The Goldman Quandary

Goldman Sachs is making a lot of money. Relative to the rest of a struggling Wall Street it is a huge amount of money. Now there are a lot of questions floating around: how are they doing so well? Do they deserve this given the bailouts? What should we do about it?

On Monday night’s Nightline (don’t judge me for watching), ABC’s Terry Moran ended the episode with one of the stupidest questions I’ve heard on a respected(?) news program: Goldman Sachs has earned its money by taking big risks, and given the bailout money that they got, should the taxpayers have a say in how much risk they can take? I thought the question (paraphrased) was misinformed, leading, of little value. Why?

To begin with, let’s address the profit Goldman pulled in. With second quarter earnings of $4.93 per share, the firm pulled down a $3.44 billion profit. That’s over that 30% more than 2008’s second quarter earnings of $2.33 billion. Now, I guess that Moran was partly right in suggesting that their earnings came from taking risks and reaping the rewards of success. However, he was wrong to imply that this only because they took big gambles—the same big gambles that got everyone into this mess. There are a lot of things that account for Goldman’s success. First, most of their major competitors have been destroyed or are on the ropes. Second, their balance sheet was the most stable of any firm in trouble. Third, they didn’t really need the bailout money in the first place (or probably didn’t), and Paulson forcing them to take $10 billion was to mask their health relative to the other zombie firms. This is largely evidenced by Goldman being first in line to repay the money.

So in the flight to quality, Goldman has stood tall to pull in customers from places like the now defunct Bear Stearns and Lehman Brothers. The money coming in means more business coming in. Combined with being one of the best run firms on Wall Street, and you get a $3.44 billion profit in the middle of a recession. They have been successful because they didn’t make as many mistakes as others and they have managed themselves well since. So Moran’s question was misinformed and leading.

It is also of little value to ask whether taxpayers have a say in how much risk firms can take. This option shouldn’t even be on a table of discussion. How in the world could the public collectively make decisions on what risks any financial institution should take? It is ludicrous. He could have asked whether the government should have a say in risk taking, which might have been what he was implying, but the answer again is clear: of course they should. It is the explicit role of regulators to set capital reserve ratios and ensure healthy risk taking. They should do this by removing the now explicit policy of the government to bailout struggling firms, but that is another conversation.

The too interconnected to fail policy has also helped Goldman make money. They have etched in stone that the government vies them, JP Morgan, and others as too important to let fail. They have the same safety net that was was implicitly there during the bubble period which encouraged more debt and risk taking. They can afford to do whatever they want now, and it is paying off.

Furthermore, Goldman was saved from some heavy losses as a result of the AIG bailout (as well as others). Not only did they get a capital injection (though unneeded), they did get the money AIG owed them that they were in trouble of not getting back if the insurance agency went under. Loans that Goldman Sachs made, especially to companies like GM, have been rescued by various government spending programs, keeping them from taking the big losses they should have as the firms failed (as they should have).

The quandary for many is what to do about it. Megan McArdle doesn’t have an answer. Neither does Justin Fox. Megan says the traditional libertarian response that the government should just make clear it won’t bailout people in the future isn’t a viable option politically because we can’t control future governments. And she is probably right. Though, Bush officials did restrain from actually nationalizing AIG because they couldn’t legally. So there is a chance a law restricting how the Fed, FDIC, and Treasury can spend money could succeed in making future bailouts impossible. That would leave Goldman out on its own and eliminate any argument that their success is the future dependent on the taxpayer.

Update 7/16:

I got a few notes on this, so I just want to clarify. When I said that Goldman has stood tall, I meant that with Bear and others gone, even a struggling Goldman on the ropes was the best out there. They weren’t in a great position, but they weren’t the worst firm on the Street. Still, it is very possible that they would have collapsed without the bailout money that came to them through other firms that were saved—like the $12.5 billion it got from AIG (they might have still got this if AIG went bankrupt, but the lag in distribution of funds might have tripped them up).