How Does Goldman Make So Much Money?

You've probably heard by now that Goldman Sachs (NYSE:GS) shot the lights out last quarter. In its 10-Q, released earlier this week, the investment bank shows just how successfully it's navigating current markets. During the second quarter, Goldman made more than $100 million in trading revenue in each of a record 46 days, with just two losing days out of 65 – for an astonishing hit rate of 97%!

How do they stack up?
In the quarter, Goldman's powerful Fixed Income, Currencies & Commodities (FICC) division alone put up record revenue of $6.8 billion – more than the total revenue for its closest competitor Morgan Stanley (NYSE:MS), and ahead of some of the world's largest, most successful companies:

Source: Capital IQ, a division of Standard & Poor's.

It beggars belief that an intermediary -- i.e., a firm that serves the needs of other corporations, governments and investors -- can make those sums. But in truth, over the past 15 years, Goldman has become much more.

A mutation in the business model
Indeed, Goldman's no longer simply a facilitator, content to pick up the crumbs (to use Tom Wolfe's metaphor) from customers' transactions. Instead, it has become a principal agent in all major markets, anteing up wagers on its own behalf. (I remember seeing Goldman described as "an investment bank bolted onto a hedge fund" as early as the 1990s.) That model -- combined with the requisite expertise in managing risk -- yields fat slices of cake, not just crumbs.

The other, less flattering, explanation, which is fundamental in explaining the firm's record earnings in this environment, is that Goldman operates at the pinnacle of an oligopolistic industry, in which current conditions are extraordinarily favorable. (Think high volatility and low interest rates.) In fact, the credit crisis has only served to tighten up this oligopoly by eliminating some securities-industry players. Lehman went bankrupt, while Bear Stearns was swallowed by JPMorgan Chase (NYSE:JPM).

I have no problem with profits, but...
I am a proud capitalist, and I celebrate companies that earn large profits as a reward for successful risk-taking. But in the case of institutions that are too big to fail (such as Goldman), I'm being asked to shoulder part of the risk.

The first priority in redesigning the financial regulatory architecture should to draw up detailed guidelines for winding down any large institution in the event of its failure. Absent that, before too long we'll find ourselves with another AIG or Fannie Mae on our hands -- or on our backs.

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