Calculating Risk: Panning for gold in Goldman's 'gut'

All five investment banks that existed a year ago are gone.

These are firms which put their own capital and the capital of big institutional and individual investors at risk, to merge or acquire companies. And were supposed to be experts at identifying, evaluating and acting on risks, before they took their shareholders or themselves down.

The risks were largely ignored, as they tried to make killings on that and trading in all forms of complex securities, including the now much-maligned batch known as mortgage-backed securities. Pools of mortgages sliced up into different pies of stuff known as “collateralized debt obligations.” No one wanted to believe the most obvious risk: That housing prices can go down, not just up.

Bear Stearns, bought before it failed by J.P. Morgan Chase. Lehman Brothers, allowed to disappear. Merrill Lynch, bought on the cusp of failure by Bank of America (causing it to go wobbly). Morgan Stanley and Goldman Sachs, turned into depository institutions, aka bank holding companies.

But even the most gold-plated of those bankers have had to fight to survive. And are not out of the woods, by a long shot.

The one with “gold” in its name is Goldman Sachs. ZDNet Undercover looked to find out whether Goldman deserves its reputation as having the most “golden gut” of all the investment banks. And, found (a) the reputation had foundation, but that (b) it’s not enough to stave off a wholesale shrinkage of its business and its bottom line, when an entire industry has bet on ever-rising housing prices. And been, collectively, wrong.

Goldman Sachs avoided commercial risk evaluation software and systems. In its examination, titled “Calculated risk: How Goldman Sachs stepped back when others didn’t,’’ ZDNet Undercover found that Goldman Sachs – using sophisticated house-built systems for analyzing the risks it faced in the complex securities it was investing in -- succeeded early on in the pricking of the real estate bubble by betting against indices of securities that were derivatives of home loans and accumulating insurance against defaults. In effect, it passed along its exposure to the collapse of risky mortgages to Merrill Lynch, the investment manager, and AIG, the international insurance agency.

But it was a very short-lived victory. In the third quarter of 2007, Goldman, by sensing in its bones that a collapse was possible, earned a $1 billion profit, by betting against mortgage-backed securities. Merrill Lynch took a $2.2 billion loss on an $8.4 billion writedown. Citigroup wrote off $5.9 billion, then another $8 billion plus.

“We didn’t get everything right, and there are more than a few decisions we’d like to take back,’’ chief executive Lloyd Blankfein told attendees of a Merrill Lynch ?nancial services conference in November.

Goldman's “net revenue” from trading in mortgage-backed securities and other complex instruments was $31.2 billion for all of 2007. Last year, it contracted to $9.1 billion. Most stunningly, that trading turned negative in the fourth quarter. Its revenue was minus $4.5 billion. And that’s the top line for business activity. No surprise at all that Goldman reported its first-ever loss on the bottom line, at $2.1 billion for the quarter.

Now, let’s see whether Goldman Sachs can report a profit for the first quarter of its new year, or if the slide continues.

Jeff Zucker, having done so well with an American version of “The Office,” is probably about to engage Simon Nye to begin penning a series for NBC entitled “Bankers Behaving Badly.”

American lenders never seem to learn from the past. The nation's savings and loans went nuts in the ‘80s, financing condos for tenants who did not exist. There were crooks, too, flipping properties with alacrity, thanks to friendly title agents and property value assessors, who made money by being in cahoots.

In this epoch, the problem was group-think. Every bank wanted to party as long as every other bank was partying. No matter what the government or public thought. Things would have to work out, because these were the smartest folks on the planet. Even on his way out, Merrill Lynch CEO John Thain, a Goldman Sachs alumnus, wondered how Bank of America could possibly survive without him. He who had the smarts to renovate his office for $1.2 million, while his company was losing billions. Now, Thain will be remembered for that, not moving the New York Stock Exchange in the 21st Century or, as he would like, rescuing Merrill Lynch from passing into oblivion.

His former colleagues at Goldman must have grimaced. They had shown that, even in this age of automated trading and automated risk analysis, the most important factor in succeeding in a financial nightmare was … good judgment. The willingness to identify when markets have turned. To generate the numbers. But look honestly at the numbers – and behind the numbers.

Then, make the call first. Goldman Sachs uses risk analysis systems to support what looks to the outside world as a seemingly intangible thing known in popular terms as a ‘golden gut.’ Go here to see how that gut is fed.