The cost of capital: Goldman Sachs' extreme makeover

July 06, 2009

In September 2008, the financial storms that had battered global markets since spring began to threaten the legendary investment bank Goldman Sachs.

The 139-year-old financial titan, known for its high-risk-high-reward approach to investing, had seen its stock plummet nearly 50 percent in a matter of weeks. With fear gripping Wall Street, nervous investors began pulling money out of the company. Three other big investment banks -- Lehman Brothers, Bear Stearns and Merrill Lynch -- had either gone bankrupt or been shuffled off to larger firms in rushed sales. Investors and Wall Street observers wondered if Goldman would be next. Another red flag for Goldman: One of its biggest trading partners, the insurance giant AIG, appeared on the verge of collapse.

Nine months later, Goldman is very much back from the brink. Its stock price has rebounded, recovering nearly 50 percent in the first four months of 2009. On June 17, it repaid with interest a $10 billion emergency capital infusion the U.S. government had provided at the height of the crisis. With several of its biggest competitors now having disappeared, Goldman Sachs is again a dominant player in global finance.

"Goldman was always one of the strongest of the big investment banks," says L. Wendell Licon, W. P. Carey clinical assistant professor of finance. "They were probably going to be one that would survive. They certainly were not going to be the zebra at the back of the pack.”

From investment bank to commercial bank

Goldman's experience in the financial crisis of 2008 demonstrates how calculations and strategies surrounding the cost of capital are critical to a firm's success, according to Licon. In the case of Goldman, strategic capital budgeting enabled it to survive even the most desperate circumstances.

At the height of the crisis, the firm made a dramatic shift in its business approach, changing its status from an investment bank to a commercial bank holding company. As a commercial bank, Goldman would be subject to much tighter regulation and more stringent capital requirements. The change required restructuring and replenishing of the firm's capital base. According to Licon, the sudden change in Goldman's status was stunning.

"The veil came down really quickly," he says. "Everyone closed ranks and all of a sudden Goldman was a commercial bank. There was not a lot of public discussion."

In a statement issued after the move, Goldman's chairman and chief executive Lloyd C. Blankfein said, "We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources."

According to the New York Times, Goldman's swift transformation allowed it to avoid the fates that befell Bear, Lehman, and Merrill. "Goldman did what it has always done in the face of rapidly changing events: it turned on a dime," the Times noted.

Varied sources of capital

The government requires commercial banks to have significantly higher reserves than investment banks. While this means commercial banks typically must raise more capital, they have the advantage of access to Federal Reserve lending, which investment banks usually do not.

When Goldman made its switch, it already had $20 billion in deposits in its banking subsidiaries, which made the company instantly the fourth largest commercial bank in the United States, according to the New York Times. The company promptly moved into its banking business another $150 billion in deposits from an existing loan operation.

Within days of becoming a commercial bank, Goldman was able to secure a capital infusion that was critical to the company's survival. Warren Buffett's Berkshire Hathaway, which had been courted unsuccessfully by other troubled financial institutions, agreed to invest $5 billion in Goldman Sachs, providing much needed capital and also reassuring other investors of the firm's viability. Shortly thereafter, Goldman raised another $5 billion in a public stock offering.

The following month, Goldman received an offer from the government that it couldn't refuse: $10 billion from the U.S. Government's Troubled Asset Relief Fund. "The TARP funds stabilized the situation," says Licon. "Stabilizing the company by itself probably had the effect of lowering its cost of capital."

A signature Wall Street firm

Founded in 1869 by Marcus Goldman, a German immigrant, Goldman Sachs quickly became a force on Wall Street as a financier of successful companies. In the 20th century, the firm expanded its scope of operations, becoming a leading investment bank, financial advisor, asset manager, and trader. In the 1970s, Goldman Sachs became a global firm, establishing offices in other world financial capitals.

The closely held company went public in 1999 with an IPO that raised $3.6 billion. BusinessWeek reported at the time that on the first day of trading, Goldman's stock climbed from 53 to 76 dollars per share, before closing the day at 70 3/8. Only 12 percent of the firm was offered in the public sale, which allowed control to remain in the hands of company officials rather than stockholders.

Like the other investment banks on Wall Street, Goldman Sachs thrived by making big, intelligent bets on risky ventures and reaping huge rewards. The extravagant pay scales at Goldman Sachs were legendary and earned the company the nickname of Goldmine Sachs. In 2006, the company reported an average salary for employees -- including secretaries as well as executives -- of $600,000. In 2007, Blankfein earned $68.7 million, then a record salary for a Wall Street executive.

Ties to government

Goldman's political connections, in particular the movement of company executives into top government positions, has long been a matter of controversy.

The U.S. Treasury secretary during the financial crisis, Henry Paulson, is a former Goldman chief executive officer. A former Goldman partner, Robert Rubin, headed the Treasury under President Bill Clinton. The chief of staff for President Obama's Treasury Secretary William Geithner is a former Goldman lobbyist.

Skeptics have questioned whether Goldman's political ties helped it to weather the crisis of 2008. Regulators approved Goldman's transition to a commercial bank almost overnight, and when the crisis eased, not only had Goldman survived but three of its principal competitors had essentially been eliminated.

Despite these suspicions, there is no hard evidence that Goldman received preferential treatment. Indeed, the government treatment of Morgan Stanley, the other large Wall Street investment bank to emerge intact from the crisis, was not markedly different than that accorded Goldman.

"We don't really know if the connections helped them or hurt them," Licon says. "Sometimes when you have connections, there is more scrutiny, and the government will make you jump through hoops."

Cost of capital in a crisis

When Goldman became a commercial bank, it agreed to tighter government regulation and also gained access to the Federal Reserve window. These developments should have improved the firm's financial picture, according to Licon.

"When you are regulated, there's less risk, so you should have a lower cost of capital," he says. "In theory, if the cost of capital went down and all of your projects are continuing to produce as before, that would mean that the value of at least some of your projects would have increased."

But these were not ordinary times. At the height of the credit crisis, many commercial banks also were at risk of collapse, and investors did not see them as particularly attractive. Goldman's stock was low when it shifted its status, and the transition by itself did not cause the company's stock to rebound.

"The cost of capital actually may have increased due to the macroeconomic circumstances," Licon says.

Goldman received another big capital infusion in late 2008 after the U.S. Congress passed bailout legislation and the Treasury began investing in financial institutions through the Troubled Asset Relief Program or TARP. Goldman received approximately $10 billion in TARP infusions.

The TARP money was a lifeline, but it was a costly one, according to Licon. With the investment, the government could dictate the executive compensation programs of TARP recipients and also set limits on dividends and stock repurchases. Taking government assistance also tarnished the image of the recipients. JPMorgan Chase Chief Executive Jamie Dimon called the TARP program "a scarlet letter." And for some recipients, including Goldman, the government charges for TARP money were higher than what companies found they could pay for private capital.

Early in 2009, Goldman began raising private funds to repay the aid. When Goldman did send in its check in mid-June, the company included $425 million in one-time dividends for the use of the government's money.

Of the decision to repay the money, Goldman's Chief Financial Officer David Viniar said at a conference, "It's not really restricting the way we do business but it was not meant to be permanent capital."

Bottom Line:

  • Goldman Sachs has long been a signature Wall Street firm, known for high risk investments, ties to government, and big profits and salaries. In the global financial crisis of 2008, the company came close to failure.
  • At the height of the financial crisis, Goldman Sachs quickly switched from being an investment bank to a commercial bank holding company, a move that under normal circumstances would have lowered its cost of capital.
  • To weather the credit crisis, Goldman Sachs tapped a number of different sources of capital, securing a $5 billion investment from Warren Buffett, selling $5 billion in stock, and acquiring $10 billion from the U.S. Treasury's TARP bank bailout program.
  • In the credit crisis, the government bailout money was a lifeline for Goldman, but it soon became a burden. TARP money was expensive, and it carried a stigma. It also limited dividend payments and executive compensation. Goldman repaid its TARP money in June 2009.