From the moment that Bear Stearns announced its hedge fund problems six months ago, the sub-prime-induced credit crunch weakened both the credibility and the balance sheets of many international investment banks, but one player emerged unscathed and significantly stronger. Goldman Sachs made the right calls on sub-prime and profited from the downturn.
So, when its top economists revealed their predictions for the global economy last week, people (and markets) naturally paid close attention to the soothsayers on Broad Street.
The predictions by Goldman for the two largest economies of the world, the US and Japan, are dire. Chief economist of Goldman Sachs in the US, Jan Hatzius, wrote a note to clients that said real gross domestic product would contract in the second and third quarter this year, and the contraction would last two to three quarters. “Recession has now arrived, or will very shortly,” Hatzius said, but he believes the downturn will be “relatively mild by historical standards”.
Goldman Sachs predicts the fast weakening economy will force the US Federal Reserve to cut interest rate to 2.5 per cent from the current 4.25 per cent, and that unemployment rates for the largest consumer society in the world will rise to 6.5 per cent in 2009 from the current five per cent.
Barely 12 hours after the sour outlook broke, Goldman Sachs’s Japan economists sent out a note to clients predicting a 50 per cent chance of a recession in Japan, based on slower growth as emerging markets cool. The investment bank expects Japan to keep its interest rates at 0.5 per cent this year, with rises only to come in the second quarter of 2009.
“We expect there to be extremely little room for rate hikes justified by domestic factors,” Goldman Sachs economists Tetsufumi Yamakawa and Naoki Murakami said in the note.
The possible recessions in the US and Japan this year would mark the end of the longest sustained period of growth the global economy has ever experienced, and the tremors would undoubtedly reverberate across the world. Asset managers are scrambling to shift funds from the markets of the export-driven economies in Asia and interest rate cuts may further weaken the dollar in 2008.
Yet even with such a dour outlook about the global economy coming from Goldman, many analysts predict the inerrant bank will continue to post profits this year, based on its stellar performance following the sub-prime fiasco.
Goldman Sachs issued massive amounts of collateralised debt obligations (CDOs) based on sub-prime residential mortgages over the past few years and invested heavily in them. These toxic securities were also held by almost all the major international investment banks, but only Goldman hedged its positions for the downturn.
Incredibly, the companies that suffered from sub-prime were not even able to properly assess their losses – Goldman Sachs analysts, on the other hand, issued spot-on forecasts of the woes of their competitors.
William Tanona, an analyst with Goldman Sachs, recently raised his forecasts for write-downs at Citigroup, JP Morgan Chase, and Merrill Lynch. He expects a write-down of $18.7 billion (Dh68.63bn) in the fourth quarter at Citigroup, up from an earlier forecast of $11bn; a write-down of $3.4bn at JP Morgan, double his earlier prediction of $1.7bn; and a write-down of $11.5bn at Merrill Lynch, up from $6bn.
“Although we have seen many companies take the appropriate actions in recent weeks as they relate to the write-downs and capital raises, we still believe it will be a couple of quarters before the current credit crisis is fully digested by the markets,” Tanona wrote in a note sent to investors.
These huge losses forced the resignations of the four top executives at Merrill Lynch, Citigroup, Morgan Stanley and Bear Stearns. Losses and write-downs at the world’s biggest banks and securities firms totalled a massive $97bn in 2007, according to data compiled by Bloomberg. The overall sub-prime losses are expected to exceed $150bn, and may reach $300bn. With a looming recession on the horizon, it may take years to rebound from the huge blow dealt by the esoteric structured finance instruments.
Bear Stearns, the Wall Street firm that began the precipitous decline, received the brunt of the punishment. Its stock tumbled from a high of $172 to $70 last year, and its current market cap of $8.6bn. Goldman Sachs’s bonus pool that is shared among its employees was $20.2bn in 2007.
In an effort to rebound and withstand the storm, Bear Stearns went hat in hand to wealthy investors for much-needed cash infusions, and it seems those who bought in have also been burned.
In September, Joseph Lewis, one of Britain’s wealthiest men, spent $860 million on a seven per cent stake in Bear Stearns (Lewis upped his position twice since then), paying an average of about $107 per share, according to the Wall Street Journal. In October, Bear sold a six per cent stake to China’s CITIC Securities for $1 billion, a deal which now looks like a lemon.
Meanwhile, Goldman Sachs continues to find profitable investments everywhere. When competitors were posting massive losses, Goldman had a record breaking year, taking in $2.85bn in the third quarter and $3.17bn in the fourth.
The firm’s much-envied propriety trading desk was mostly responsible for hedging against sub-prime and delivering profits, but the private equity unit is increasingly contributing large portions of the bottom line. (Goldman Sachs is criticised by clients and competitors for being both a merchant bank and investment bank, especially because it has a bird’s-eye view of fund flows and deal information).
The private equity arm of Goldman Sachs was actively sourcing deals even when the rest of the world slowed down for the holiday season.
In December, First Marblehead, a student-loan company based in the US, was down by 75 per cent in 2007, as investors worried about loan defaults and revised their risk management controls in a tight credit market. On December 21, Goldman Sachs bought 20 per cent of the company for $260.5m and offered a line of credit. First Marblehead stock rallied in the past two weeks, demonstrating once again that Goldman’s winning streak remains intact.
And there was yet one more important prediction that rang true. On March 31, 2005, when crude was at $55 a barrel, Goldman Sachs said oil markets have entered the early stages of a “super spike” and will hit $105, but did not give a timeframe.
The firm recently raised its outlook on oil prices and said crude will average $95 a barrel this year and will reach $105 per barrel by the end of 2008. Oil broke the $100 barrier last week.
Today, Goldman’s market cap is more than $76bn, its balance sheet is intact, and it is the one doing the investing. For now, Goldman Sachs can do no wrong.
The long reach of goldman alumni
During recruitment weeks at Harvard, Stanford, Princeton and other Ivy League universities, Goldman Sachs usually draws the biggest crowds. The young and ambitious flock to the investment bank mainly for the prestige and lucrative paychecks, but also for the post-Broad Street opportunities available to ex-staff.
The firm’s employees are smart, well-educated and effective networkers who fit in the upper halls of power, so it is no surprise that they occupy high positions in the US Government. Robert E Rubin, a former vice-chairman at Goldman, served as the 70th US Secretary of Treasury under President Bill Clinton, and is currently a director and chairman of the executive committee at Citi (he acted briefly as the chairman of Citi last year). During his time in government, he pushed for increased trade liberalisation and was one of the main backers for bailing out US investors caught up in the Asian financial crisis in 1997.
The current US President’s Chief of Staff, Joshua B Bolten, a former employee, recruited Henry M Paulson, the former CEO of Goldman, who holds more than $700 million (Dh2.5bn) of the shares, for the Secretary of Treasury job.
Jon S Corzine, once a co-chairman, is now the Governor of New Jersey, after serving in the US Senate. The wealthy banker self-financed both elections – $60 million for the senate job, and $43 million for the governorship.
For the ex-Goldman employees who wish to stay on Wall Street, the opportunities are endless.
John A Thain, a former Goldman co-president, recently took the helm at Merrill Lynch. His move to Merrill left the top spot at the New York Stock Exchange vacant, so Duncan L Niederauer, another alumnus, filled the position.
The hedge fund industry is heavily populated with ex-Goldmen – Daniel Och, a former trader, recently took his $30 billion hedge fund public.
Internationally, the list goes on. The heads of the Canadian and Italian central banks are Goldman alumni. The World Bank President, Robert B Zoellick is another. And in academia, Robert S Kaplan, a former vice-chairman, was recently selected as the interim head of Harvard University’s $35 billion endowment, as The New York Times noted.
In this election season, Goldman Sachs executives are executing similar hedging strategies that proved successful during the sub-prime debacle. Its employees are the top contributors to Barack Obama and Mitt Romney, and the second highest contributor to Hillary Rodham Clinton. Current Chief Executive Lloyd Blankfein (who took home $70m bonus in 2007) has held a fund-raiser for Hillary in his flat and has come out publicly in her favour.