Goldman's Money or Yours?

Why doesn't anybody talk about interest rates?

I played golf a couple of weeks ago with a general contractor who asked me if interest rates were going to go back down. I said, "What?"

Higher interest rates have "killed" his business over the last 6-9 months or so he insisted.

The only interest rates that have gone up this year are those of very short term duration. Either the guy doesn't know his business or his customers are re-doing their kitchens based on short term loans; either way I told him his business prospects sucked for the foreseeable future. I said to him, "You probably made good money for the last ten years, didn't you?"

"Yes", he confirmed. "Well, it's over. Be grateful for the good times and move on, or at least recalibrate your expectations", I lectured him. (His business is suffering because the housing bubble is deflating.)

Every fool can tell you the exact price of gasoline at local gas stations or how many points the Patriots scored yesterday, but hardly a soul around could draw a basic graph of oil prices or interest rates. I have news for you people, you should know this stuff!

I rehash this interest rate subject because today I want to talk about Goldman Sachs. Why are they making so much money these days and drawing the ire of class warfare mongers?

It's very easy for me to learn the prevailing agitprop without consuming any of it - I just go to an extended family gathering.

At Christmas, two separate (but equally misguided) relatives complained to me about the average pay at Goldman Sachs being six hundred thousand bucks in 2006.

Aha! That must be a prominent socialist talking point these days, or so realized CaptiousNut.

Is that a lot of money? Of course. The average pay actually ended up at $521,000. Basic math dictates for every secretary making 50k, there has to be someone making around $1 million. Or for every two secretaries, there must be someone making $1.5 million, etc.

Now I could care less about how much Goldman employees earn. First, I don't own any of their stock. Second, I don't believe in zero-sum economics whereby every dollar Joe Blow earns is a dollar out of my own pocket. Third, I am not a deadly sinner.



Envy was listed as a deadly sin long before Marcus Goldman founded his firm in 1869; it's in the Old Testament, Proverbs 6:16-19.

Of course none of the kvetchers think themselves envious. In fact, they contort the entire issue into a crime of greed on the part of Wall Street, corporations, hedgefunds, and sundry other bogeymen. One of my relatives in fact referred to Goldman Sachs as "the moneychangers".

It just so happens that greed is also a deadly sin. So their moral transgression ought to be excused by another's?

As Greg Mankiw would say, how elegant!

I submit that my newspaper-addicted relatives are in fact quagmired in envy. Look at it this way, if they had a son or daughter that worked at Goldman, would they be appalled at the child's take home pay? No, their kid would have earned it. In this case, would they be rooting for Goldman and Wall Street to have a bad year and slash bonuses? Of course not. Would they be ashamed that their child worked at one of the most profitable and powerful banks in the world? No, they'd be quite proud of it.

Sorry, that's not hypocrisy; that's pure envy.

As for the greed, what do people expect Goldman to do with all of their earnings?

Goldman's earnings set an alltime high for investment banks in 2005--then grew 76% last year to set a new record. In 2006 revenue rose 50% to $38 billion (net of interest cost). Its dealmakers handled an industry-high $1.1 trillion in mergers and acquisitions; its wealth managers raked in $94 billion in new- customer money. Its stock climbed 55% to hover near $200.



As you can see, the stock has gone from $150 to over $200 per share just since the summer. Overall, the stock is up 100% in the last two years so shareholders aren't exactly complaining.

Don't think that if Goldman paid smaller bonuses and banked the money or paid it out as a dividend that the stock would necessarily have performed even better. That would be indulging in unquantifiable conjecture and defy certain business realities.

If I were ever going to start the ideal investment bank or trading firm I would try to situate it far from Manhattan. Though it's the financial capital of the world and much of my firm's business would reside in and derive from the Big Apple, the City presents a major problem for employing labor. There are so many jobs and opportunities there that when the labor market gets tight, every employee becomes an unrestricted free agent.

It's not just the econo-illiterate but also most people that haven't lived in the New York Metro area that don't understand this phenomenon. New Yorkers change jobs like others change their underwear, or thereabouts. In a good job market, firms lose employees left and right. Furthermore they have to throw all sorts of money at the employees that do stay just to keep them happy.

If Goldman issues smaller bonuses or paid out their profit swell through dividends, they run the risk of hemorrhaging valuable traders and bankers who are already itching to jump into more lucrative ventures like hedge funds or other investment banks. Losing talent en masse would hamper future profitability AND preclude any theoretical stock price gains. At the end of the day, Goldman knows better than newspaper columnists and your big-mouthed relatives how best to spend their money.

You can read that cover story on Goldman in Forbes but it won't tell you what I am going to tell you. Forbes runs through a rather boring litany of successes for Goldman: Kinder Morgan buyout, NYSE equity trading, hedgefund services, etc.

I submit that Goldman is knocking the cover off the ball simply because of low long term interest rates. Allow to me explain.

As an investment bank, they traffic in businesses and assets, right? Well following simple present value discounting, low interest rates make all income bearing assets worth more. When interest rates drop from 8% to 6%, your house is worth more, taxi medallions are worth more, stock exchange seats appreciate, as do gas stations, consulting firms, and every other business or asset.

Why would a gas station worth more?

Well, say it pumps out 100k in yearly income and the market presently values it at around $1 million. That's a 10% yield. But if one can borrow the money at 5%, as is likely in today's market, investors will buy the station, pay 50k a year in interest and pocket the other 50k profit almost risk- and work-free. This doesn't really happen too often; more likely the station will cost closer to $2 million - approximating a 5% yield. The gas station, and just about every other business under the sun, will always have its price dictated by the cost of money, i.e. interest rates. Cheap currency always leads to high prices.

Consider those slimy real estate agents. Today they sell a house for 500k and divy up a healthy 25k (5%) commission. Five years ago they were selling that same house for 300k and only reaping a 15k commision. Clearly, the higher the asset prices, the more lucrative the real estate brokerage biz.

The same goes for Goldman but on a more massive scale because the assets they transact in (like shopping malls and oil pipelines) have more zeroes in the price tag. Remember, at the most cynical level, finance is but the largest skimming operation there is. There's simply more cream to be had when the cup runneth over.

I am short the bond and cash laden so I'll do fine should interest rates rise from here - as will Goldman Sachs since they are diversified into commodities (however average pay may fall to 400k).

I hope one day people envy my earnings as they do Goldman's.