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Eisinger on a Goldman breakup

by Robert Teitelman | Published January 21, 2011 at 2:12 PM

Jesse Eisinger at ProPublica has a column up that, after wandering through Goldman, Sachs & Co.'s recent travails, makes an argument that the firm needs to break itself up. The gist of Eisinger's logic is this: Goldman's business model is broken. Betting against its clients -- that is, the conflict problem, which is also the "sophisticated client" problem -- was "unseemly," but the firm's real problem is "structural," that is, in classic fashion, it "lent long and borrowed short." As Eisinger writes, "Goldman, like all other major investment and commercial banks, had become too big and too intertwined, making the financial system too fragile. In other words, the flaws in the financial system were structural, more like problems of poverty and not based on character. As such, they require solutions beyond pledges of better behavior." Eisinger thinks Goldman should be split into three pieces, which seems to be, based on comparisons he makes to the share prices of other firms, advisory (like Lazard), market maker (like Jefferies) and asset manager (like BlackRock). That eccentric trio of firms constitutes the extent of his analysis.

What to think about this? It's true, Goldman is a very large, systemically important firm, perhaps too large from a public policy perspective. It's also undeniable that Goldman may well have been sucked under if the panic of 2008 wasn't stanched by TARP, though we will never know for sure. And who can argue that, particularly in the panic, that Goldman's highly leveraged, short-term-funded business model looked like it was fatally flawed, as it proved to be for Bear Stearns Cos. and Lehman Brothers?

But that's where we climb off this particular bandwagon. Many (even most) financial institutions lend long and borrow short, which is why they tend with great regularity to blow themselves up. The Wall Street business model was fatally flawed in a very particular, and for all the talk of black swans, relatively rare, panic-stricken market. Goldman's large size is less a problem for the firm, which among all other financial firms on this planet has shown an ability to exploit that bulk and to orchestrate its troops in a way that can generate very large and consistent profits: Despite its recent embarrassing pullback on the Facebook fund, look at the way Goldman uses its relationship with the social media giant to generate fees and investment profits in any number of ways. Goldman isn't Citigroup. Goldman's size and too-big-to-fail status is a regulatory issue -- a pressing one -- not necessarily a managerial one, although Eisinger frankly seems to be hazy about what exactly its problems are.

Does Goldman have a fundamental business model problem? In the real world, all companies should ask that question every day; and there's evidence that Goldman does exactly that more regularly than most (look how quickly the firm changed its mind on real estate, then, with impressive speed and consistency, altered its strategy). The problem with Goldman's model right now is not that the business has fundamentally changed because of the crisis -- Dodd-Frank tolerates great size, short-term funding and far more trading than many might desire -- but that there's great uncertainty over the rules of the game in the near and medium term. Goldman is undoubtedly already reallocating capital between various units; it will adjust, even if it means reducing trading. There's lots of ugly traits you can ascribe to Wall Street firms, but flexibility and change in search of profits isn't one of them. New rules based on the Dodd-Frank framework are being frantically written as we speak. The lobbying continues. While the economy is recovering, exactly what the regulatory landscape will look like is murky; again, that's another lesson of the Facebook mess, which at bottom, appears to be a failure to communicate with regulators that's hard to fathom in a firm of Goldman's experience.

How badly off is Goldman? As we all know, Goldman skillfully negotiated its way through the crisis and the two-year recovery period. Yes, TARP helped; so did all that money pumped through AIG to Goldman. But only a year ago, pundits were complaining that Goldman and J.P. Morgan Chase & Co. were too dominant (break 'em up was the cry then too, for different reasons), and were reaping windfalls far beyond their peers in a very low-interest-rate environment. Back then Morgan Stanley, which was rebuilding itself after the crisis, appeared to be lagging, eliciting cries of doom; now that Goldman has hit a soft patch, Morgan Stanley is rolling. Do either of those comparisons, last year and now, provide a definitive test of anything except a certain cyclicality? Only if you believe share prices predict the future. A last note: Cries to break Morgan Stanley also sounded when it was struggling, this time for business model reasons: too big, too universal.

Eisinger employs the simplest of metrics to nail his point -- share prices -- that of course tell us very little in the long sweep of time. He also deigns to offer up what investors think. "Investors," he writes, "prefer annuities to swing-for-the-fences profits." Really? What investors? Hedge funds, pension funds, mutual funds, Cramer fans? Undoubtedly there are investors today seeking out annuity-like returns. But the evidence of the past decades is that the largest, most influential equity investors putting their money into Wall Street firms not only were quite happy to see these firms go for home runs (including all that that implies: leverage, high compensation, a certain volatility of earnings, M&A), but actively encouraged it. Investors knew these firms were built on short-term funding; they were aware the mortgage business was generating huge profits; and they saw the pay figures. But, given the fact that most large investors were widely diversified, they felt they could shoulder the risk. Has anything changed, except along the margins? Has performance been dethroned? The fact that Goldman's share price and comp rose last year, as the firm exploited bountiful markets with trading gains, suggests that it hasn't.

Goldman does face serious issues. For better or worse, validly or not, it has allowed itself to be characterized as a predatory, speculatively driven, amoral aggregation of buccaneers that is both too large and too risky. It has shown a really striking inability to understand and communicate with the public, a result, perhaps, of its nature as a skillful market player, but also, clearly, of its long history as a very private partnership operating in wholesale businesses. The danger to Goldman lies less in the markets, less in its size and ever-evolving model, and more in that public arena: regulation and policy (where its influence is probably far more potent than its PR has been), but also the more amorphous, if essential, ability that hinges on reputation and the willingness to sign up for a ride into the future, its recruitment and retention of the very best talent. That's where Goldman's vulnerability lies. And that's why the firm is not about to take Eisinger's advice and break itself apart. - Robert Teitelman

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