Wednesday, July 21, 2010

Goldman's Profit Magic Goes Missing

When the financial markets are topsy-turvy, Goldman Sachs Group Inc. has a knack for finding a way to profit from the turbulence. That didn't happen in the second quarter.

Goldman reported an 82% profit tumble, hurt by a surprisingly steep decline in revenue that included a wrong-way bet on the stock market's volatility. The New York company didn't disclose the size of the loss, which occurred in its equity-derivatives business and is an unusually large blunder given Goldman's reputation for prudent risk management.

In contrast, the hit to Goldman's bottom line from the $550 million settlement announced last week with the Securities and Exchange Commission plus $600 million set aside to cover the new U.K. bonus tax caused barely a ripple among analysts and investors. (A federal judge in Manhattan signed off on the settlement on Tuesday.)

Net income fell to $613 million, or 78 cents a share, down from $3.44 billion, or $5.59 a share, in last year's second quarter, when Goldman earned more than it did in all of 2008. Net revenue shrank 36% to $8.84 billion from the year-earlier $13.76 billion. The latest quarter's net revenue and earnings were the smallest since 2008's fourth quarter, while net income was the fourth-lowest since Goldman went public in 1999.

Like J.P. Morgan Chase & Co. and other financial firms that rely on trading revenue, Goldman was bruised in the second quarter by worries about economic growth, toughened financial regulation and Europe's sovereign-debt problems. Goldman Chief Financial Officer David Viniar said many trading clients "lacked conviction" and "sat on the sidelines."

Goldman, led by Chief Executive Lloyd Blankfein, also reined in its own trading appetite, with the firm's value-at-risk declining to an average of $136 million in the second quarter from $161 million in the first quarter and $245 million in last year's second quarter. Value-at-risk is a yardstick of how much in losses could be suffered in one trading day.

But the firm made a costly decision not to completely hedge bets made by customers that the market's volatility would rise during the second quarter. "We were directionally wrong," Mr. Viniar said.

Asked whether Goldman itself made a mistake in the firm's view of turbulence in the market, Mr. Viniar responded that Goldman "didn't hedge it fast enough."

One managing director on the stock-derivatives desk that is responsible for the losses recently left Goldman, and other employees in the unit are considering leaving, according to people familiar with the situation. The departed managing director was a salesman. Goldman declined to comment.

As a result of the losses, "the most striking shortfall on the revenue line was equities trading, which registered the lowest quarterly figure at least back to 2003 in our model," said Barclays Capital analyst Roger Freeman. Analysts surveyed by Thomson Reuters had expected Goldman to report revenue of $8.94 billion.

Net revenue in the firm's equities department, which includes the stock-derivatives desk, fell 62% to $1.21 billion from $3.18 billion in last year's second quarter. Fixed-income, currency- and commodities-related net revenue, the biggest profit engine at Goldman, fell 35% to $4.4 billion from the year-earlier $6.8 billion.

Excluding the impact of the SEC settlement and U.K. bonus tax, Goldman said it earned $2.75 a share.

Goldman set aside $3.8 billion, or 43% of its net revenue in the latest quarter, to cover employee compensation and benefits. So far this year, Goldman has set aside $9.3 billion, or $272,581 per employee, in total compensation and benefits, down 18% from $11.36 billion, or $364,135 per employee, in the first half of 2009. The U.K. bonus tax imposes a non-deductible 50% tax on financial companies that issue discretionary bonuses of larger than £25,000, or about $40,000.

Mr. Viniar reiterated that the SEC's civil-fraud lawsuit against Goldman, filed in April and settled last week, didn't cause a noticeable client exodus, adding that firm still ranks No. 1 in the high-profile business of advising companies on mergers and acquisitions.

But some analysts remain concerned that Goldman could face further SEC accusations. Last week, the SEC said as part of its settlement announcement that the $550 million deal "does not settle any other past, current or future SEC investigations against the firm."

In a separate statement last week, Goldman said it believed that "the SEC staff also has completed a review of a number of other Goldman Sachs mortgage-related CDO transactions and does not anticipate recommending any claims against Goldman Sachs or any of its employees with respect to those transactions based on the materials it has reviewed."

Mr. Viniar said Tuesday that the SEC reviewed Goldman's statement before it was released. A spokesman for the SEC declined to comment on Mr. Viniar's remarks.

The SEC is proceeding with civil-fraud charges against Fabrice Tourre, the Goldman trader accused by the SEC of being "principally responsible" for piecing together the deal at the center of the suit.

Mr. Tourre, who is on paid leave from Goldman, denied in a court filing late Monday misleading investors. Goldman is paying the legal costs of Mr. Tourre's defense. Mr. Viniar described the case as "a separate suit against him, not against us, so it's totally appropriate for him to have his own lawyer."
—Joe Bel Bruno
contributed to this article.

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