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The Daily Reckoning | Thursday, April 22, 2010 Goldman Sachs: Successful, criminal, or both... The unseen costs of the Fed's "easy money" myopia, Plus, Bill Bonner returns from the wilderness with tales from the frontier... Squeezing Through the Discount Window The Truth Behind Financial Firm Profits Eric Fry Reporting from Laguna Beach, California... Yesterday, on G+3, Goldman Sachs remained the top financial news story. The initial shock may have subsided, but the ensuing awe is just beginning to unfold... When you Google "Goldman Sachs Fraud," you get 10,200,000 responses, which is only 5,000,000 responses fewer than you get when Google just plain old "Goldman Sachs." In other words, "Goldman" has become nearly synonymous with "fraud." This alarming development may be good news for class-action attorneys, but it is probably bad news for the stock market...at least in the short term. Goldman is not merely the stock symbol "GS," it is much, much more. Goldman is both a shrine to modern American capitalism and a landfill for popular discontent and vitriol. As such, Warren Buffet worships at the Goldman altar, even while securities regulators, litigators, journalists and sundry "Average Joes" line up to unload their contempt on the reviled financial firm. Goldman's (few remaining) apologists insist the firm is merely successful. Everyone else assumes the firm is merely criminal. Most likely, the truth lies somewhere in the middle - Goldman is successfully criminal. But whatever the exact secret sauce - or witches brew - that nourishes Goldman's success, the stuff seems to be toxic for Goldman's clients...and they are becoming a bit sick of it. Some clients are hiring lawyers; others are merely keeping a safe distance away from Goldman's trading desk. Both of these responses are likely to impede earnings growth. But client discontent is not the only assault on Goldman's earnings growth. Goldman, along with all the other major financial firms, faces the grim prospect that the cost of borrowing money from the government may rise...perhaps by a lot. When it converted into a bank holding company back in 2008, Goldman became eligible to borrow cheap money from the Fed's discount window. Morgan Stanley did the same thing. As a result, Goldman, Morgan Stanley et al. may borrow billions of dollars from the Federal Reserve and use the proceeds to purchase higher-yielding government securities of longer duration. In other words, Goldman may borrow from the government at 0.75%, then loan the money back to the government at 3% or 4%. All in a day's "trading." Not surprisingly, all the major financial firms have been reporting blockbuster profits. Yesterday, for example, Morgan Stanley wowed the Street by nearly doubling its expected earnings result. Bond trading provided most of the juice, as Morgan's fixed-income revenue more than doubled from the prior year's first quarter. Prior to Morgan Stanley's results, Bank of America, JP Morgan Chase and, yes, Goldman Sachs, had all reported record quarterly revenue from fixed-income trading. On the surface, these monster profits would seem like good news. But this silver cloud contains a very dark lining: without the Fed's low-cost financing, fixed-income profits will be much harder to come by. A related dark lining is this: without the financial sector's resurgent profitability, corporate earnings aren't very impressive. "Total US corporate profits rose 30.6% year-over-year in the fourth quarter, a huge swing from the -25.1% trend a year ago," observes The Daily Reckoning's favorite economist, David Rosenberg. "But almost the entire story is in the financial sector, where profits have soared 240%, which is unprecedented... Financial sector profits have accounted for 85% of the overall increase in corporate earnings. Total non- financial earnings are up a grand total of 5.2% year-over-year... "The financial share of total profits bottomed at 10.8% in the fourth quarter of 2008," Rosenberg continues, "and has since soared to 28.2% of total profits, one of the highest percentages ever. This trend does not look sustainable to me." Net-net, the finance sector is probably a better "sell" than a "buy"...and Goldman may be the best "sell" of all. But what do we know? Warren Buffet owns the stock and, last we checked, he had a lot more money than we did.... And now for today's column... The Daily Reckoning Presents A Free Market in Chains Dan Amoss If left to its own devices, a truly free market would have already corrected many of the imbalances of the late, great credit bubble. Instead, US policymakers at the Federal Reserve and the Treasury Department have been trying to re-inflate the credit bubble by pumping trillions of dollars of fresh credit and currency into the financial system. The Fed is still maintaining these Keynesian tactics, despite the increasing possibility that inflation and other adverse outcomes will result. Kansas City Fed President Thomas Hoenig is one of the few policymakers who appear to grasp the following simple economic truism: There is no free lunch. In his April 7 speech "What About Zero?" Hoenig says, "Low rates, over time, systematically contribute to the buildup of financial imbalances by leading banks and investors to search for yield." In other words, Hoenig doesn't want to be complicit in the ZIRP (zero interest rate policy) experiment the Fed is currently conducting. "The search for yield involves investing in less-liquid assets and using short-term sources of funds to invest in long-term assets, which are necessarily riskier," Hoenig continues. "Together, these forces lead banks and investors to take on additional risk, increase leverage, and, in time, bring in growing imbalances, perhaps a bubble and a financial collapse." Hoenig has the courage to speak up about long-term consequences. This is a refreshing contrast to what passes for judgment among other Fed governors, whose votes reflect short-term thinking and ignorance of the long-term consequence of ZIRP. The rest of the Fed's academics point to the alleged benefits of zero interest rates and deficit spending, while remaining either blissfully unaware of - or intellectually dishonest about - the unseen costs of these policies. A good example of this myopia was on display when Alan Greenspan testified in front of Congress last week. Even after the 2008 crisis, Greenspan still refuses to acknowledge the destructive economic distortions that his Fed policies nurtured. The unseen costs of "easy money" policies are hard to identify or measure, but that doesn't mean they don't exist. By definition, the Federal Reserve is giving a subsidy to someone anytime it provides credit that costs less than the private-market cost of capital. And, by definition, a subsidy is an expense that someone else must bear. In today's post-crisis economic environment, the Fed's ZIRP policy provides a very direct and obvious subsidy to the nation's largest financial firms. These firms borrow from the government at low rates of interest, then loan the money back to the government at much higher rates of interest. In the first instance, only a handful of privileged financial firms may borrow money from the government at low, preferential interest rates. But in the second instance, we, the taxpayers, must bear the cost of the high rates of interest the government pays back to the financial firms. Meanwhile, in order to fund our growing national deficits - which are caused partly by the subsidies our government provides - political leaders in the US are making up for the lack of domestic savings by importing the excess savings of the rest of the world. Foreign creditors are financing our deficit-spending by buying Treasuries. But global savings don't come free; they come in exchange for claims on the future productive capacity of the US economy. The US is selling claims on its assets in exchange for propping up an unsustainable status quo. Academic economists come up with overly simplistic reasons why this process can continue indefinitely, including the old standby, "Japan has done it for 20 years, and its bond market yields are still low." Not all countries have the productive captivity and competitiveness that Japan has. Greece does not, and its government debt hasn't turned out to be sustainable. China has its problems and bubbles, but at least its government's make- work projects are adding to the productive capacity of its economy (physical and intellectual capital that will exist, even after the world abandons its unworkable currency and government debt systems). In China, politicians try to do everything they can to promote economic growth that adds to its productive base. In the US, politicians are doing everything they can to redistribute wealth, no matter the economic consequences. And all the while, the line of phony capitalists seeking subsidies in Washington, DC is growing longer. The more corporate subsidies the US government hands out - whether it be to banks, health insurance companies, or auto makers - the faster the government undermines its own creditworthiness. Treasury yields could rise sooner than most investors expect. Not because of inflationary pressures, or because of the Fed hiking rates, but because of the simple mechanics of overwhelming Treasury supply and falling creditworthiness. Bond investors know that a surging supply of Treasury securities is on the way. So these investors might become much less eager to pay high prices (low yields) at future bond auctions. In short, the federal government's eyes have become much bigger than the taxpayers' stomach. The illusion that the US government has unlimited resources will come to a painful and decisive end in the form of higher Treasury yields...and much lower profitability in the US financial sector. Dan Amoss for The Daily Reckoning