Here’s how Goldman Sachs makes all that cash

John W. Schoen Senior producer • Profile • E-mail

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.

MORE FROM ANSWER DESK

Answer Desk Section Front

Jobless benefit bedlam Who needs overpaid bankers? Who gets extended jobless benefits Easing job losses point to wobbly recovery Long-term jobless face frayed safety net GDP growth overstates case Recession over? Readers don't believe it Breaking down the cost of health care Commercial real estate bust looms 'Official' job numbers don't tell the whole story Answer Desk Section Front   Add Answer Desk headlines to your news reader: