken a beating that competitors such as J.P. Morgan (JPM - Free J.P. Morgan Stock Report) and Morgan Stanley (MS) were able to dodge. Politicians have targeted Goldman and its practices for causing the financial upheavals. This negative public image has certainly hurt the bank's stock considerably. How will Goldman fix its problems?

In the short run, there doesn't seem to be a solution. Goldman's competitors are capitalizing on its weakness by taking away market share. As the 2012 elections come up, expect Goldman's public image to take another hit. In the long run, however, we believe Goldman is still the gold standard. As competitors, including Goliath-sized Chinese banks, start absorbing larger and larger chunks of the investment banking market, we believe banks like Goldman will start consolidating in order to compete. We think Goldman will get larger. With Goldman's unique understanding of global markets and client needs, we look for Goldman to be a leader in financial innovation regardless of the industry evolution.


At the time of this article’s writing, the author did not have positions in any of the companies mentioned.