Goldman Record Income Shows New Wall Street in Market Shakeout

By Christine Harper and Jenny Strasburg
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Oct. 8 (Bloomberg) -- Somewhere in the wreckage of securities backed by subprime mortgages and the resulting seizure in the credit markets, is a new paradigm on Wall Street where Goldman Sachs Group Inc., increasingly perceived as the world's biggest hedge fund, will report record earnings for 2007.

While Goldman, the largest securities firm by market value, insists that it caters to the needs of clients and has never been anything but customer-driven, New York-based Goldman also is considered No. 1 in proprietary trading and manages more hedge funds than anyone except JPMorgan Chase & Co.

And like Paulson & Co., Harbinger Capital Partners and Hayman Advisors LP, which are posting their highest returns when so many conventional financial institutions are reeling from subprime investments, Goldman profits substantially from allowing its traders to use the firm's capital to speculate on whether the price of assets will fall or rise.

``The real world is much better than what we're reading in the headlines,'' said Michael Holland, who oversees more than $4 billion at Holland & Co. in New York. ``Many more billions are being made on the positive side than are being lost.''

Goldman may be the most prominent example of the transformation of the securities firm that behaves more like a hedge fund. Like New York-based Goldman, Morgan Stanley and Lehman Brothers Holdings Inc. also will report record earnings this year, according to analyst estimates compiled by Bloomberg.

Summer `Carnage'

Where Paulson, Harbinger and Goldman used hedging strategies to prosper in the third quarter, Merrill Lynch & Co., Bear Stearns Cos. and UBS AG weren't so nimble when the subprime tide ran out. The divergence, following three years when earnings at the top investment banks rose almost in lockstep, also illustrates why hedge funds exist -- to take advantage of others' distress.

``Out of this carnage of the summer, it was clear there were going to be huge opportunities because for all the managers who blew up, there were sure to be a bunch that exploited the situation,'' said Bill Grayson, president of Falcon Point Capital LLC, a San Francisco-based hedge fund manager.

Goldman's third-quarter earnings soared 79 percent to almost $2.9 billion after the New York-based firm, led by Chief Executive Officer Lloyd Blankfein, took positions that rose in value as the price of mortgage-backed securities declined.

By contrast, Merrill, the biggest U.S. brokerage, and Zurich-based UBS, Europe's largest bank, reported their first quarterly losses in more than 4 1/2 years after mortgage-related writedowns. Bear Stearns, the No. 5 U.S. securities firm, posted its biggest earnings drop in a decade.

Northern Rock

Merrill said Oct. 5 that losses from mark-to-market accounting for subprime mortgages and collateralized debt obligations were $4.5 billion, net of hedging gains, in the third quarter. Anticipated losses on non-investment grade lending commitments were an additional $967 million, or $463 million after including underwriting fees, the firm said.

New York-based Merrill blamed ``an unprecedented move in credit spreads and a lack of market liquidity in these securities, which intensified during the third quarter.''

The worst credit markets since Russia's debt default in 1998 and the collapse of John Meriwether's hedge fund, Long-Term Capital Management LP, was triggered by defaults on subprime mortgages in the U.S.

The tumult spread to the U.K. where mortgage lender Northern Rock Plc was bailed out last month by the Bank of England after rising short-term financing costs hampered its ability to sell new mortgages. The Newcastle, England-based company is now looking for a buyer.

ABX Indexes

``You've only seen the first round in the deterioration of the mortgage area,'' said James Melcher, president of Balestra Capital, a New York-based hedge fund with about $270 million of assets. ``The second round is just starting, and it's going to be worse.''

Balestra Capital's fund rose about 130 percent this year through September, according to a letter sent to investors. The fund used so-called ABX indexes to benefit from the increase in home-loan delinquencies. ABX indexes allow investors to buy into derivatives called credit-default swaps on multiple securities. Bearish investors have used ABX bets to wager against the health of mortgage lenders to people with bad credit histories.

An ABX index tied to 20 subprime mortgage bonds rated BBB- slumped 46 percent in the third quarter. The index has declined about 70 percent this year, data compiled by administrator Markit Group Ltd. show.

Homebuilding Index

Home prices in the U.S. will drop on a year-over-year basis for the first time since the Great Depression of the 1930s as an estimated 1.5 million people are in danger of losing their homes to foreclosure, according to estimates from the Fisher Center for Real Estate and Urban Economics at the University of California at Berkeley. The 16-member S&P Supercomposite Homebuilding Index has fallen 62 percent since the housing boom peaked in September 2005.

While Northern Rock, Merrill, UBS and Bear Stearns weren't prepared for the market reversal, Harbinger's $11 billion hedge fund, run from New York by former Barclays Capital trader Philip Falcone, climbed more than 65 percent this year. The $4.5 billion Paulson Credit Opportunities Fund rose more than 300 percent and Kyle Bass's Dallas-based Hayman reported a 400 percent return. All the funds benefited from the slumping mortgage market.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.

Trading Risks

Like hedge funds, Goldman uses its capital to take bigger trading risks than rivals. The firm's so-called value at risk, a measure of how much the bank estimates it could lose from trading in a single day, rose to $139 million in the third quarter, up 51 percent from a year earlier to the highest ever, according to company reports. The increase was most pronounced in interest rate-related risk, which almost doubled to account for about 40 percent of the total.

On a similar basis, New York-based Morgan Stanley, the second-biggest U.S. securities firm by market value, said its trading VaR was $87 million in the quarter, up 55 percent from a year earlier. Lehman, the fourth-biggest firm, said VaR was $96 million, citing ``a combination of higher levels across a range of products for the period and a higher level of risk associated with an increase in fixed-income related assets.''

Since taking over in 2002, Merrill Chief Executive Officer Stanley O'Neal has pushed the firm to match its rivals by expanding in proprietary trading and private equity, businesses that put more of the company's capital at risk in exchange for higher returns.

First Franklin

The 56-year-old CEO extended the strategy into subprime mortgage lending last year when Merrill purchased San Jose, California-based First Franklin for $1.3 billion. Like Bear Stearns and Lehman, Merrill planned to make money by packaging loans into bonds and selling them to investors. Buying a mortgage company helped assure a steady supply for Merrill's debt-securities underwriting.

Less than two months later, the mortgage market began to unravel as HSBC Holdings Plc, the biggest U.S. subprime lender, disclosed that bad-loan provisions increased 20 percent. By early April, New Century Financial Corp., the biggest independent subprime lender, had declared bankruptcy. About 100 mortgage companies have halted operations, declared bankruptcy or sought buyers this year.

Last week, Merrill reported its first quarterly loss since the fourth quarter of 2001, after the Sept. 11 terrorist attacks that had destroyed the World Trade Center.

Market Swoon

Shares of Goldman are trading as if the market swoon of July and August never happened. They have gained 39 percent since falling to a 52-week low on Aug. 15 and now sit less than 3 percent below their all-time high. Stephen Schwarzman's Blackstone Group LP, manager of the world's largest leveraged buyout fund, has gained 35 percent since falling to a record low of $21.54 on Sept. 7.

Goldman's stock rose 14.6 percent so far in 2007, the best performance of the five biggest U.S. securities firms. Morgan Stanley gained 1.9 percent, while Merrill and Lehman dropped 18 percent, and Bear Stearns fell 19 percent.

Not all of Goldman's traders were so successful. Global Alpha, a $6 billion hedge fund run by Mark Carhart and Ray Iwanowski, lost almost 35 percent in the year through September after shedding 6 percent in 2006. Goldman raised $1 billion from investors and injected $2 billion of its own capital into another fund, Global Equity Opportunities, after it dropped 30 percent in first two weeks of August.

More Pay

Still, Goldman pays employees more. The company set aside $16.9 billion for compensation and benefits in the first nine months of the fiscal year, up 21 percent from a year earlier, the company reported last month. The outlay exceeded Morgan Stanley's $13.4 billion and Lehman's $7.3 billion. Bear Stearns was the only one to reduce compensation as its revenue declined. The firm's costs fell 5.9 percent from a year earlier to $3.1 billion, according to company reports.

``There's kind of a love-fest going on with Goldman right now, as they were able to weather the subprime storm much better than anyone else,'' said Peter Kovalski, who helps manage more than $12 billion at Purchase, New York-based Alpine Woods Investments, which holds shares of Goldman and Merrill. ``They're one of the best-run investment banks out there.''

When Canadian Prime Minister Stephen Harper went looking for a governor for the Bank of Canada, he settled on former Goldman investment banker and finance ministry official Mark Carney.

Carney's Ace

Craig Wright, chief economist at Royal Bank of Canada, the country's largest bank, said Carney's ``experience in the private sector seems to have been the ace in the hole.''

Former Goldman executives including U.S. Treasury Secretary Henry Paulson and Bank of Italy Governor Mario Draghi have been named to top policy-making posts. Paulson, Goldman's former chief executive officer, last year became the 10th senior official to join the U.S. government. Ex-Goldman leaders Robert Rubin and Stephen Friedman served as White House appointees, while Paulson's former co-CEO Jon Corzine was elected to the Senate before becoming governor of New Jersey.

Goldman reported record fixed-income trading revenue of $4.9 billion in the third quarter, exceeding the combined tally of Morgan Stanley, Lehman and Bear Stearns. Analysts estimate Goldman will earn almost $11 billion this year, 30 percent more than its closest competitor Morgan Stanley.

Morgan Stanley will earn a record $8.4 billion in the fiscal year that ends in November and Lehman will earn a record $4.3 billion, according to a survey of analysts by Bloomberg. Bear Stearns's net income may fall 31 percent to $1.4 billion.

The Storm

``For being an awful fixed-income year, it sure looks like a pretty good bottom-line year,'' said Brad Hintz, an analyst at New York-based Sanford C. Bernstein & Co., who recommends buying shares of Merrill and Morgan Stanley.

Bear Stearns Chief Executive Officer James Cayne, who ousted his potential successor Warren Spector in August, told shareholders on Oct. 4 that his firm will ``weather the storm.''

``The businesses are much, much more global than they were seven years ago,'' said Peter Goldman, who manages about $500 million, including shares of Bear Stearns and Morgan Stanley, at Chicago Asset Management. ``They are more diversified and with the exception of Bear they didn't have such a compartmentalized risk profile.''

Last Updated: October 7, 2007 20:30 EDT