Squeezing Through the Discount Window

Yesterday, on G+3, Goldman Sachs remained the top financial news story. The initial shock may have subsided, but the ensuing awe is just beginning to unfold…

When you Google “Goldman Sachs Fraud,” you get 10,200,000 responses, which is only 5,000,000 responses fewer than you get when Google just plain old “Goldman Sachs.” In other words, “Goldman” has become nearly synonymous with “fraud.” This alarming development may be good news for class-action attorneys, but it is probably bad news for the stock market…at least in the short term.

Goldman is not merely the stock symbol “GS,” it is much, much more. Goldman is both a shrine to modern American capitalism and a landfill for popular discontent and vitriol. As such, Warren Buffet worships at the Goldman altar, even while securities regulators, litigators, journalists and sundry “Average Joes” line up to unload their contempt on the reviled financial firm.

Goldman’s (few remaining) apologists insist the firm is merely successful. Everyone else assumes the firm is merely criminal. Most likely, the truth lies somewhere in the middle – Goldman is successfully criminal.

But whatever the exact secret sauce – or witches brew – that nourishes Goldman’s success, the stuff seems to be toxic for Goldman’s clients…and they are becoming a bit sick of it. Some clients are hiring lawyers; others are merely keeping a safe distance away from Goldman’s trading desk. Both of these responses are likely to impede earnings growth.

But client discontent is not the only assault on Goldman’s earnings growth. Goldman, along with all the other major financial firms, faces the grim prospect that the cost of borrowing money from the government may rise…perhaps by a lot.

When it converted into a bank holding company back in 2008, Goldman became eligible to borrow cheap money from the Fed’s discount window. Morgan Stanley did the same thing. As a result, Goldman, Morgan Stanley et al. may borrow billions of dollars from the Federal Reserve and use the proceeds to purchase higher-yielding government securities of longer duration.

In other words, Goldman may borrow from the government at 0.75%, then loan the money back to the government at 3% or 4%. All in a day’s “trading.” Not surprisingly, all the major financial firms have been reporting blockbuster profits. Yesterday, for example, Morgan Stanley wowed the Street by nearly doubling its expected earnings result. Bond trading provided most of the juice, as Morgan’s fixed-income revenue more than doubled from the prior year’s first quarter.

Prior to Morgan Stanley’s results, Bank of America, JP Morgan Chase and, yes, Goldman Sachs, had all reported record quarterly revenue from fixed-income trading. On the surface, these monster profits would seem like good news. But this silver cloud contains a very dark lining: without the Fed’s low-cost financing, fixed-income profits will be much harder to come by.

A related dark lining is this: without the financial sector’s resurgent profitability, corporate earnings aren’t very impressive.

“Total US corporate profits rose 30.6% year-over-year in the fourth quarter, a huge swing from the -25.1% trend a year ago,” observes The Daily Reckoning’s favorite economist, David Rosenberg. “But almost the entire story is in the financial sector, where profits have soared 240%, which is unprecedented… Financial sector profits have accounted for 85% of the overall increase in corporate earnings. Total non-financial earnings are up a grand total of 5.2% year-over-year…

Financial Sector Profits

“The financial share of total profits bottomed at 10.8% in the fourth quarter of 2008,” Rosenberg continues, “and has since soared to 28.2% of total profits, one of the highest percentages ever. This trend does not look sustainable to me.”

Net-net, the finance sector is probably a better “sell” than a “buy”…and Goldman may be the best “sell” of all. But what do we know? Warren Buffet owns the stock and, last we checked, he had a lot more money than we did….

Eric Fry
for The Daily Reckoning

The Daily Reckoning