Fraud Charges Aren't Goldman's Only Worry

Since the SEC brought civil fraud charges against Goldman Sachs (NYSE: GS  ) last month, the Wall Street giant has shed about 20% of its market capitalization. The possibility of potentially firm-destroying criminal charges lingers, and shareholder lawsuits are starting to mount.

Yet these are just the most-publicized worries for Goldman Sachs. Its enormous trading business could also face headwinds from financial reform legislation and a move away from complicated derivatives securities on the part of "sophisticated" institutional clients.

Building a trading empire
In 1999, the year Goldman went public, it had $13.3 billion in annual net revenue. The company was relatively balanced across its three primary segments: Its trading and principal investments business led the way with 43% of net revenue, while investment banking accounted for 33%, and asset management covered the remaining 24%.

Ten years later, Goldman's net revenue has more than tripled to $45.2 billion. Now, though, the trading and principal investments segment dominates the company, generating 76% of overall net revenue. Most of those gains have come from the FICC (fixed income, currency, and commodities) division of the trading segment. FICC alone made up more than half of the entire company's net revenue in 2009, up from just 21% a decade ago.

Goldman Sachs' most recent 10-K filing with the SEC lists three sources of trading revenue. In two of the three, market changes driven by financial reform or reduced client appetite for the most complicated transactions could hurt the company.

  1. "First, in large, highly liquid markets, we undertake a high volume of transactions for modest spreads and fees." -- The financial crisis has been a boon to this part of Goldman's trading business. With competitors Lehman Brothers and Bear Stearns out of the picture, Goldman Sachs and fellow survivors Morgan Stanley (NYSE: MS  ) , JPMorgan Chase (NYSE: JPM  ) , and Bank of America (NYSE: BAC  ) face less competition.
  2. "Second, by capitalizing on our strong relationships and capital position, we undertake transactions in less liquid markets where spreads and fees are generally larger." -- The Senate's financial reform bill aims to move over-the-counter derivatives transactions to exchanges and clearinghouses to provide greater transparency and improve risk management. Transactions done through these platforms could become less profitable, as spreads and fees would likely shrink.
  3. "Finally, we structure and execute transactions that address complex client needs." --Legitimate needs for complex transactions will always exist. But institutional clients -- particularly pension funds and insurance companies -- might be more reluctant to join the party, even if Moody's or S&P bestows a security with a AAA rating.

While there's a lot to dislike about Goldman Sachs, it's too early to count the company out. Just look at how it transformed itself over the past decade -- the money moved, and so did Goldman. That said, I wouldn't touch the stock right now, even at current prices.

More Foolishness on Goldman and financial services:

Fool contributor April Taylor does not own any of the companies mentioned. Moody's is a Motley Fool Inside Value selection and a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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