Paying for 'Goldman Envy'

Why did some banks and brokerage firms get so badly scorched by the subprime debacle and others come through relatively untouched? What's the difference between Citigroup and J.P. Morgan Chase? Morgan Stanley and Goldman Sachs? UBS and Deutsche Bank? Merrill Lynch and Lehman Brothers?

On the face of things, these companies may look quite similar to those they're paired with. But Citi, Morgan Stanley, UBS and Merrill have among them written off $65 billion so far because of the credit crisis. Meanwhile, J.P. Morgan Chase, Goldman, Deutsche and Lehman have racked up write-downs totaling around $9 billion. The average share-price performance of the first quartet was minus 36% last year. The latter group was down 5.3%.

There are several reasons for this. One is luck. But something else explains a lot of the difference. The losers were infected by what one could call Goldman envy. The winners were more immune to the malady.

Goldman envy started to become a serious problem after the turn of the millennium, when that Wall Street firm started to pull away from the investment-banking pack. Its profits per employee rose sharply as it deployed more of its own capital to big and sometimes complex bets — whether it was trading securities on its own account or investing in private equity.

Of course, it wasn't just Goldman that had competitors turning green. They also were agog over the burgeoning hedge funds and private-equity groups that have been raking it in over the past few years and making ordinary investment bankers seem like poor relations. And many yearned for the juicy returns of Lehman Brothers' mortgage business.

One common response among those lagging behind has been to try to emulate the alpha males of the banking world — in particular by increasing their bets in the once-booming fixed-income market.

Former Merrill boss Stan O'Neal would frequently berate his subordinates for not delivering Goldman-like results. Morgan Stanley's ex-second-in-command Zoe Cruz was constantly using Goldman as the yardstick for her firm's performance. And Citi executives described the megabank as a growth stock until just recently, putting its businesses under pressure to show commensurate earnings growth.

The snag is that mere desire doesn't turn a chimpanzee into a gorilla. Building successful operations takes time. Part of Goldman's success comes from the fact that its risk-taking approach — and the accompanying discipline of risk management — derives in part from betting its employees' money.

But desire can drive reckless growth. Take Citi and Merrill. Five years ago, neither was a big player in underwriting subprime-mortgage bonds and collateralized debt obligations, or loans often tied to risky mortgages, that were repackaged into different levels of risk. But by 2006, they were at or near the top of the league tables for both markets.

The snag is that a bank is unlikely to manage things well when it's expanding rapidly and doesn't have experience. It may put the wrong people in place, not institute the right controls and implement the wrong incentive schemes.

The banks and brokers with the biggest problems seem to have made such mistakes. UBS, for example, quickly ramped up its residential-mortgage business. But not because there was any strategic value in being in that market. Rather, it decided it wanted to bulk up in the hot securitization business, and trading and underwriting residential mortgages and CDOs was the easiest part of the market to enter.

So why were others relatively immune to Goldman envy? Well, Lehman had a big, lucrative mortgage-lending and structuring business, so it didn't need to engage in a breakneck game of catch-up. Deutsche arguably also had a more ingrained risk-taking culture. Meanwhile, J.P. Morgan had more market-savvy leadership in James Dimon than, say, Citi had in Charles Prince.

All this suggests two lessons. If you are a chimp, don't try to kid yourself that you're a gorilla. And, if you see a chimp pumping itself frantically with steroids, sell its stock.