By Simon Johnson
Goldman Sachs is investing $450 million of its own money in Facebook, at a valuation that implies the social networking company is now worth $50 billion. Goldman is also apparently launching a fund that will bring its own high net worth clients in as investors for Facebook.
On the face of it, this might just seem like the financial sector doing what it is supposed to – channeling funds into productive enterprise. The SEC is apparently looking at the way private investors will be involved, but there are some more deeply unsettling factors at work here.
Remember that Goldman Sachs is now a bank holding company – a status it received in September 2008, at the height of the financial crisis, in order to avoid collapse (for the details, see Andrew Ross Sorkin’s blow-by-blow account in Too Big To Fail.) This means that it has essentially unfettered access to the Federal Reserve’s discount window, i.e., it can borrow against all kinds of assets in its portfolio, effective ensuring it has government-provided liquidity at any time.
Any financial institution with such access to such government support is likely to take on excessive risk – this is the heart of what is commonly referred to as the problem of “moral hazard.” If you are fully insured against adverse events, you will be less careful.
Goldman Sachs is undoubtedly too big to fail – in the sense that if it were on the brink of failure now or in the near future, it would receive extraordinary government support and its creditors (at the very least) would be fully protected. In all likelihood, under the current administration and its foreseeable successors, shareholders, executives, and traders would also receive generous help at the moment of duress. No one wants to experience another “Lehman moment.”
This means that cost of funding to Goldman Sachs is cheaper than it would be otherwise – because creditors feel that they have substantial “downside protection” from the government. How much cheaper is a matter of some controversy, but estimates made by my co-author James Kwak (in a paper presented at a Fordham Law School conference last February) put this at around 50 basis points (0.5 percentage points), for banks with over $100 billion in total assets.
In private, I have suggested to leading people in the Obama administration and in Congress that the “too big to fail” subsidy be studied and measured more officially and in a transparent manner that is open to public scrutiny, for example as a key parameter to be monitored by the newly established Financial Stability Oversight Council. Unfortunately, so far they have declined to take up this approach.
However, there is consensus that the implicit government backing afforded to Fannie Mae and Freddie Mac in recent decades allowed them to borrow at least 25 basis points (0.25 percent) below what they would otherwise have had to pay; this is a significant difference in modern financial markets. In 13 Bankers we refuted the view that these Government Sponsored Enterprises were the primary drivers of subprime lending and the 2007-08 financial crisis – that debacle was much more about extreme deregulation and private sector financial institutions seeking to take on crazy risks. But it is still the case that Fannie and Freddie were badly mismanaged – and followed the market in 2005-07 with bad bets based on excessive leverage – in large part because they had an implicit government subsidy. Those institutions should be euthanized as soon as possible.
Goldman Sachs now enjoys exactly the same kind of unfair, nontransparent, and dangerous subsidy; it has effectively become a new form of Government Sponsored Enterprise. Goldman is not a venture capital fund or primarily an equity-financed investment fund. It is a highly leveraged bank, meaning that it borrows through the capital markets most of the money that it puts to work.
As Anat Admati (of Stanford University) and her colleagues tirelessly point out, the central vulnerability in our modern financial system is excessive reliance on borrowed money, particularly by the biggest players.
Goldman Sachs is a perfect example. Most of this firm’s operations could be funded with equity – after all, it is not in the retail deposit business. But issuing debt is attractive to shareholders because of the subsidies associated with debt funding for banks, and compelling to bank executives whose compensation is based on return on equity – as measured, this increases with leverage. If they have more debt relative to equity, that increases the potential upside for investors. It also increases the probability that the firm could fail – unless you believe, as the market does, that Goldman is too big to fail.
Social networking firms should be able to attract risk capital and compete intensely. They do not need subsidies in the form of cheaper funding (seen today as a more favorable valuation for Facebook) or in any other form.
Social networking is a bubble in the sense that email was a bubble. The technology will without doubt change forever how we communicate with each other, and this may have profound effects on the nature of our society. But investors will get carried away, valuations will become too high, and some people will lose a lot of money.
If those losses are entirely equity-financed, there may be negative effects but they will likely be small – in the revised data after the 2001 dotcom crash, there isn’t even a recession (i.e., there were not two consecutive negative quarters for GDP).
But if the losses follow the broader Goldman Sachs structure and are largely debt-financed, then the US taxpayer will have helped create another major financial crisis.
And if you think that sophisticated investors at the heart of our financial system can’t get carried away and lose money on Internet-related investments, read up on Webvan:
“During the dot-com bubble, Goldman invested about $100 million in Webvan, the online grocer that never got off the ground and eventually collapsed in bankruptcy.”
An edited version of this post appears today on the NYT’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.