Banking vs. Trading at Goldman Sachs

Like many Wall Street firms, Goldman Sachs had humble origins. The firm began by collecting and discounting merchants’ receivables. This allowed merchants to generate needed cash. Founding partner Marcus Goldman carried the receivable notes in his top hat as he made his rounds.

In the early part of the 20th century Goldman expanded into another form of short-term financing, commercial paper (CP). Goldman Sachs, now a partnership, operated as a dealer of these unsecured promissory notes. This meant it facilitated the marketing of corporate CP to its network of investing clients. Risk taking by Goldman was carefully managed.

As mid-century approached, American banking operated in three distinct silos. Commercial banks like Chase and First National City Bank (later Citibank) operated branch networks that took deposits and made residential, commercial and consumer loans. The second silo was brokerage. This involved distributing stocks and bonds to investors, many of them “retail” customers. The most famous brokerage house, Merrill Lynch, Pierce, Fenner, & Smith had branch offices nationwide.

Investment banks, such as Morgan Stanley and First Boston, constituted the third silo. Some of these firms had started as departments within commercial banks, but had become independent as a result of the Glass-Steagall Act. This depression-era law forbade institutions that took deposits from also underwriting and selling securities or insurance. The newly independent firms cultivated close relationships with Fortune 500 companies. Investment bankers provided clients with advice on financial issues ranging from capital structure to mergers and acquisitions. When a relationship client decided to issue securities, its investment bank formed and led a syndicate underwriting the offering. Virtually all investment banks operated as partnerships with limited amounts of capital and small balance sheets. Annual profits also were small, often less than $10 million per firm. The business was, however, prestigious and afforded partners the opportunity to build considerable net worth over a career.

Through the early 1970s investment banking was dominated by a “bulge bracket” composed of the firms with the foremost client relations. Morgan Stanley headed up this group, followed by First Boston, Dillon Read, Goldman and Kuhn Loeb. Salomon Brothers and Merrill Lynch eventually made it into the bracket based on their ability to distribute securities to institutional and retail clients respectively.

Goldman was something of an anomaly among investment banks, as its origins lay in brokering short-term paper. From 1940–1970 it followed the investment bank playbook, and transformed itself into a formidable competitor. This was made possible by the personal efforts of Sidney Weinberg, its senior partner. Weinberg proved adept at getting close to corporate clients. He eventually served on numerous boards of directors, including General Electric, Sears, and Ford. Weinberg used these ties to encourage firms to bring Goldman into their capital market deals. His greatest triumph came in orchestrating Ford’s 1956 IPO, for which Goldman earned a $1 million fee.⁵ Goldman’s total capital at the time was only $9.2 million.

While Weinberg was building Goldman into a traditional investment bank, another partner, Gus Levy, was anticipating investment banking’s future. Levy was an instinctive and brilliant trader. Returning to Goldman after WWII, Levy began arbitraging the bonds of bankrupt railroads. He quickly discovered three things: (1) a lot of money could be made quickly via trading; (2) successful trading required better information and analysis than other market participants; and (3) trading required capital to absorb losses from occasional wrong bets. Buying the railroad bonds up cheap, he awaited the eventual reorganizations and then sold at much higher prices.⁶ Profits exceeded by several multiples the fee Goldman earned on the Ford IPO, while requiring only a fraction of the manpower and effort.

Gus Levy steadily expanded Goldman’s trading operations. Goldman developed considerable prowess in bloc trading, the assembly and marketing of a large amount of stock on behalf of a client. During the 1970s Levy added risk arbitrage. This type of arbitrage involves a bet on whether public companies are likely to merge or be acquired. Stocks of companies being acquired often rise 25% or more after a merger is announced. Large profits are available to those who correctly guess that such an announcement is coming. Because of its inherent riskiness, arbitrageurs seek to discover information that competitors don’t have. It is the nature of the practice that risk arbitragers sail close to, and sometimes cross over, the legal lines prohibiting trading on inside information.

As the 1970s dissolved into the 1980s, trading and risk arbitrage assumed a larger profile within Goldman. Future stars like Robert Rubin and Mark Winkelman were growing the business. Levy encouraged his traders to move into commodities and foreign exchange. Goldman was somewhat bigger now, the partners’ invested capital totaling about $240 million.⁷ That sum was, however, a small base for supporting an expanded trading platform. Two developments drove this home to Goldman. One involved Goldman’s competition. The second concerned the biggest acquisition Goldman had ever made.

Competitive Pressures Change Wall Street’s Business Model

Wall Street’s investment banking and brokerage models started to unravel late in the 1970s. Brokerage commissions came apart under the weight of increasing competition. Small firms were gobbled up by national chains like Merrill Lynch, Paine Webber and Dean Witter.

Meanwhile, investment banking saw its relationship clients start to bid their security offerings competitively. Underwriting commissions declined along with a firm’s ability to count on a certain level of business from its client base.

Major Wall Street firms responded in a variety of ways. One was to become much bigger. For many that started with transforming small partnerships into publicly traded companies. The resulting “permanent capital” provided a much larger base for leveraging the firm and for trading securities. Salomon Brothers led the way, going public in 1978. Bear Stearns went public in 1985, Morgan Stanley in 1986. Other firms got bigger by merging, sometimes with public financial companies.

Bigger balance sheets facilitated riskier business models. Firms with dominant banking models promoted corporate takeovers. “Leveraged buyouts” allowed new private equity funds, other corporations and even managements to take over well-known companies. Wall Street investment banks identified potential targets, and put companies “in play” by encouraging investors to acquire positions. Next, the banks put financing packages together to fund the ultimate buyout. At times investment banks facilitated such transactions by making “bridge loans.” These enabled purchasers to close their acquisition and complete their fundraising later.

Firms with trading platforms grew adept at combining innovation with risk capital. The 1980s were something of a “golden age” in financial innovation. New instruments, such as interest rate swaps, collateralized mortgage obligations (CMOs) and junk bonds were invented and then traded. Because the instruments were new, understanding of them was limited. This gave the inventing firm, usually the primary market maker, a significant trading advantage.

Trading, however, proved a difficult business model to sustain. Initial advantages eroded, often quickly, as competitors gained experience with the new securities. Trading profits could surge in one year, only to disappear in the next. Banks with large trading operations, such as Bankers Trust and Salomon, saw their stocks trade at disappointing multiples—ones that reflected investor caution that current profits might not prove sustainable. In response, trading firms sought out ever more markets to penetrate while continuing to invent new, hard to understand financial products.

Banker-dominant investment banks also saw their business models approach limits. There was little that was proprietary about promoting mergers and making large loans. Soon all the major investment banks had similar operations and capabilities. Big commercial banks like Citibank, Chase and Chemical jumped into the game, bringing even bigger balance sheets. Once again fees began to erode and mandates became harder to win.

Throughout this period, Goldman remained a partnership. It was so confident about its bankers and their relations with leading firms that it felt sufficient high fee business would still come its way. Goldman rode through the leveraged buyout craze specializing in defending firms under attack. It was the only Wall Street firm to take such an approach. Goldman also took advantage of the buyout frenzy to reap increasing risk arbitrage profits.

Several events caused Goldman to question the sustainability of its “banking + trading within a partnership” model. The first came when it acquired J. Aron & Company, a commodity trader, in 1981. Goldman bought the company to extend its trading expertise into commodities. For five years the experiment fizzled. Goldman ended up firing most Aron staff.⁸ Eventually, Robert Rubin and Mark Winkelman turned J. Aron around, but not before they realized that harvesting J. Aron’s potential required a different type of information. The pre-Goldman J. Aron took little risk. The J. Aron that emerged from Goldman’s reconstruction identified “smart” bets and took “at risk” positions. This required information and analysis that could consistently “outsmart” traders at other firms.

Where would such information come from? One answer was from the kind of operations routinely employed by Goldman’s risk arbitrageurs. These players moved in quiet circles where rumors and inside information were discussed. Last year’s takeover client could be this year’s information source. Goldman’s traders began to look at the firm’s banking clients with new interest. As one wag at the firm put it: “If you have a conflict, we have an interest.”⁹

As Goldman’s traders found ever more success, pressures built to emulate the other firms that had gone public. Goldman considered an IPO in 1987, but the firm’s culture and partnership ethos caused the idea to be rejected.

Then, Goldman hit more bumps in the road.

Embarrassment and Unprecedented Losses

On February 12, 1987, U.S. Marshals entered Goldman Sachs’ Broad Street office with an arrest warrant for Robert Freemen, head of risk arbitrage. Freeman would eventually be charged with felony counts of conspiring to commit securities, wire and mail fraud. Freeman had been implicated by Kidder Peabody’s Martin Siegel, who had already admitted trading inside information with the likes of Ivan Boesky.

Freeman denied any wrongdoing and passed several lie detector tests. Goldman staunchly stood by him during two years of prosecutorial maneuvering by U.S. Attorney Rudy Giuliani. In the end, Freeman pled guilty to one count of mail fraud, was fined $1 million, and served four months of a one-year jail sentence. He also resigned as a Goldman partner.¹⁰

Freeman maintained his innocence to the end. His former boss, Robert Rubin, made two comments worthy of note. Freeman recounted that Rubin had told him: “Bob, you’re probably the only arbitrageur here on Wall Street who can pass a lie detector test.” Later on Freeman said that on the day he was arrested, Rubin had said out loud: “there but for the grace of God go I.”¹¹

This incident illustrated the connection between successful trading and the need to sail close to the line to get non-public information. To produce consistent and growing trading profits, traders either have to be endlessly innovative or they have to develop superior information. The first is exceedingly hard to do, and the second constantly flirts with being illegal.

Shortly after the Freeman episode ended, Goldman discovered another side of the trading business—wrong guesses could lead to large losses.

By the early 1990s Goldman had morphed into a giant proprietary trading house. This didn’t happen as a result of some top-level strategic decision. Goldman grew into it organically, as soaring profits fed the hiring of more traders. Infusions of equity capital from Sumitomo and a consortium of insurance companies brought the capital base up to $2 billion. By 1993 there were over 500 “proprietary” traders at Goldman, all seeming to hold similar positions.¹² Some individual traders were producing annual profits of $100 million. Their success came with big risks. Goldman now had a $100 billion balance sheet and leverage of 50/1.¹³

Disaster struck in February 1994. Collectively, Goldman’s “prop” traders had made a massive wrong-way bet on interest rates. The trading desks started losing more than $100 million per month.¹⁴ Losses continued at that pace throughout the summer. Eventually positions were unwound and markets reversed, but Goldman, for the first time in decades, lost money for the year (the firm reported a small profit, achieved by reversing loss reserves).

The effect of this performance on Goldman’s partners was profound. Typical cash compensation fell 40%. Partner capital accounts eroded by a similar amount. The firm’s investment bankers were irate. They wondered if all they had worked for was about to be wiped out. Some 40 partners decided not to find out; they departed, taking their capital with them.¹⁵

Trading profits recovered in 1995. Still, the Goldman partnership was traumatized. Changes were made, starting with risk management. Goldman had no systematic trading limits, no value-at-risk models, and no database showing consolidated trading positions to a risk committee. That all changed. A chief risk officer was appointed to supervise the new system. Goldman’s controllers, legal and audit functions were strengthened. Firm management took special pains to assure that career specialists in these areas were not treated as second-class citizens.¹⁶

Some big issues remained unresolved. Foremost among these was the nature of Goldman’s competitive model. Would Goldman be led primarily by its bankers? If so, what types of transactions would they target? The takeover frenzy of the 1980s had given way to the opening of banking markets in emerging nations and former communist countries. State companies were being privatized and capital markets developed. At home, information technology was bringing forth a host of new start-up companies. Were these opportunities short term in nature or sustainable? If sustainable, what competitive advantages would keep Goldman in the forefront?

The alternative view was that investment banking had become too competitive, and that Goldman’s real advantage lay in trading. This view had acquired a more nuanced articulation since the 1994 scare. Increasingly the trading advocates saw the firm’s bankers and analysts as information gatherers. Clients might be less loyal and transaction fees down, but clients still talked to Goldman’s bankers. They also asked the bankers to arrange complex transactions, ones that might, for example, involve buying another company’s stock and buying puts to hedge the position. This was interesting information. Traders could assemble these data bits, connect the dots, and devise proprietary trading strategies.

Would this trading model prove more sustainable than Goldman thinking it could outguess the bond market? Jon Corzine thought it would. So long as Goldman’s clients continued to talk to the firm, Corzine believed Goldman would have unique information to support proprietary trading. Taking this perspective helped Corzine settle the two other unresolved issues. For Corzine, it made sense for Goldman to set very high Return on Equity financial targets. Meeting such targets would re-solidify the partnership ranks. It would also drive forward the trading model. Corzine did not think that the banking side of the house could generate comparable revenue and profits. Finally, it would make an IPO inevitable. Ever bigger trading would overwhelm the partnership structure, making an influx of big permanent capital the obvious answer.

Hank Paulson Decides on a ‘Counter to Corzine’

As Paulson reviewed Corzine’s notes, it occurred to him that he felt a great deal more concern about potential conflicts of interest. Corzine was a trader. He was more familiar with counterparties than with clients. Paulson had grown up on the banking side of Goldman. He was famous for relentlessly calling clients to get in the door. But he was also famous for giving them advice they found so valuable that they sought Paulson out again and again. The same clients also made sure Paulson’s firm was involved when the time came to do any important transaction.

Paulson wondered if he should provide a strategic alternative to Corzine’s proprietary trading vision. What would a banking-dominant vision look like? Paulson was prepared to stress two initiatives for the coming years: growing asset management and Goldman’s electronic systems for distributing securities. Foreign markets also continued to offer interesting banking possibilities, though it was necessary to be selective.

Was there a way for Goldman’s trading acumen to be integrated with such an approach? Paulson did see certain trading opportunities, specifically high-yield debt, syndicated bank loans and foreign exchange. These markets, in his opinion, were far from efficient and offered both arbitrage and speculative possibilities.

Harvesting those and other trading opportunities without fatally damaging client relations would be the problem. Proprietary trading by itself wasn’t the problem. Proprietary trading informed by client relations was the issue. What constituted a legitimate use of client information, what was likely to cause clients to feel trust had been violated, and what was misuse of inside information?

Paulson felt that these types of conflicts had increased in recent years. Goldman’s ability to manage the conflicts had not kept pace.¹⁶ Goldman’s increasing global reach, its growing market share, and clients’ increasing feeling that their private information was being abused had contributed to a plethora of client complaints. These complaints stemmed, at least in part, from Goldman’s inability to manage conflicts as well as it should. Goldman owed clients full disclosure regarding conflicts and 100% dedication to achieving client objectives.

Paulson knew the firm had failed to provide these conditions on numerous occasions in recent years.¹⁷ Doing a better job would come easier if either the banking model led the way for Goldman and/or if proprietary trading were subjected to robust disciplines. Those choices, in turn, influenced and were influenced by the debates over target Rate of Return and partnership versus IPO.

Paulson decided that answering all of these questions would benefit from detailing what he meant by “a sophisticated management approach for ‘relationship’ conflicts as well as legal conflicts.” He debated whether his remarks following Corzine’s were the proper place to lay out such a system.

Holding on to that thought, Paulson picked up a yellow legal pad, his brief on future potential conflicts of interest, and began to sketch out what such a system might look like.

Author’s Note

In the wake of the financial crisis, Goldman Sachs has been frequently and severely criticized for allowing conflicts of interest to infect its treatment of clients. This case presents Goldman at an earlier moment, when the firm’s strategic direction is up for grabs. Students must examine both the potential for conflicts evident in 1996, and also Goldman’s competitive dilemmas. Then they must decide how future CEO Hank Paulson should try to address conflicts of interest within the firm’s management structure. At stake, hypothetically, is a chance to “redo” Goldman’s behavior during the financial crisis.

The case provides considerable material about Goldman’s historic competitive models, how Wall Street changed in the 1980s, and how proprietary trading brought both big money and serious losses to Goldman in the 1990s. Goldman’s business dilemmas are not minor. Students must grapple with whether to target aggressive or more modest return targets, and depending on the answer, how to produce them. In Jon Corzine, Goldman has a full-throated advocate for the trading model. Paulson’s attitudes are more complex. He comes from the banking side, but is not “anti-trading.” Students can use his more flexible outlook as a whiteboard on which to outline their recommended path forward. This should take the form of talking points for Paulson to use in his upcoming Arrowwood address.

The case draws heavily on Money and Power, How Goldman Sachs Came to Rule the World, William D. Cohan’s in-depth history of Goldman. Cohan is a Wall Street veteran who understands the business of investment banking. His account was enriched by access to Goldman executives, past and present, and by extensive documentary research. Charles D. Ellis’ reverential history, The Partnership, is useful for its detailed factual account.

Attachment 1 is a Historical Recreation that outlines Jon Corzine’s planned remarks for the Arrowwood conference. No such public document is known to exist. This version, however, is faithful to Corzine’s actual remarks as recorded in Cohan’s detailed account of that conference. Attachment 3, an outline of potential conflicts of interest, is also a Historical Recreation. To the best of our knowledge, Paulson did not seek such an analysis and no Working Group existed to provide one. The content of this document actually reflects a broad series of episodes recounted by Cohan over the course of the book. Cohan gives examples of these in the pages (378–380) that immediately follow his quoting Paulson’s conference remarks.

There is no doubt, historically, that Paulson expressed more concern than did Corzine about potential trouble from conflicts of interest. He also made clear in 1996 that he thought Goldman needed to do a better job managing them. One obvious question then, is whether Paulson acted on these perspectives once he became CEO. Students of this case will now have a chance to chart how they think he should have acted.