Everybody Will Freak Out Over Goldman's Bad Quarter—They're Wrong

What the leading investment bank's second quarterly loss since 1999 means for the firm

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How bad was the market in the third quarter? It was so bad that it battered investment banking titan Goldman Sachs to a quarterly loss for just the second time since the firm went public in 1999. To be sure, this will provide the Occupy Wall Street crowd some reason to cheer in the streets today. Goldman Sachs has become a symbol of everything wrong with the financial industry over the past couple of years. What went wrong in the third quarter for the firm, and what are the implications of its loss?

What Happened?

Yesterday, I wrote that most big banks actually managed to do pretty well in the third quarter. Goldman didn't: it posted a $393 million loss. What was different here? Goldman still has more of a traditional investment bank structure, and it has a huge trading presence. So a rough market can affect the firm more than the other big institutions: it lacks the diversification that those other banks enjoy, like in business segments like consumer lending.

And the third quarter was a very rough one for the stock market. The S&P 500 was down 17%. That alone can cause a firm with a big exposure to equities to post a loss. And Goldman's "Investing and Lending" revenues were negative $2.5 billion. Predictably, Goldman blames "a significant decline in global equities" and "unfavorable credit markets." The firm lost $1 billion on its investment in Chinese bank Industrial and Commercial Bank of China Limited (ICBC) alone.

But trading was only a part of the story: its investment banking revenues also took a big hit. They were down 33% compared to a year earlier and 46% lower than the second quarter. You might recall that as the second quarter ended, the economy began to weaken. When firms' outlook fades, they aren't as likely to do as many deals. That means less revenue in fees for a bank like Goldman from merger advisory and underwriting.

Why Did It Happen?

Investors should find this result a little bit troubling. Over the past twelve years, the market has experienced plenty of bad quarters, but this is only the second one during which Goldman recorded a loss. So this should leave shareholders wondering what changed this time. Here are a couple possible theories:

Just Bad Luck?

Even the best poker players lose from time to time. No matter how good you are at the game, sometimes the cards just aren't dealt in your favor. Take the ICBC investment, for example. From a long-term strategy play, it makes tons of sense for Goldman to have exposure to a major Chinese banks. China is a rapidly growing market. But Chinese institutions had a particularly rough quarter as the nation's growth is thought to be trending down in the near-term. So this investment wasn't so much a bad call as it was bad luck. In time, however, this loss could quickly reverse as China's growth eventually strengthens.

Fears of Bad PR?

Another possibility is that the firm has become less willing to seek profit at any cost. If we think back to dark period of 2008-2009, Goldman managed to remain profitable in part because it was ahead of the curve on recognizing the housing bubble's pop. It hedged, or possibly even profited from, the housing market's collapse. However, some of its antics led to a high profile lawsuit brought by the Securities and Exchange Commission. In this quarter, however, it's not entirely clear what sort of bad public relations could have resulted from better hedging. But the firm could just be generally less aggressive covering its bets for fear of public perception.

Goldman Just Bet Poorly

Or maybe Goldman really is just fallible. It may have believed that its bets were smart ones. Perhaps it would have happily covered its bad positions if it had known better, but it just didn't. Nobody is right all the time, so Goldman's traders might just be human, after all. Although this might disappoint its shareholders, it probably comes as a relief to everybody else.

The Consequences of New Financial Regulation

Another possibility is that Goldman began heeding new restraints that make it harder for the firm to hedge its bets swiftly and effectively. Although the new Volcker Rule, which limits a bank's proprietary trading, hasn't been fully implemented yet, we have heard that banks were already beginning to make changes. If the firm's trading arm is less robust and able, then perhaps it couldn't executive the trades necessary to avoid a big loss.

Will It Happen Again?

Is this just a blip or does it signal a turning point for Goldman? Of the explanations above, only the last one would really suggests that last quarter was fundamentally different from pervious ones. Unless, going forward, Goldman is physically constrained from trading in such a way that it can no longer regularly avoid losses, we have little reason to believe that the firm is doomed.

In fact, as John Carney reported back in July, Goldman may be taking its emphasis off of trading in general. This shift would mean that bad quarters like this one will not be as common in the future. If the firm relies less on trading and more on fees, then a weak quarter would likely just mean that its fee revenue, though weaker, would make up a bigger portion of total revenue and could more easily overshadow a trading loss.

As the firm's earnings release proclaims in its highlights section, Goldman remains the worldwide leader for 2011 in merger and acquisition advisory and equity underwriting. So customers are hardly shying away from the firm. Unless we start to see this begin to change, we have little reason to believe that the bank is in trouble.

Are Layoffs Coming?

But this loss will have repercussions for the bank's employees. For starters, it will affect bonuses. The firm reports that its quarterly accrual for compensation and benefits declined by 59% compared to the same period in 2010. Presumably the bad trading quarter will impact the bonuses of Goldman traders, in particular.

And the loss will also keep the firm's downsizing on track. Its earnings announcement also reveals that its headcount shrunk by 4% during the quarter. Some reports have indicated that the firm is looking to cut its staff by as much as 20%. If it is moving away from trading, then this division of the firm will likely be more adversely hit by layoffs than others. And a $2.5 billion quarterly trading loss isn't going to make management think twice about axing those traders.

So for now, we shouldn't consider Goldman Sachs in that serious of a pickle. It has already begun cutting its trading business in response to new regulation, so future trading losses might not affect the firm as significantly. This quarter was a particularly rough one for the stock and credit markets, so we shouldn't be surprised to see a big investment bank focused on trading have some trouble. If Goldman's earnings continue to slide in coming quarters, then its shareholders might have more reason to be concerned.

Image Credit: REUTERS/Lucas Jackson