Goldman Sachs and the Volcker Proposal

Peter Lattman and Kate Kelly report on pg. C1 of the Journal today: "The [Volcker] proposal, debated on Capitol Hill last week, is short on detail. But, should it become law, it could have by far the biggest impact on Goldman [Sachs] ... The firm's private-equity exposure exceeds that of the world's largest buyout firms. Goldman has roughly $14 billion of corporate and real-estate private-equity holdings on its balance sheet ... Under Mr. Obama's proposal, banks would likely be free to manage customer money earmarked for private-equity funds. But Goldman would have to divest its own holdings, a complicated task. One alternative would be to spin out its private-equity arm, according to people familiar with the firm. Goldman could also give up its bank-holding-company license to avoid spinning out the private-equity business."

Goldman is especially vulnerable to the Volcker proposal because of its willingness to be liberal with its balance sheet. In the past, this willingness (coupled with vigilant risk management) has served the bank well. But if the proposal turns out as Obama indicated, its hard to see how Goldman could still make the kind of money it earned this year. The most profitable segment of the firm by far is Trading and Principal Investments, where trading generates on average 68% of GS' revenue and profit. Sure, most of these profits come from making markets but where do you draw the line? If the Volcker rule is enacted as put forth by Obama, it would have the same effect on GS as Glass-Steagal had on JP Morgan in 1934. You could literally carve out a large hedge fund, private equity shop, and merchant bank to spin-off at great prices.

But its unclear how some of these operations would fair outside the Goldman umbrella. GS provides valuable synergies to these firms in such areas as back office operations, execution, and human capital. Perhaps most important is the low cost of capital. Trading is much easier when you can borrow directly from the Fed.

It's unlikely that we will ever see the "Squid's" tentacles untangled after the recent comments by Sen. Dodd. But it is ironic that one of the firms that practiced the best risk management during the crisis is now most vulnerable to the government's efforts to curb risk taking.