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I. Introduction This article isn’t going to talk about the charged arguments that are normally thrown around when talking about Goldman. (Should the public have funded them? Was AIG a bailout for Goldman, orchestrated by the government? Have public funds allowed Goldman to profit off of public money? Has Goldman created the crisis? Is Lloyd Blankfein a Virgo or from Mars? Exactly which deity’s work is Goldman doing?) These questions, regardless of the merit or the level of interest, will not be discussed here. I think these clarifications are important because of two recent pieces on the bank (both after this piece was mostly written). The first was a piece written by Charlie Gasparino. The second was the much more riveting, much better-supported, and much longer piece by Bethany McLean at Vanity Fair . I feel it’s important to address Mr. Gasparino’s theories and arguments here, head on, before diving into the salient issues. Throughout this article I’ll need to point out his flawed reasoning, lack of rigor and depth in his arguments, and a fundamental lack of understanding. I will dismantle Mr. Gasparino’s arguments and examine his flawed assumptions, and his claims that have poor or missing support. The motivation for drawing these distinctions is simple: our conclusions are very similar and I do not want anyone confusing my well-reasoned and informed arguments for his. II. Recent History Goldman, often maligned (remember the “fight” between two of the least informed people on the planet? ), has had a good year. They survived the credit crisis, paid back the treasury in short order, and have continued to make money (use whatever definition of that you’d like: stay cashflow positive, generate revenue, generate earnings, etc.). However, the future looks to be very challenging for the firm — their profitability will likely not remain at the recent, elevated levels. To understand why, we must first look at the recent past (and explain some things). To examine Goldman, it might help to think of the firm as a large pool of money — this is the money that is actually owned by Goldman’s shareholders, or the equity they own in Goldman (shareholders equity). When Goldman wants to purchase securities or make an investment in a company, it uses some of this equity and borrows the remainder (depending on the investment, the ratio of Goldman’s money to borrowed money can go from 1:1 to 1:100; the exact amount depends on the risks of the given investment). To help put some numbers on it, Goldman’s leverage in the third quarter was 13.5x (meaning 13.5 dollars of assets for every dollar of equity, or 12.5 dollars borrowed for every dollar Goldman shareholders owned), versus a long-term average of around 22x, and went as high as around 28x in recent years. Then, when Goldman exits its investment, the borrowed money is returned–only the profits or losses and Goldman’s capital remain. (As an example, let’s say Goldman buys a bond for $100. In our example it borrows $99 and contributes $1 itself, or uses leverage of 100x. If that bond’s goes up by $1, Goldman can sell the bond, return the $99, recoup its $1 investment and the $1 profit — this is a 100% return on its equity.) This measure is generally what people call “Return on Equity” and its the main measure of how well a financial services firm invests its capital. From their filings, we can see that in the third quarter of 2008 (pdf) Goldman had $42.5 billion in equity. From that filing, we also know that Goldman’s return on that equity was 7.7% for that quarter and 14.2% for the first nine months of that fiscal year (both numbers are annualized). Compare those numbers to the third quarter of this year (pdf): Goldman returned 21.4% on its equity in that quarter and 19.2% over the first nine months of 2009. Further, and Goldman had $58.4 of equity at the end of the third quarter of 2009. [Note that, in some sense, when a person buys shares of Goldman's stock they are buying part of Goldman's capital along with the firm's ability to manage and grow that capital. Put another way, I'm buying equity that I am allowing Goldman's traders and bankers to use in exchange for a share in the profits (in the form of the capital I own growing). This is the sense that financial firms are different from non-financial firms: in an industrial firm equity represents ownership of tangible assets and an ongoing business whereas in a financial firm equity represents capital used to invest. But, I digress... ] When we compare this performance to its peers (see the chart), we can also see that Goldman’s ability to invest its capital and grow it has exceeded that of its peers both consistently and significantly. The source of this outperformance is what we are going to examine — is this pace sustainable? I do not think so. Source: Bloomberg III. Recent Results — Investment Banking Before we dig into Goldman’s other businesses, one important aspect of Goldman is its investment banking business. Mr. Gasparino goes out of his way to make claims about Goldman losing ground here. Using the bluntest instrument one can think of for examining the claim, the league tables , its easy enough to disprove his ridiculous claims. Inexplicably, Mr. Gasparino seems to never cite a single number. Make no mistake, I am not a huge an of the league tables as a measure of quality — if I do one deal whose value is $100 billion do I have a better banking franchise than if I had done 10 deals valued at $9 billion each? I would argue “No” but the single $100 billion deal would be ahead in the league tables. We can almost fix these sorts of problems by looking at the league tables based on fees and not transaction volume, but using the league tables in general still leaves a lot to be desired. Just to hammer the point about investment banking home, merely look at the Thomson league tables for the year through the third quarter (as of the writing of the other pieces, the most recent complete dataset, free registration required). Goldman maintains the top spot in both worldwide and U.S. completed M&A when ranked based on fees. Further, when looking at fees from capital markets activity, including debt, equity, and equity-related instruments, we see Goldman maintains exactly the same position as it did last year (fourth). In short, I see no evidence that anyone can point to in the actual numbers that Goldman is slipping in investment banking. IV. Recent Results — Trading Goldman’s other businesses, though, show an interesting trend: Goldman’s ability to generate returns on its own capital for 2009 has been massive. This is partially because Goldman was able to keep operating and deploying capital while many of its competitors weren’t. A relevant fact: when firms can’t borrow money against their capital, or pay higher rates to do so, this has to be reflected in asset prices — firms will demand a higher return to cover their costs. (Example: If I’m trying to buy a house and the bank quotes me a 5% rate on my mortgage, I’ll probably pay more for a specific house than if the bank quotes me a 10% rate. The fact that the borrowed money is more expensive affects the price I’m willing to pay.) For Goldman, who was viewed as more stable and whose cost of borrowing wasn’t rising as much as its competitors, this drop in asset prices created a huge opportunity — Goldman could pay the same price its competitors were willing to pay and earn a higher return, outperforming its peers. Mortgage bonds, for example, traded at very attractive levels, which allowed Goldman to use it’s cheaper borrowing and available capital to buy these bonds cheaply. In fact, Goldman had the opportunity to deploy billions to make a profit from this dislocation in the market — in mortgages specifically, there is an opportunity to make a profit purely by having cheaper financing than the next guy (this trade is called a dollar roll — read more here or here ). What does this have to do with anything, this esoteric portion of a small market, you ask? Well, Lloyd has an answer for you (pdf): Last month, for instance, we provided short-term liquidity to a portion of the mortgage market through a large agency mortgage transaction.