Macaskill on markets: Goldman premium eroded by fixed-income trading setbacks
The collapse in fixed-income revenues at Goldman Sachs in the second quarter might accelerate the war of succession between rivals for the role of next chief executive.
Jon Macaskill is one of the leading capital markets and derivatives journalists, with over 20 years’ experience covering financial markets from London and New York. Most recently he worked at one of the biggest global investment banks
It will certainly prompt soul-searching among senior executives at the firm. Goldman’s top managers were probably already reconciled to JPMorgan’s assumption of the mantle of leading global investment bank. JPMorgan dominates global underwriting fee income and is beginning to break clear of the pack in sales and trading revenue generation, with equities its only area of relative mediocrity.
But Goldman’s key staff – from group heads down to top revenue producers – will have found the second quarter’s underperformance relative to Morgan Stanley much harder to stomach.
Morgan Stanley edged out Goldman in fixed-income sales and trading and investment banking revenue for the first time and came close to matching its equity sales and trading total.
This can be explained in part by a different approach to risk in the quarter. Morgan Stanley increased average value at risk to $145 million from the $121 million logged in the first quarter, while Goldman’s average VAR fell from $113 million to $101 million.
But serious problems with the functioning of Goldman’s vaunted risk distribution model compounded the effect of a decision to cut net exposure.
An uncharacteristically uncertain performance by Goldman’s longstanding CFO David Viniar on the firm’s earnings call reflected this turmoil.
Viniar struggled and failed to reconcile two conflicting messages for the analysts in attendance on the call. His core message was that Goldman’s edge had not been fatally eroded by its reputational woes and the impact of regulatory changes.
"We don’t believe there was any impairment of our franchise during the quarter," Viniar said. He backed this by asserting that client volumes had fallen, but were not much lower, without offering any detail.
Viniar then undermined this argument when asked about the implications of the slump in fixed-income, currency and commodities revenues for future earnings.
"I don’t think there is such a thing as a run-rate in FICC," he said.
This glib line is one he has used in the past. It was effective when Goldman was consistently outperforming its rivals in fixed-income trading. The quote projected a quiet confidence that Goldman actually could be relied upon to provide stable FICC revenues – or at least to suffer less from cyclical reverses than its peers.
But if there really is no such thing as a FICC run-rate then Goldman faces serious questions about its long-term valuation, given its reliance on fixed-income trading revenue in the past decade.
A key reason for the "Goldman premium" in that period – both in its price and reputation – was the widespread assumption that the bank had a unique ability to manage a portfolio of risks across fixed-income and commodity markets.
Goldman’s trading through the 2007/08 crisis – despite the reputational headaches individual hedging deals would bring – seemed to bear out this thesis.
The bank suffered a breakdown in its legendary ability to manage the inventory associated with industrial-scale fixed-income trading in recent months, however.
There were hiccups in different sectors. In mortgage-backed security trading Goldman appears to have been one of the banks that suffered from the Federal Reserve’s botched handling of the sale of the Maiden Lane portfolio of former AIG holdings. When the regulator pumped too much supply on the open market there was a sudden plunge in cash MBS prices that was not matched by related derivatives, causing basis losses for dealers that compounded the impact of any net long exposure.
The commodities price plunge in the second quarter also hurt the sector leaders among dealers Goldman and Morgan Stanley. Both firms said that they avoided net losses in commodities, but they suffered a slump in revenues on the double whammy of a fall in client activity and trading dislocation.
Goldman also singled out problems in its Asian and European franchises as a factor in the fall in its FICC revenues, which were down 63% from the first quarter and 53% below the level in the same quarter last year.
The list of problem areas was unusually long for Goldman and so was the tone of its excuses, with Viniar complaining that political uncertainty was making economic decisions on trades difficult. That was a strange line from the firm once known as Government Sachs for its unique insight into the interaction of policy and pricing.
The failure of the firm’s FICC inventory management machine has revived suspicions that Goldman has been hit harder by changes to its proprietary dealing capacity than it is letting on.
Its equities-based principal strategies group and the macro fund have been closed, while the debt-based special situations group was shifted to the relatively new investing and lending division at the firm.
The special situations team seems to have had an underwhelming quarter. Net revenues for investing and lending were $1.04 billion but that came chiefly from realizing gains on existing stockholdings, with debt and loan net revenues of only $200m, mostly from interest income. No prop group can be expected to deliver blow-out results every quarter but it marked another area where Goldman is underperforming.
The bigger question is whether recalibration of Goldman’s business model is affecting the way outright prop trades interact with prop-lite inventory hedging decisions in maximizing the revenue from client trades.
The surprising shift in relative second-quarter fortunes of the two big remaining pure-play investment banks led one slightly excitable analyst to dub Morgan Stanley "the new Goldman Sachs".
That call could be premature. After all, when former Morgan Stanley chief executive (and still chairman) John Mack led the last attempt to copy Goldman’s business model, the experiment ended with the biggest single trading loss in history and the near collapse of the firm.
The strong second-quarter FICC performance at Morgan Stanley came in part because of recouped losses in MBIA hedges and against a backdrop of significant swings in rates positions such as Tips trades put on by former Goldman dealer Glenn Hadden. That indicates that there could be further volatility ahead in fixed-income performance at Morgan Stanley.
But for key staff at Goldman it won’t be enough simply for Morgan Stanley to fail again. They will want to regain their mojo, in the form of the conviction that they work at the sharpest firm on Wall Street. And that will require a dramatic turnaround in Goldman’s trading performance – potentially with new direction from the top.