Wall Street’s Accident Waiting to Happen

Wall Street’s masters of the universe may not control the world, but they do seem to control economic policy in the United States. The end result could be a bonfire of the vanities involving the dollar, stocks, bonds and real estate – and the disappearance of many of those masters.

Last year master-in-chief Henry Paulson was elevated to the position of Treasury Secretary, following in the footsteps of another Goldman man, Robert Rubin, who held the job for much of President Bill Clinton’s time in office. Wall Street naturally cheered that one of their own was getting the job rather than the traditional Republican industrial corporate types like his predecessors Paul O’Neill and John Snow. They knew about mainstream business, but were looked down upon by the whiz-kids of financial manipulation, those with the mega-million pay packages who followed the advice of that early 1970s swindler and fund-of-funds creator Bernie Cornfeld. Answering his own question, “Do you sincerely want to be rich?” Cornfeld advised, “Don’t fool around with steel or light globes. Work directly with money!”

So it should come as no surprise that Paulson’s preoccupation as Treasury Secretary has been to shore up the shaky edifice of debt and opaque financial instruments that he played a major role in creating as head of Goldman Sachs, which grew its balance sheet 33 percent in 2005 and around 20 percent since then, has leverage of 16 times and a debt to equity ratio of over 3 to 1 – all the ingredients of rapid growth in good times and potential disaster in bad ones.

Paulson is in the thick of talks with major US banks – and the Federal Reserve – to buy out or provide funding for low-grade paper that had been stuffed into Special Investment Vehicles, black holes whose creation made billions for the likes Goldman and millions for Paulson himself. (He had stock worth US$1 billion and his last income from Goldman was $27 million)

The idea is to fool the markets by re-packaging the same previously re-packaged junk into bundles that look more attractive. So far he has pulled Citibank and some others into the scheme, but the canny Goldman has so far held back. Even if it reaches its $80 billion target it will only encompass a quarter of the estimated $320 billion of SIV paper. But all help is needed to keep this stuff off the market.

If this intervention is necessary to save the US financial system, so be it. But that Paulson, whose firm played such a role in creating the mess, is now being presented as a savior is dubious. It will certainly not go unnoticed by the foreign holders of US$2 trillion of US Treasury and agency debt, who must seriously wonder whether they will ever get their money back except in massively devalued greenbacks.

While all this was going on, Goldman itself was engaged in yet another of Wall Street’s favorite devices – keeping profits looking healthy through accounting procedures barely any more transparent than those of the late Enron, which hid reality until its massive collapse.

Last week, Goldman surprised the markets by reporting very good third quarter earnings just as the time when its peers were reporting downturns due to market turmoil, in particular losses on their bond portfolios. It reported trading earnings for the quarter of $8.2 billion, up 70 percent on a year earlier. Goldman’s share price naturally jumped on the news.

But how true was the overall earnings figure? Perhaps Goldman had been cannier than other investment banks and hedged the value of bonds and loans it was holding. But it also seems to have made use of accounting provisions which enable non-liquid securities to be marked not to a market – because they cannot readily be marketed – but according to in-house estimates.

Such assets and liabilities are reported under a so-called Level 3. In Goldman’s case Level 3 yielded net gains of $2.9 billion of which $2.6 billion were unrealized paper profits. (And someone else’s paper losses!) Remarked one analyst quoted by Fortune: “The opaqueness of Goldman’s balance sheet makes us immediately question how they made money in the quarter… Common sense tells me that a lot of their losses were real and a lot of their gains were paper”.

The underlying fact is that Goldman is massively leveraged and like its peers sits on a heap of hard-to-value assets and complex derivative products. Wall Street’s overall balance sheet expansion has been a classic symptom of a financial market bubble and a harbinger of the sort of disasters that destroyed once equally high-flying institutions like Drexel Burnham Lambert. They flew so high the wax that held their wings together melted.