One Year Later: Goldman Sachs's amazing rebound

The financial crisis crystallized the realities of systemic risk -- the idea that in certain panic-stricken environments, no company reliant on functioning credit markets is safe, even if it is fundamentally sound on its own merits.

No company may have been hurt more by guilt-by-association during the market's meltdown than Goldman Sachs (GS), widely recognized to have been the best positioned investment bank entering the fall of 2008. As Bear Stearns and Lehman Brothers went under, the competitive landscape was theoretically clear for Goldman to make sizable market share gains. But the same reliance on short-term financing and market fears of potentially hidden risks in the company's assets forced drastic changes.

Goldman joined Morgan Stanley in becoming a bank holding company, transitioning away from the high-leverage investment bank model to gain access to emergency lending facilities created by the Federal Reserve to stabilize credit markets. At the same time, Goldman was also early in raising equity capital from Berkshire Hathaway, effectively gaining the endorsement of Warren Buffett as it bolstered its balance sheet. On that day, Goldman stock traded at $120; it entered this weekend nearly one year later at $175, even as the worst economic macro-environment since the Great Depression continues to unfold.

All conspiracy theories and squid jokes aside, Goldman shone during the crisis because it did not make the same errors that impaired or brought down its competitors. The firm did not push its leverage too far, it was willing to raise capital from Buffett even when terms were less than favorable, and it had relatively little exposure to bad mortgage assets because of its hedging activities.

Unlike some management teams which publicly insisted all was well and that raising capital at dilutive terms was unnecessary, Goldman leaders were willing to give Buffett attractive terms on his $5 billion preferred stock investment to secure equity at a precarious time. Though Goldman's stock would eventually trade for less than $50 per share at its low and Buffett would be second-guessed on his investment, the move was central to giving Goldman the balance sheet strength to wait for the markets to turn.

Of course, one reason why an investor like Buffett was willing to become involved with Goldman Sachs is that it was a fundamentally healthier company than others. Goldman was a late entrant to the subprime securitization business, and thus lacked the significant inventories of mortgage assets that Bear Stearns or Lehman Brothers had on their books. Additional differentiating factors were risk-management practices and proprietary trading, which led Goldman to hedge risks from subprime assets by purchasing protection and actually allow it to profit as prices fell. Finally, Goldman did not push its leverage ratio as far as other banks, and maintained a Global Core Excess Liquidity Reserve, cash meant to tide the firm over in times of extreme distress.

As the acute strain of the financial crisis faded under a wave of government and Federal Reserve initiatives, Goldman was able to take advantage of wider spreads in its trading business and book enormous second-quarter profits. The official investment bank model might be dead, but the early results of Goldman Sachs as the premier bank holding company still look very good.

James Cullen edits and writes He is the Vice-President of the Boston College Investment Club, which owns GS, but has no personal position in those stocks.
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