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How a Conservative Strategy (Mostly) Saved Goldman Sachs

October 05, 2008

By Nicole Gelinas

Financial institution after financial institution has toppled this year—so what's the secret of the few giants left standing (if a bit wobbly)? Readers hoping to unlock the secret behind survival will be disappointed after reading Charles Ellis' "The Partnership," for it turns out that the formula is reasonably smart people working hard and acting reasonably intelligently and competently most of the time, with a dose of luck mixed in.

Goldman Sach's success arguably came from the fact that the firm seemed to intuitively know to use its knowledge of business to improve finance, not the other way around.

A book about modern Goldman is also a book about many of today's public figures, including former Lower Manhattan Development Corporation chief John Whitehead, who co-headed the firm three decades ago, Clinton-era Treasury Secretary Robert Rubin and New Jersey Governor Jon Corzine, who ran the firm in the '90s, and Treasury Secretary Henry Paulson, its chief until 2006.

It's interesting to learn that Paulson, for example, "was all about careful plans and always had everything worked out in advance." If true—and Ellis, no doubt helped by his own consulting firm's relationship with Goldman, did score interviews with many current and former insiders—then Paulson must be learning a new skill as he makes things up as he goes along amidst today's crisis environment.

Goldman gradually came into being in the last third of the 19th century, when Marcus Goldman, a Jewish refugee from Bavaria, used knowledge he gained of the textile industry to start financing the day-to-day needs of that industry in New York.

Goldman knew who was a good credit and who wasn't, and he and his son-in-law, Sam Sachs, used his knowledge and his modest capital to lend money to firms on a short-term basis. The firm would then sell those promissory notes to the bigger investment houses, making a profit on the spread. This business grew to be the now multi-trillion-dollar commercial-paper business, which Goldman quickly dominated.

Non-Jewish firms kept Goldman out of the business of financing industrial firms with long-term bonds. But the firm knew instinctively how to capitalize on that "luck," sticking to its commercial-paper business and building up valuable knowledge of corporations through day-to-day intimacy with big borrowers. And because the big industrials shunned scrappy Goldman, it turned to the retail industry, underwriting lucrative early deals for companies like Sears and building up relationships through positions on firms' boards of directors.

But Goldman's story isn't one of slow and steady rise. It is also the story of a colossal, nearly fatal mistake. Before the Great Depression, it had followed the crowd in starting an in-house corporation to manage other corporations. It layered debt structure upon debt structure to squeeze out every last bit of profits, funneling heaps of borrowed capital through complex financial engineering devices that proved difficult to unravel when assumption after assumption went bust (sound familiar?).

It took Goldman until the end of the war to recover from this debacle—but in doing so, it made one shrewd decision that today's economic and financial stewards can learn from.

The family partners at Goldman were smart enough to know that they were too close to the situation to be able to emotionally separate themselves from the tough decisions that needed making, and they elevated an outsider, Sidney Weinberg, to make the objective decisions that it would have been too painful for family members to make.

Seventy years later, Merrill Lynch would prove smart in doing the same thing, getting an outsider—a former Goldman man—in last year to sift through a decade's worth of mistakes. No, Merrill won't survive into the future on its own. But the decisions it made last year to start clearing off its toxic assets before its competitors did helped it to affect an orderly sale of itself this year and protect at least some shareholder value, more than some competitor firms can say.

Ellis details stories like the meltdown of the Long-Term Capital Management Hedge Fund in 1998, which required federal coordination of investment banks so that they didn't force the fund to sell its hundreds of billions of dollars in investments all at once. In doing so, he points up some risks that are magnified hundreds-fold in the current credit crisis.

Ellis writes that Goldman realized, "there was one risk against which" the hedge fund, through all of its complicated mathematical controls, "was not diversified: the risk that somehow all the many different markets around the world would all react the same way to a specific, important, very unlikely and very distressing event." Further, Ellis notes: "when they really need to sell, sellers don't choose the price, buyers do." Holders of once perfectly saleable mortgage-backed securities are remembering the same lesson today.

Ellis also chronicles Goldman's move in the late 1990s from a partnership structure, in which managers' money was most at risk, to a corporate structure, in which its was shareholders that would take the first losses. Ellis writes that "without the substantial permanent capital that public ownership could provide...the firm would always be exposed to the unanticipated catastrophic risks that had been the final experience of so many once-famous firms."

Of course, as the demise of Bear Stearns and Lehman, both publicly trade firms, shows, outside capital is a buffer, not a failsafe. Plus, in that it encouraged firms to take bigger risks with other people's money, it turned out not to be much of a buffer at all.

Right now, the thinking is that the best protection is a stable base of insured depositors that only a commercial bank can provide. Effective two weeks ago, Goldman decided to convert to such a commercial-bank structure, ending its century as a pure investment house. Goldman did what it had to do to survive, just as it did seven decades ago.

The Partnership: The Making of Goldman Sachs By Charles D. Ellis (Penguin)

Original Source: http://www.nypost.com/seven/10052008/postopinion/postopbooks/the_partnership_132179.htm

 

 
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