Sunday, July 19, 2009

Goldman Sachs signals Wall Street's return to risk taking

Bloomberg reports that Goldman Sachs'risk-taking has reached an all-time high in the second quarter, as equity bets increased 58% to amass record trading revenue and quarterly earnings. Its Value-at-risk (VaR), a measure of how much money the firm could lose in a day’s trading, rose to $245 million (at the 95th percentile, or a 5% probability that its portfolio would fall in value by more than $245 m over the day) from $240 million in the first quarter, and up from $184 million last May. Most of the increase during the second quarter stemmed from equity-trading risk, which surged to an average of $60 million per day from $38 million in the previous three months.

Quarter End Value-at-Risk Shareholder Equity
(Daily Average) (at Quarter End)

June 26, 2009: $245 million $62.81 billion
March 27, 2009: $240 million $63.55 billion
Nov. 28, 2008: $197 million $64.37 billion
Aug. 29, 2008: $181 million $45.60 billion
May 30, 2008: $184 million $44.82 billion
Feb. 29, 2008: $157 million $42.63 billion
Nov. 30, 2007: $151 million $42.80 billion
Aug. 31, 2007: $139 million $39.12 billion
May 25, 2007: $133 million $38.46 billion
Feb. 23, 2007: $127 million $36.90 billion

Goldman has been aided by the fact it enjoys a pile of blanket government debt guarantees, capital remains at historically cheap rates, and the market has been decimated leaving Goldman as one of the few players with the ability and appetite for risk taking. Further, a number of beleaguered financial institutions have been trying to leverage the government assistance to raise equity and other capital in the market, opening up large numbers of business (under-writing and other services) opportunities for investment banking majors like Goldman. On top of all these, the myriad government actions and bailouts of recent months have unmistakably signalled to the financial markets that the "too-big-to-fail" institutions, and there are none bigger than Goldman, will not be allowed to fail.

One of the criticisms of the regulatory regime in the build-up to the sub-prime crisis was the arguement that the non-depository institutions like investment banks and those in the shadow banking system assumed very risky positions using their proprietary capital and the regulators could nothing to control this. It was thought that the business model of investment banks, that relied on massive short-term leverage and making big investments with this borrowed money is bound to fail and carries unacceptable risks. In contrast, the capital requirements imposed on regulatory institutions enabled regulators to maintain some regulatory oversight on deposit taking banking institutions.

Now, with Goldman and its other major investment banking colleagues like Morgan Stanley becoming bank holding companies and thereby coming under the scanner of the Federal regulatory insitutions, it was hoped that their risk taking would be controlled. The dramatic recent increases in VaR appears to have belied such hopes and appears to have not had any effect on the firm’s appetite for wagering its capital on trading. Goldman's risk capital (or capital put at risk) has increased much faster than its capital has risen. In fact, Goldman has been allowed to assume its riskiest positions ever after it came into the formal ambit of the full Federal regulatory architecture!

As Felix Salmon puts it very appropriately, "I guess Goldman Sachs worked out how to generate profit growth in a world that no longer tolerates high leverage. It just increased the amount of capital it puts at risk every day." Two other nice articles analyzing Goldman's assuming of such huge risks are here and here.

It is being argued that the higher profits by Goldman Sachs, driven by its increased appetite for risk taking, reflected in its rising VaR, will force the other remaining big Wall Street into assuming more risks and thereby renewing the mad and unwinnable "risk" race that triggered off the sub-prime crisis in the first place. The low interest rates and the blanket government guarantees provides the ideal credit and financial environment for these institutions to assume large and cheap leverage positions, with potentially disastrous consequences for systemic risk. To this extent, Goldman may be exerting a hazardous negative externality on Wall Street!

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