Masters of the Universe II: The return

Goldman Sachs' New York HQ. The returns for survivors such as Goldman look bigger than ever after the collapse of competitors like Lehman and Bear Stearns. Photo / Bloomberg

Nine months ago, investment banks were left for dead, devastated by a global financial crisis so deep that only intervention by government prevented a complete meltdown. A business model that depended on aggressive lending and risk-taking was seen as one of the reasons that precipitated a slump that has put millions out of work.

Following the collapse of Lehman Brothers, the former "masters of the universe" of Wall St and the City of London were on the defensive: lambasted in the media, vilified by politicians, their top executives carpeted for paying themselves sky-high bonuses, their boards criticised for ineptitude and greed.

Now, it seems that they are making a comeback. Barclays Capital has gone on a hiring spree, Credit Suisse is making a tidy sum and JP Morgan reported a strong performance last week. Goldman Sachs is on course to pay its staff a record US$20 billion ($30.5 billion) in pay and bonuses after reporting a surge in second-quarter profits.

Outsiders are bemused at how some investment banks are making so much money in the teeth of almost unprecedented global economic turmoil. But David Williams at broker FPK says: "If you have adequate capital, good risk controls and you haven't been knocked senseless by the credit crunch, then you are in an excellent position to go and chase business."

Not all are doing well, of course, with institutions such as UBS and Citigroup still struggling to stay afloat. But the winners, such as Goldman, are defying expectations. And while people are reluctant to speak of green shoots, fearful of granting a hostage to fortune, Doug McWilliams at the Centre for Economic and Business Research, one of Britain's leading commercial economic think tanks, says that "signs of life in the financial sector could be interpreted as a forward indicator of recovery in the real economy".

For evidence of what is going on, you need to scratch beneath the surface of the figures produced by Goldman last week to discover more precisely what areas of investment banking business are doing well, and why.

The debt issuance market, for instance, is exploding, with volumes well up on a year ago. Rather than battling to secure bank loans from institutions that have been poleaxed by the credit crunch, large companies are plumping for the easier option of issuing bonds to fuel expansion.

Bonds are sold to City of London investors in much the same way as shares, in return for an annual "coupon", or dividend payment. With coupon rates as high as 5 per cent, investors are in line for higher returns than if they simply keep the money on deposit, while at the same time they can avoid the risks associated with volatile global equity markets.

In the middle of these bond trades are the investment banks, which charge commissions at the point of sale as well as arrangement fees. As Goldman's latest figures suggest, this business has been going great guns since the turn of the year.

Governments, too, are using the banks to trawl for investors prepared to inject funds into fixed-income and floating-rate government bonds. These products are effectively IOUs that are underwritten by the state and which bankroll the yawning deficits run up throughout the developed world.

"The bigger the deficits, the bigger the sovereign debt market," says McWilliams. "For investment banks with strong balance sheets, the opportunities are out there."

But there is business elsewhere, too. With the return of confidence, investors of every kind - wealthy individuals, speculators, insurance and pension funds - are looking at how to hedge against risk. That means buying derivative products that insure investors against volatility on foreign exchange markets, or future rises in the price of iron ore, nickel, tin and wheat.

Call it insurance against an upturn, if you must - but once again, investment banks are sought-after intermediaries.

John Winter, head of investment banking at Barclays Capital, says: "There is no shortage of demand for investment banking products and services. Our clients need finance, and advice. But they are looking for players with copper-bottomed reputations."

Investment banks also trade on their own account. A number of banks are said to be piling into oil in the belief that prices will be up by the end of the year. A source in the City - as London's financial district is known - says: "People don't know it, but many banks are risking their own money by investing in oil - renting tankers and space at ports - in the belief that the price will be up by around 25 per cent in three to six months' time."

But the success of banks is bound to cause controversy. David Viniar, Goldman's chief financial officer, attempted to play down the bank's record remuneration prospects. "It's a pay-for-performance culture," he said. Nevertheless, the payouts are political dynamite: in Britain, the authorities are trying to reform the financial system in the wake of the crash and meet public criticism that big bonuses fuelled irresponsible risk-taking.

Vince Cable, the Opposition Liberal Democrat Party Treasury spokesman, hit out at the impending Goldman bonuses, saying: "Executives there clearly have short memories. In the space of 10 months, they've gone from taking a begging bowl to the US government to paying out massive bonuses. If we are to have stability in the finance sector, we must see pay restraint in all banks, irrespective of which country they are based in."

McWilliams adds to the debate when he says it is a bit disconcerting that Goldman is "promoting products to clients that they are also trading themselves, giving rise to a possible conflict of interest".

Goldman denies it has done anything untoward, but its success rankles with competitors. True, it has repaid the US$10 billion lifeline that it was thrown when the US government bailed out all the American banks in the wake of Lehman's collapse. But critics remember how the bank was the recipient of help a second time (and saved billions) when the White House bailed out AIG, the stricken insurer, last October.

The authorities were concerned that if AIG was allowed to fail, it would drag the rest of Wall St down with it, so steep were the counterparty risks. Banks were exposed to billions linked to AIG's collateralised debt obligations, with Goldman and Deutsche Bank viewed as among the most vulnerable.

"Goldman is thriving, but it suffered a near-death experience and might have sunk if not for the intervention of government," says one corporate governance activist.

Now all banks face a backlash from regulators. This month, a preliminary review published by banker and former regulator Sir David Walker in London said that bank bonuses should be more carefully controlled, and that non-executive directors should be better trained.

Walker's proposals are designed to prevent banks from endangering economic stability by providing more accountability and strengthened checks and balances.

Among the measures is a suggestion that City high-flyers be forced to reveal their pay and bonuses in the annual report and accounts. But - unlike similar ideas aired in the US - the big earners would not be named: instead, only the numbers of employees within given salary bands would be disclosed annually. Walker argues that exposing pay structures for highly paid staff would discourage the excesses that fuelled the global credit crunch.

Not that Goldman is usually linked with systemic failure. Its comparative success during good times and bad is legendary and the dedication of employees is well known. Lloyd Blankfein, the chief executive, describes the culture as a blend of confidence and "an inbred insecurity that drives people to keep working and producing long after they need to. We cringe at the prospect of not being liked by a client."

Even before the crisis, when Goldman was earning huge profits, Blankfein seemed more anxious than arrogant. Yet loyalty sometimes spills over into inexcusable behaviour, as when a female job candidate was asked if she would have an abortion rather than lose the chance to work on a big deal.

Over the years, Goldman has never flinched from taking a long, hard look at itself. It was this kind of navel gazing that led to its own flotation in 1999, after years of often rancorous debate among the partners. The move gave the institution permanent capital with which to expand, but exposed it to the vagaries of stockmarkets - and, some said, loosened the ties that had previously bound its leaders closely together.

After its public offering Goldman moved into "principal" investing, risking its own capital in markets, and its competitors followed its lead.

Here the profit margins are bigger than in client-driven business, but so are the risks. In magnifying its bets with large amounts of borrowed money and peddling sub-prime securities, Goldman certainly played a role in bringing America to the brink of catastrophe.

Even so, McWilliams says Goldman has demonstrated that it is in the camp of better-capitalised banks that are emerging leaner and fitter from the debris of the crisis. The rewards for survivors look bigger than ever after the disappearance of key competitors such as Lehman and Bear Stearns and the retreat of rivals such as UBS, RBS and Merrill Lynch - the latter being swallowed by Bank of America.

But snapping at Goldman's heels is the new kid on the block: Barclays Capital, part of Barclays Bank, which acquired Lehman's US business for a song at the height of the crisis. It has been recruiting aggressively as it tools up to take on the competition and plug gaps left by rivals that have gone to the wall.

The Britain-based bank is starting from scratch after buying the Lehman Brothers unit last autumn and has hired more than 210 bankers, analysts and salespeople in London, continental Europe and Japan, as well as 250 back-office people to support them.

"This is a phenomenal opportunity that we are seizing right now. We have built our businesses organically before with great success," says a spokesman, citing BarCap's decision to enter the commodities markets in 2000.

But even Goldman is not immune to future shocks. Professor Richard Portes at the London Business School says: "I don't think there has been a resurgence at Goldman; its results reflect greater risk-taking in highly volatile markets. One wonders if things can stay this good."

His words are tantamount to a health warning for the whole sector. And rightly so: history shows that though banks can increase profits year after year, they are capable of losing everything in a few short months. In the process, they turn the world on its head - as the recent crisis has brutally demonstrated. We forget at our peril.

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