Case Study: Goldman Sachs Heads for Harbor*
By: Prof. Shlomo Maital

In July 2007, and in the following months, Wall Street was in shock. As mortgage-backed securities prices collapsed, in the wake of the collapse of the subprime mortgages that were their foundation, Wall Street firms piled-up mounting losses, losses that grew daily. One company largely avoided this: the venerable investment bank Goldman Sachs.

How? What was their risk management secret? The telescope (zoom-out big-picture thinking about global risk) and the microscope (zoom-in daily DNA analysis of P&L's and risks). It was their version of the telemicroscope.

In December 2006, Goldman Sachs' risk indicators, including VAR (Value at Risk) and other models began suggesting that something was wrong. "Not hugely wrong," as Nocera writes, but "wrong enough to warrant a closer look."

Value at Risk models are mathematical tools for risk management aimed at projecting and evaluating worst-case scenarios for the performance of investment and other financial activities and initiating appropriate and effective loss-limiting strategies. The essence of VAR models is the analysis of the left ‘tail’ of the normal curve, where large losses accrue, and analysis of the quantitative exposure of the investor to such potential losses. The most dramatic failure of VAR was in the near bankruptcy of Long Term Capital Management, a highly leveraged hedge fund founded by Nobel Prize winners in economics and seasoned Wall Street experts. 

"Our mortgage business lost money for 10 days in a row," notes Chief Financial Officer David Viniar. "It wasn't a lot of money, but by the tenth day we thought that we should sit down and talk about it." 

Goldman Sachs' custom was to examine their P&L's (profit and loss statements) daily. Some 15 people took part in the meeting on mortgages, including risk managers and senior traders. A thick report was examined that included every trading position Goldman Sachs had (The "microscope"). They also talked about "how the mortgage-backed securities market 'felt' (The "telescope").”

"Our guys said that it felt like it was going to get worse before it got better," Viniar recalls. A decision was made: Get closer to home. In trading jargon, that means reducing the risk exposure. This is done either by selling mortgage-backed securities or hedging them, so that if their value declines, the hedges generate financial gains that offset and negate the losses. Goldman Sachs both reduced their mortgage-backed securities positions and hedged the remaining ones. They avoided the huge losses that later led to the collapse of the 5th largest investment bank, Bear, Stearns (taken over by J.P. Morgan), and the bankruptcy of Lehman Brothers. 

Goldman, Sachs has not escaped losses. With nearly all asset prices plummeting, there is no possible way it could. Its share price has plunged from a high of $260 down to $78 in January 2009. And it has been forced, like other investment banks (including Morgan Stanley), to transform itself into a bank holding company. 

But Goldman Sachs is alive and well and its P&L will recover. It remains almost alone among its old Wall Street peer companies as a solvent, independent going concern. And it has the distinction of gaining a $5 billion dollar cash infusion from legendary investor Warren Buffett and his Berkshire Hathaway company. Other companies whose microscopes and telescopes were flawed and did not communicate are gone, including the 165-year-old Lehman Brothers.  

What drove the decision to "get closer to home"? Was it the microscope (VAR)? Or the telescope (a group of wise experienced leaders who set aside their quantitative models and made their decisions based on 'subjective beliefs about an uncertain future')?

It was, of course, both.  

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* This case study is based on Joe Nocera, "Risk Mismanagement", New York Times Magazine, Jan. 4, 2009 (referenced at www.nyt.com) and on Charles D. Ellis, The Partnership: The Making of Goldman Sachs (Penguin, 20xx, 729 pp). It will appear in S. Maital & D.V.R. Seshadri, Global Risk/Global Opportunity (SAGE, Sept. 2009).