At first glance, the top line number for Goldman Sachs’ third quarter performance looks spectacular: Net Revenue of $12.37 billion, and $3.19 billion of Net Income. These numbers were multiples larger than the results for the third quarter last year, at the peak of the credit crisis, when Goldman converted itself into a commercial bank. It’s when you look into the details you realize that Goldman didn’t make its numbers this quarter as a commercial bank, nor even as an investment bank (which is what it used to be), but as a hedge fund.

The spectacular part of the performance came from Trading ($5.99 billion in net revenue – mostly from trading credit products and mortgages); Equities ($2.78 billion in net revenue, mostly from equity derivatives), and Principal Investments net revenue of $1.28 billion. The image one gets from the word “trading” is that Goldman Sachs has hundreds of very bright and aggressive young men sitting in front of screens and making brilliant decisions on what to buy and sell, and when. Traders are supposed to live by their wits, making judicious bets on the market. Good traders who don’t have inside information tend to win about 55% of the time and lose money 45% of the time, the difference being their profit resulting from their trading acumen.

Goldman Sachs doesn’t work this way. They have bright people no doubt, and somewhere on the trading floor these people on occasion make good and bad judgment calls. From what it looks like, however, their traders are benefiting from two things: information not available to the market, and muscle. These two things give the firm an edge that almost guarantees substantial “trading profits” quarter after quarter.

The information part comes from a variety of sources. We’ve seen this year the scandal over High Frequency Trading, where Goldman and other firms have computers positioned at the New York Stock Exchange getting information on trades a millisecond before they are posted publicly. Goldman sees where the market is going second by second, positions itself for very short term profits, and in effect extracts a tax on trading by individual investors and mutual funds. Goldman Sachs is the biggest player in this business, and no wonder they are lobbying in Congress to prevent the government from shutting this down, and/or imposing its own transactional tax on trading.

For credit products, mortgage securities, and equity derivatives, Goldman Sachs extracts similar information from its clients interested in buying or selling these products. Goldman can tell when a particularly large deal is going to move market prices, and the firm can piggy back along with the client by doing its own trading. In these businesses, dealers also hold a trading position for liquidity purposes, and given Goldman’s enormous size in the market, they can use this position to muscle prices in the direction they want. This bullying tactic works short term, usually intraday or over one or two days, but that is sufficient to generate hundreds of millions in trading revenue.

None of these information sources or uses are illegal at this point, unless Goldman were positioning itself before the client’s order was placed in the market. Also, Goldman is smart enough not to allow its traders to know if Goldman is bringing an equity or bond issue to market, because this would breach “Chinese Wall” restrictions.

How do we know all this revenue is based on information and muscle? Because Goldman Sachs does not show any of the performance measures typical of a trading firm. Its Value at Risk measure, which calculates how much it could lose on a given day under very adverse market circumstances, went down from $245 million to $208 million. VAR should be sharply higher reflecting the increased risk necessary to generate so much more trading revenue. Similarly, Goldman had a record number of “$100 million revenue days” and very few days in the quarter when they lost money trading. This is hardly the profile of your typical day trader pitting his wits against the fickleness of the market; this is the profile of a hedge fund with critical information and size advantages, using them to maximize profit.

Notice that the firm made $1.26 billion from Principal Investments. The firm holds a pool of $21.08 billion in its own investments that are not related to client activity, and that can be held for short or long periods of time. This is speculation pure and simple – the sort of thing a hedge fund would do with its investors’ assets.

Now let’s look at how well Goldman Sachs performed in its traditional investment banking business. All these results are for the quarter, compared to the dreadful third quarter of last year.

· Investment banking: $899 million in revenue, down 31%
· Financial advisory: $325 million in revenue, down 14%, mostly due to a decline in merger activity
· Underwriting: $574 million in revenue, down 15%
· Asset management: $1.45 billion in revenue, down 29%
· Securities services: $472 million in revenue, down 48%

As an investment bank, Goldman Sachs is doing very poorly, or the economy and market for investment banking services is doing very poorly. After all, Goldman and Morgan Stanley are the only two traditional investment banks in business; all the rest collapsed last year or were merged into commercial banks.

Don’t bother looking for Goldman’s results from commercial banking. They don’t exist. Goldman has resolutely stated that it has no intention of changing its “banking model”, which means no intention of getting into the traditional banking business of making loans to companies and individuals. This despite the fact that it probably owes its very survival to an agreement from the government in September last year to allow it to convert into a commercial bank.

This begs the critical question: Why is the government allowing Goldman Sachs to function this way? It now has access to the Fed discount window and lender of last resort facilities, it gets funding from the Fed at close to zero percent, it is no longer subject to market runs on its stock because the FDIC backs up its deposits, and supposedly it is now visited routinely by Fed examiners who can see exactly what is going on. Yet there is not a peep of objection from the Fed, the Treasury, the White House, or even Congress about a soi-disant investment bank now converted into a commercial bank, which openly disdains any suggestion it should act like a commercial bank, which is struggling in its traditional investment banking businesses, and which is still allowed to make money hand over fist through outright speculation and what we might call “trading with advantages.”

It is also allowed to keep its own peculiar VAR model, very different from the ones used by commercial banks, and which is probably understating in comparison the true risks it is taking. It is allowed to peg its compensation pool not to net income, like a commercial bank does, but to the much larger number of net revenue. This explains in part why of its $7.58 billion in total expenses for the quarter, $5.35 billion was spent in salaries and bonuses. This is not necessarily against accounting standards, but it is much more on the scale of compensation found at a hedge fund, not at a commercial bank.

Maybe the Fed has difficulty deciding what to do about Goldman Sachs because other large commercial banks, like JP Morgan Chase and Citigroup, have investment portfolios and proprietary trading just like Goldman, only on a smaller scale. Still, Goldman Sachs even before the credit crisis was an anomaly in the investment banking world, since it was acting increasingly like a hedge fund. It is now a much bigger anomaly in its new home of commercial banking.

Most of the talk about Goldman Sachs is about its outsized bonus pool and insensitivity to the role taxpayers played in saving the firm from destruction. This misses the bigger point, which is the fact that the outsized bonus pool comes from the firm’s conversion into a hedge fund, when its legal status as a commercial bank should forbid this activity.

It is time for somebody, somewhere in government with authority to give Goldman Sachs’ shareholders an ultimatum: you have 90 days to decide what you want to be: a commercial bank, or a hedge fund. If you choose to be a commercial bank with access to all the taxpayer-funded benefits, you will present to the government a plan for divesting all of your “trading” and proprietary investment activity, and you will show how and when you will begin building up a credit culture and start making loans to American businesses and consumers.

If you choose to be a hedge fund, adios and good luck, and don’t come running to the government ever again if you get into trouble. Oh, and by the way, as a hedge fund, divest yourself of the investment banking, advisory, underwriting, asset management, and securities services businesses. We hear Wells Fargo is looking to get into these businesses, and there are no doubt other banks that would take a serious look as well.

Until such time as someone in government delivers this ultimatum to Goldman Sachs, it will continue to thumb its nose at each and every taxpayer in this country who saved its hide.