The Source of Goldman's Profits

I'm a little surprised that the source of Goldman's record profits in Q2 is being treated as a Great Mystery. Both John Hempton and Rick Bookstaber, for example, wonder aloud where Goldman's profits are coming from. Of course, Goldman doesn't explain their trading strategies to us, as some people apparently think they should. But even so, I think it's pretty clear where Goldman's profits came from. Here's my take on it.

Conditions in Q2 couldn't have been better for a market-making dealer bank with a strong balance sheet, and Goldman is, without a doubt, the quitessential market-maker. For that reason, the following factors likely played a big role in Goldman's blowout quarter:

1. Volatility. While down relative to last fall, volatility was still pretty high. Carrying inventories of securities for trading purposes—which is what market-makers do—is riskier when volatility is higher, so dealers demand wider bid-ask spreads to compensate for that risk. (The bid-ask spread represents the dealer's profit on each trade.) That means Goldman's trading business would have been more profitable even if its trade flow had remained at normal levels.

2. Reduced competition. With Lehman and Bear Stearns out of the picture, and many other dealers struggling, Goldman and a few other major dealers—e.g., JP Morgan, Credit Suisse—have been increasing their market share. With fewer market-makers out there to choose from, the remaining dealers have been handling increased trade flows—which, as I said, is now more profitable per trade, due to the high volatility.

3. Mass portfolio rebalancing. Goldman's increased trade flow didn't just come from Lehman and Bear cast-offs. Banks and investors all over the world undertook a dramatic rebalancing of their portfolios last quarter. Pretty much every investment firm in the world went into an uber-defensive position last fall, which meant lots of Treasuries and lots of cash. Firms didn't come out of their financial bomb shelters en masse until there was sufficient certainty about the path of the world economy, which didn't really come until last quarter. As governments worked out the details of their financial rescue packages firms started to rebalance their portfolios and reallocate capital (I hate the phrase "reallocate capital," but I can't think of any other way to say it right now). This mass portfolio rebalancing really took off after the U.S. government completed the so-called stress tests and many banks quickly raised capital; there was a palpable change in investor sentiment after the stress tests were completed. The point is that nearly every investment firm in the world was exiting old trades and entering into new ones, which increased the trade flows for the major dealer banks like Goldman even more.

4. Steep yield curve. The yield curve was also relatively steep throughout the second quarter—the 10yr/2yr was over 200bps for nearly the entire quarter. A steep yield curve helps dealers' rates trading desks, as they tend to be long duration. The conventional wisdom is that rates trading desks had a huge quarter, and the fact that most of Goldman's revenues came from FICC is consistent with that story. Plus, bond issuance volumes were still off-the-charts in Q2, so in addition to earning a share of those fees, all of those embedded interest rate swaps would have boosted Goldman's rates trading desk as well.

I'm sure there were other factors too—like the negative basis trade starting to snap back and benefit the firms that were able to stay in them—but the factors I highlighted seem to offer the best explanation. To me, at least. I could be wrong. It certainly wouldn't be the first time.

(I didn't include high frequency trading (HFT) because, like John Hempton, I just can't imagine that HFT is anywhere near that profitable for Goldman. In fact, they put out a statement saying that HFT, broadly defined, accounts for less than 1% of total revenues. That sounds about right. I think the whole HFT thing has been blown way out of proportion. And by the media, no less! What's next, Republicans advocating for tax cuts?)