How NOT to Address the Windfall Profits Debate

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While the New York Times may be home to many a nonsensical finance argument, Steven M. Davidoff (Dealbook's "Deal Professor") should know better. Davidoff's bio -- cum laude at UPenn, Masters in Finance, former M&A lawyer, and current professor at U-Conn -- doesn't lead you to expect an argument of populist non sequitur.  But for some reason, that's exactly what we find in a Goldman post from The Professor a few days ago.  And to think, he began with such promise:

The real issues are twofold. First, how much are Goldman's profits and bonus payments related to the benefits provided by the federal government during the financial crisis?


This first question isn't necessarily unfair, but let's not just focus on Goldman, the evil robber-barrons du jour. Save for Lehman, Bear, WaMu and Wachovia, all of the remaining large banks in the country have benefited enormously from the government's unprecedented intervention to stabilize the financial system.  Now let me be clear: I never imagined -- not in a million years -- I'd be defending Goldman Sachs (or any other financial institution for that matter!) but the ire directed at Goldman by the media, Main Street, and politicians across the country is simply out of hand. 

Goldman has become the scapegoat for the entire industry, despite the fact that many other firms were just as, if not more responsible for a vast series of screwups which culminated in our current unpleasantness. Go ahead and blame the whole lot, but don't blame the firm that arguably turned in the least-terrible performance of the bunch!  (Note: The other myriad accusations levied against Goldman are outside the scope of this article, and have been discussed elsewhere in far greater detail than I know, or care to address)

Let's take a look at The Professor's next "issue," emphasis mine:

Second, how should this compensation, if and when paid, be structured to prevent future undue risk-taking? In this mix is the specter of a windfall profits tax on Goldman Sachs and others in the banking industry to claw back any excess benefit these institutions have received.

The first, non-bolded part is perfectly reasonable; however, the latter sentence is prima facie ridiculous to anyone with even the slightest predilection towards unbiased analysis. How, prey tell, should we (the government) define what, precisely, constitutes a "windfall profit" and the circumstances under which a firm can be said to enjoy one?  (What about "windfall losses?"  If the Government doesn't intervene, or does so poorly, do firms get to pay bonuses anyway?)  If we can somehow establish reasonable answers to these questions (I posit we cannot), how then, in practice, would these clawbacks and/or taxes be applied?  If, as it's almost always been the case, a small proportion of employees contributed to the destruction of a firm as a whole, should we clawback and/or tax all of the employees or just the ones we somehow "deem" to be responsible, assuming for a second we could do so in the first place?

Davidoff continues to mystify the mind as he tries in vain to rationalize his "windfall profits" tax:

This benefit [of government support] fits the circumstances for the imposition of a windfall tax. A windfall tax is best suited when the gain is unexpected, like winning the lottery. Taxing it is appropriate since the payees do not expect a windfall and so taxing the amount does not distort their future economic actions. This alone would justify a tax. 

I'm curious why someone who spent a not-insignificant amount of time around Wall Street types is of such a mentality; profits are always expected, 100% of the time.  Sure, sometimes you lose money unexpectedly, and other times you make more money than you expected to make, but even then, the above criterion for applying a windfall tax makes little-to-no sense.  What if, for example, after receiving Government support Goldman had made enough money to repay TARP, but instead of turning in record numbers, only did well-enough just to get by?  Would anyone be demanding a cut of those relatively minimal profits? I think not.  

Even if Davidoff's definition of "unexpected" refers to the tenuous claim that without Government support, Goldman wouldn't have made a dime - or worse, lost a fortune - I still don't buy the argument.  How many times has the Government bailed out or otherwise supported the airlines, automakers, and even the agriculture industries?  The entire point of government support - regardless what firm or industry receives the benefit - is to make said firms and/or industries generate (sustainable) profits! 

Additionally, I'm curious how he states such a tax is "appropriate" based again, upon the tenuous claim that it would have no effect on the future economic actions of those upon whom its levied.  Perhaps Mr. Davidoff should ask the lot of bankers and traders in London how they feel about being subject to Alistair Darling's 50% windfall bonus tax.  Were I a betting man, I'd have a good chunk of change on plenty of key producers making a B-line out of The City in the next few months or even years out of fear the tax will come back to bite them in the wallet again (and again, and again...) down the road.

Continuing his argument with a complete lack of facts, formulae or what-have-you, the Professor continues:

But there is another justified reason for a tax on Goldman Sachs. A portion of Goldman's profits are really the government's profits. Allowing Goldman to keep this money is simply allowing the investment bank to keep money earned from the efforts of the federal government. This would be a simple wealth transfer from the American taxpayer to the partners of Goldman Sachs. Don't be fooled by any billion-dollar donation Goldman may announce -- the benefits it has received far exceed this number.

Indeed, a portion of Goldman (and Bank of America's, and JP Morgan's...) profits were really the government's profits!  That's why each bank repaid the government, not just in-full, but with interest. JP Morgan paid almost $800 million in dividends and Goldman $425 million.  I won't attempt to adjust for risk (anyone else care to quantify that?), but those are some pretty attractive annualized returns for any investor, especially in a declining interest rate environment.  Davidoff says the benefits realized as a result of Government support vastly outweigh what TARP (etc) recipients paid for them, but makes no attempt to explain how, or to what degree.  Even if someone claimed to be able to answer these questions definitively (which again, I posit one could not), isn't that the point? Spend X to support the banks in hopes they'll make back some multiple of X, repay the Government, and achieve financial sustainability?

I understand that media outlets need to sell pages (real or virtual) and ads, but so much reporting, from factual to op-ed is riddled with populist pandering I'm more disgusted by the bandwagon critics than the questionable (at best) actions made by firms like Goldman over the past few years.

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Presented by

Jordan Terry

Jordan S. Terry is Founder & Managing Director of Stone Street Advisors LLC, which provides independent financial research & analysis services to institutional investors.

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