Let's say you had a great business idea, but you needed a billion dollars to make it happen. Fortunately, there was someone who specialized in raising money for business plans, in the form of debt and equity, in return for a percentage of the total proceeds. The business is not much different than that of a real estate broker. These people are known as "investment bankers," or, in the old terminology, "financiers."
By helping to turn investment ideas into products and services, the investment bankers provided a contribution to society. And, because a small percentage of a very big number is still a big number, they were well paid.
In addition, they facilitated trading in the secondary market for securities, the institutional version of Ameritrade. This has become a very boring and low-profit business, so beginning in the 1980s, they developed a market for side wagers in the underlying debt and equity, known as derivatives. Although it does often serve to "transfer risk" as its proponents claim, mostly it is the institutional investing equivalent of video poker. The casino operator makes a small percentage, of course. Capitalism worked fine without a big derivatives market. Indeed, the average U.S. citizen was probably better off in the 1950s and 1960s than today, derivatives or not.
You probably heard that Goldman Sachs made a lot of money in the last three months. Some of this (10%) came from actual, old-fashioned "investment banking," which was very active because there were a lot of companies who needed some fresh money -- including Goldman Sachs itself, which raised $8.9 billion in equity, debt and asset sales. But, most of it (78%) came from trading its own money, somewhat like a hedge fund, or that guy down the street who is a "day trader."
I say "somewhat" because no hedge fund operates, or could operate, like Goldman Sachs does. Goldman Sachs uses enormous leverage. The company had equity capital of $50 billion dollars at the end of the quarter, but it owned about $500 billion of (adjusted) assets. Which, you will note, is ten times greater. To buy this $500 billion of assets, Goldman Sachs borrows about $450 billion dollars.
Who would loan Goldman Sachs $450 billion dollars? Aren't they afraid they won't get it back? They were afraid, last year. Lehman Brothers was a company very much like Goldman Sachs. However, the day came when nobody would loan Lehman any more money. For good reason: Lehman's existing creditors, after all the smoke cleared, got about $0.09 for every dollar they loaned. Talk about subprime!
But Goldman, and Morgan Stanley, became "bank holding companies." They now enjoy an implicit guarantee from the Federal government. This allows them to continue in business, when, without the Federal government (and Federal Reserve) backup, they would probably be out of business, like Lehman Brothers. Under a separate program, the FDIC's Temporary Liquidity Guarantee Program, Goldman Sachs issued $28 billion of debt between November and April with an explicit government guarantee -- same as Treasury bonds.
This guarantee on new debt effectively guarantees the existing debt as well. For example, let's say you have $20 billion of non-guaranteed debt. When it matures, you get your $20 billion back. Because Goldman can issue $20 billion of new, government-guaranteed debt, it is certain to be able to pay back your $20 billion of non-guaranteed debt.
Not even Fannie Mae and Freddie Mac, the recently nationalized home lenders, have an explicit government guarantee. Certainly no hedge fund does.
In the 1930s, the Federal government decided that small retail depositors needed to have some insurance that they would get their money back even if their bank failed. Until recently, this was limited to $100,000. This program, to protect Joe and Jane Average from the stupidity of bankers, is operated by the FDIC, the same agency that is now guaranteeing Goldman's debt.
In return, banks fell under the oversight of the Federal government so that they wouldn't do anything too risky. Regular banking was separated from "investment banking" via the Glass-Steagall Act. The idea was to separate the regular banking system -- borrowing from depositors and making low-risk, long-term loans to companies and homebuyers -- from the gamblers on Wall Street, so that even if the gamblers blew up, the regular banking system would be OK. Then, the regular banking system was regulated, so that bankers wouldn't do anything excessively risky. Although many regulations, including Glass-Steagall, were weakened or eliminated over the decades, regular banks still have to meet certain standards regarding capital and risk exposure.
Unless, it appears, you are a "bank holding company" like Goldman Sachs and Morgan Stanley. In that case, you can gamble your head off, and the Federal government will still guarantee your debt. Also, as a "bank holding company," you can borrow directly from the Federal Reserve, via the discount window or all kinds of "swaps," which we will look into later. So, if nobody will loan to you, you can still borrow money and not end up like Lehman and Bear.
Not only that: Unlike a hedge fund, if you gamble and lose, you don't have to take your losses. You just hide them under the rug for a few years. You make them disappear.
The details of Goldman's financials for the second quarter are not out yet. But, at the end of the first quarter March 31, the company had "level 2" assets of $352 billion, and "level 3" assets of $59 billion. These were in the form of both cash instruments and derivative contracts. The company claims some "netting," giving a net exposure to "level 2" assets of about $200 billion, and "level 3" assets of $54 billion.
Not too long ago, everyone was talking about "toxic assets," most of which were linked to mortgages going bust, and some of which were linked to "levered loans," or loans to highly levered companies owned by private equity. Guess what: housing prices are still going down. Foreclosures are still going up. Companies owned by private equity are still sucking wind, and have way too much debt. Commercial real estate looks sicker every day. These "toxic assets" are still just as toxic.
Most of these "toxic assets" are "level 2" and "level 3" assets, which means that there is not a regular, liquid market for them so they are hard to value. We know they have been money losers, but it remains to be seen how much money would actually be lost. In the first quarter, there was an accounting rule change which said that banks have a lot more leeway regarding the valuation of these assets. You could say that the bankers could just make up their values. So, if you owned some crappy mortgage-related paper, or made a loan to a private-equity deal that now looks like hell, you could say that it's worth a lot more than its likely true economic value, or what it would fetch in the market. The losses disappear.
This is important if you are levered ten-to-one, like Goldman Sachs. Remember, they have $500 billion of assets, $50 billion of equity and $450 billion of debt. This is sort of like the condo-flipper buying with 10% down. If the value of the condo (assets) goes down, to say $400 billion, then the condo-flipper would have $450 billion of debt and only $400 billion of assets. They would be "upside-down," in condo-flipper-speak.
Now remember that, of those $500 billion of assets, there is $200 billion of "level 2" assets, which are somewhat questionable, and $54 billion of "level 3" assets. The "toxic" stuff. Which might be worth less than what Goldman is saying. Let's just imagine the level 2 stuff was worth 10% less than what Goldman said it was worth on March 31, and the level 3 stuff was worth 30% less. Is this reasonable? Who the heck knows. But it is not a real big mark down, considering the carnage we've seen. That would mean a hypothetical $36 billion loss that is "hidden under the rug," is pretty close to Goldman's capital of $50 billion. They would be close to being "upside down." A dead duck. Another Lehman Brothers.
You can see why no hedge fund could get away with this stuff. If a highly-levered hedge fund had a $36 billion loss on $50 billion of capital -- a 72% decline -- they couldn't hide it under a rug. They would be out of business in an eyeblink. But that is only the beginning. We'll look a little more at Goldman Sachs in the near future.
Banks are complicated. If you want to follow what's going on, it's important to understand how they work. Last year, I wrote a series on my website called How Banks Work. You can read it here:
Disclosure: the author has a short position in Goldman Sachs (GS)