The man who must keep Goldman growing

Lloyd Blankfain worries. True, as CEO of Goldman Sachs (GS), he stands at the summit of the financial world. He just led his firm to its best year ever. He was paid $68.7 million in 2007—a record for a Wall Street chief—and recently bought a $26.5 million apartment at 15 Central Park West, the Robert A.M. Stern-designed building that also houses Sting and Sandy (Weill). But still, Lloyd Blankfein worries. “If you’re really poor at what you do, maybe there’s a 9% chance that you’ll have a problem,” he frequently says. “If you’re really, really good, maybe there’s a 3% chance.” Or he says, “If you’re on a beach and a tsunami hits, you’ll drown whether you’re a small child or an Olympic swimmer.” Or he says simply, “Some things will go bad no matter how good you are.”

In other words, Blankfein, 53, knows that Goldman Sachs, despite all appearances to the contrary, is not invincible. And he wants to make sure that you know that he knows it “I’m always imagining how much worse the headline about Goldman will be when we screw up if we have a quote out there claiming magnificence,” he told the firm’s managing directors at a meeting in London in October. “People are dying for us to misstep.”

Of course, it’s hard to remember the last time that Goldman seriously stumbled. (Its Global Alpha hedge fund has underperformed badly, but that’s a rounding error in the firm’s results.) Goldman has come to outshine its industry the way few companies ever do. While other companies confessed to billions of dollars of losses amid the collapse in the mortgage market—and jettisoned their CEOs—Goldman‘s revenues famously grew, jumping 22% to a record $46 billion as profits hit a record $11.6 billion. Goldman‘s shareholders’ equity, which stood at just $10.1 billion at the end of 1999, is now $42.8 billion. Its total assets have also quadrupled, to more than $1 trillion. Goldman‘s 2007 bonus pool of $20.2 billion could buy Bear Stearns, as noted in a Bloomberg story that sped around Wall Streeters’ inboxes.

That success has inspired a mixture of admiration, envy, resentment, and fear that can border on paranoia. “I wake up every morning with a pit in my stomach realizing I have to compete against them,” says one banker at a rival firm, describing a common ailment on Wall Street. The presence of so many Goldman alums in powerful positions—Hank Paulson, Treasury Secretary; Joshua Bolten, White House chief of staff; Jon Corzine, governor of New Jersey; Robert Zoellick, head of the World Bank; and on and on—breeds conspiracy theories. “How can you be right that much?” asks a money manager who worries that Goldman‘s alumni connections give it access to information that others don’t have. The writer and gadfly Ben Stein went so far as to suggest in the New York Times that Goldman was broadcasting gloomy economic forecasts to support its trading positions.

Success has also subjected Goldman to intense scrutiny. “The business media focus on us like People focuses on movie stars, except they’re better-looking and have more fun,” says Blankfein,who is as good a wisecracker as he is a worrier. The fact that Goldman made bets against the housing market while selling mortgage-related securities inspired protesters to gather outside one of its holiday parties, singing “Goldman the Two-Faced I-Bank” (to the tune of “Rudolph the Red-Nosed Reindeer”) and “Frosty the Goldman (“Frosty the Goldman/Was a very crafty soul”). Blankfein, for his part, seems in equal parts proud of and—surprise—worried about Goldman‘s image. “We’ve gone from, maybe being pitied is a little too strong, to scary,” he says.

Over the past few months Fortune had the chance to learn of Blankfein’s worries and visions for Goldman firsthand, giving us an unusually personal view of the man who has the daunting job of sustaining Goldman‘s winning streak in an increasingly treacherous market What we saw was partly what you’d expect—a stunningly smart, demanding, and competitive executive at the top of his game—but also a surprisingly thoughtful, self-reflective leader with a wicked sense of humor. “Anything I haven’t asked about?” I say at one point in our conversations. “Virgo, blue,” he shoots back. (It took me a moment to figure that out, which probably explains why I left Goldman Sachs in 1995, after working as an analyst for three years.) Of course, the joke goes only so far. As a former Goldman executive puts it, Blankfein is “funny and self-deprecating and can reach across the table and rip your throat out when it’s warranted.”

Now Blankfein’s prediction that “things will go bad” may be on the verge of coming true. Analysts are speculating that the first quarter will bring an end to Goldman‘s string of stellar results, given the bank’s exposure to troubled sectors of the market, such as the loans used to fund leveraged buyouts, where risks can’t be hedged away. But coping with a bad quarter shouldn’t be a big deal. Blankfein’s real challenge is to help Goldman keep the balance it has historically maintained between competing strains in its culture: aggression and caution, entrepreneurship and robot-like teamwork, confidence and (yes) worry, and looking out for the firm’s own interests vs. those of its clients. Blankfein doesn’t want to be the Goldman chief who falls off the tightrope. In London he told a group of managing directors that every time he walks by the portraits of former Goldman Sachs leaders—from John Whitehead to Gus Levy to Robert Rubin, all legends in the world of finance—at the firm’s Manhattan headquarters, he thinks, “If you inherit the empire, you don’t want to leave behind a smaller or worse empire.”

Photograph by Tom Pietrasik

Just a few years ago, though, Goldman was more an embattled kingdom than an empire. Among rivals there was a palpable sense that it was vulnerable. The firm’s traditional franchise—advising companies that were being sold or helping companies go public—was being encroached on by larger banks that would also lend those companies money. Goldman didn’t want to take that risk, and in truth, its balance sheet was too small—small enough that Goldman was routinely mentioned as a takeover target. “People were speculating, making book, on how long we would survive as an independent company,” Blankfein said in London.

Today, as Blankfein relishes pointing out, the rap is that Goldman is too big and too powerful. But it’s more than just a super-sized version of the former firm. Goldman, in a comparison Blankfein likes to draw, remade itself into a modern, and global, incarnation of the old J.P. Morgan, the bank that dominated American finance in the early part of the 20th century. “Goldman Sachs has undergone a brilliant transformation,” says Ken Griffin, the CEO of Chicago-based Citadel Investment Group. “It is now one of the world’s greatest merchant banks.”

That means Goldman doesn’t simply execute orders on behalf of its clients but makes loans and often puts its own principal at stake, just as Morgan did. For example, Goldman not only advised Mittal Steel on the $34 billion acquisition of rival Arcelor in 2006 but also arranged, and contributed to, the $16 billion in financing. And Goldman doesn’t act as a mere broker. Instead of earning a commission for selling 500,000 shares of IBM to, say, Fidelity, Goldman is more likely to earn a spread between its cost of acquiring those shares and the price it sells them for. The transformation of Goldman into a merchant bank began years ago, but Blankfein has pushed the strategy at every opportunity. “If we had not gotten into the principal business, we would be a boutique,” he says.

Goldman‘s activities are also integrated in a way that is unique on Wall Street, where firms tend to consist of competing fiefdoms. For instance, a utility may call up a Goldman Sachs investment banker because it wants to hedge the cost of natural gas for ten years. Goldman‘s commodity trading operation may learn of that opportunity from the banker and offer the hedge, but also offset that position by, say, shorting natural gas in a separate trade. A Goldman M&A banker may be approached by a company that wants to sell, and Goldman‘s private equity operation might end up buying it. “Five years ago, if you were in investment banking, you’d go all-out to win an assignment, but you wouldn’t worry about the other parts of the firm,” says Chris Casciato, a formerGoldman partner who now works for Lightyear Capital. “Now the mindset has changed. You think, ‘What is best for Goldman Sachs as a whole?'”

Its range of operations gives Goldman unparalleled access to information and ideas from around the world. “Goldman has more touch points to more clients around the globe,” says Jeff Harte, an analyst at Sandler O’Neill. “It gives them more opportunities and better collective intelligence.” Indeed, Goldman‘s clients give it an information edge that the very best hedge funds don’t have. “Clients are our bread and butter,” says Blankfein. “Without them we would starve to death.”

At the same time, Goldman has to advance its own interests, which may put it in conflict with its clients. And different clients may have clashing interests. Take a private equity firm that usesGoldman as an advisor but then finds itself bidding against Goldman to buy a company. Or a mutual fund that uses Goldman to execute a large purchase of stock. Does the fact that the trade becomes part of Goldman‘s collective intelligence mean that the mutual fund somehow loses? “We always put our clients ahead of the firm,” says Jon Winkelried, Goldman‘s co-chief operating officer.

But for years Goldman has heard accusations that it puts its own profits first, to the detriment of its clients. “They have embarked on a very aggressive course of having their cake and eating it too,” says one private equity executive, who, like many, will not speak on the record because he does not want to lose access to what the firm has to offer. “Are we a client-focused firm with an appetite for risk, or are we a trading firm with client relationships?” asks a former Goldman partner, explaining that he thinks Goldman has tipped to the wrong side of that fine line. And some clients find themselves in a bind: They may worry about the edge their information gives the firm, but they turn to Goldman anyway because often it can do a trade that no one else on the Street can or will. A common refrain is that you “do business with Goldman not because you want to, but because you have to.”

Recent events provide a window into one type of conflict Goldman can face. In February the credit crisis spread to obscure instruments known as auction rate securities, long-term debt on which the interest rate is reset frequently via a bidding process. The higher the demand for those securities, the lower the rate. Goldman and other investment banks had supported this market by committing their own capital to buy the securities. But in February the banks abruptly stopped doing so. As a result, even issuers with strong credit, such as the University of Pittsburgh Medical Center, found themselves paying exorbitant interest rates.

Although UPMC considered Goldman its advisor—Goldman underwrote a recent UPMC bond offering and also manages a portion of its investment portfolio—treasurer Tal Heppenstall saysGoldman (and other Street firms) withdrew from the auction bond market all at once and without any notice. As a result, UPMC’s rates on $450 million of auction rate securities began to leap as high as 17%. UPMC believes that its interests were subordinated to the interests of Goldman and the other banks, and Heppenstall says he wonders who benefited from the higher interest rates.Goldman says its decision to stop bidding for auction rate securities was necessary to protect its balance sheet in a market that seems scarier by the day. “We hate disappointing people, but market conditions are extraordinary, and selling pressure has been unprecedented,” says a Goldman spokesman. In other words, even mighty Goldman is vulnerable to today’s turbulence.

The episode shows how tough Goldman‘s balancing act can be. As Philip Murphy, a former Goldman partner who is now the finance chair of the Democratic National Committee, says, “Conflict resolution is not an A business. Either the client felt like Goldman was looking out for its interests or it didn’t.” Murphy feels that Goldman does get an “A,” as do others. “The world is awash in conflicts,” says Ken Griffin, whose fund does business with Goldman. “Firms either pretend they don’t exist and get in trouble for it, or they recognize that conflicts exist and deal with them thoughtfully and openly. Goldman does the latter.” Nor does client dissatisfaction show up in Goldman‘s numbers. Goldman, as Blankfein frequently notes, has market-leading positions in many client businesses, including M&A. “Can you imagine how much worse the criticism would be if we weren’t No. 1?” he asks. “People say these things, but that is not how they are responding to us.” Says Oppenheimer analyst Meredith Whitney: “Ultimately people vote with their feet, and the feet keep marching toward 85 Broad Street.”

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Which isn’t to say that Goldman itself isn’t worried (that word again!) about—maybe even obsessed with—the questions of conflicts. During the past year Blankfein has held 30 Chairman’s Forums at Goldman offices around the world, in which he talks to a small group of managing directors about an area of concern for the firm. His focus? Client relationships.

The most recent Chairman’s Forum was what brought Blankfein to London last fall. Blankfein told the assembled managing directors, “We feel we get clients right, but people out there are saying, ‘The industry has gotten selfish. The industry is subordinating the interests of clients. And Goldman Sachs, we don’t think you’re any different. In fact we think, You especially.'” There was dead silence in the room.

The group then talked through several case studies. The first: “A major private wealth-management client calls her GS coverage person to express frustration that while GS is generating record results and outperforming as a firm, returns on her portfolio have been mediocre.” This scenario could have been ripped from the headlines (although Goldman says it wasn’t). Last August,Goldman‘s flagship hedge fund, Global Alpha, plummeted. For the year the fund finished down 37%, in sharp contrast to Goldman‘s record results. The managing directors didn’t seem to have any solutions beyond informing clients that their investment objectives were different from Goldman‘s. At least for now, though, the strength of Goldman‘s brand is such that despite Global Alpha’s results, Goldman was able to raise $7 billion for a new hedge fund last fall.

Another hypothetical could have come straight from a Goldman Sachs detractor. “An investing client delivers the message to his GS salesperson that GS has not been selected to execute a large and potentially profitable trade. When pressed, the client says that his decision was based in part on the assumption that GS is more focused on proprietary investing than client service, and that he and his firm fear that its data and ideas might be used by GS for our own purposes.”

“Would someone ever have this reaction about GS?” asks Blankfein sarcastically. The whole room knowingly cracks up. But as Blankfein points out, every Goldman Sachs trader who has leftGoldman to start his own hedge fund has chosen Goldman Sachs to handle his business. If Goldman misused clients’ information, those traders would know—and presumably pick another firm.

While clients may be crucial to Goldman, Blankfein did not have a reputation for being client-friendly when he took over. But in Street parlance, he has exceeded expectations. Jim Coulter, a founding partner of private equity giant TPG, says that in a year where there was a lot of tension between private equity firms and Wall Street as the markets turned sour, he was surprised to get a phone call from Blankfein during the week before Christmas, thanking him for TPG’s business. “It was a great client service touch,” says Coulter.

Then again, Lloyd Blankfein is not a guy who likes a predictable narrative. The son of a Brooklyn postal worker, he was the first in his family to attend college. At 16, he began putting himself through Harvard and then Harvard Law School, with scholarships and financial aid. But Blankfein complains that he is tired of being characterized as poor kid who made good and wishes that reporters would skip straight to the “Harvard-trained lawyer” part when recounting his background.

After graduating from law school in 1978, Blankfein worked as a lawyer for a few years, then tried to get a job at Goldman Sachs. He was turned down. Instead, in 1982 he took a job as a gold salesman at commodities trading firm J. Aron—which Goldman had recently acquired. J. Aron was a rough-and-tumble place. “We were street fighters,” recalls Dennis Suskind, a former J. Aron partner who hired Blankfein. “We didn’t wear suspenders.” Blankfein himself joked in London, “We didn’t have the word ‘client’ or ‘customer’ at the old J. Aron. We had counterparties—and that’s because we didn’t know how to spell the word ‘adversary.'”

Blankfein started as a salesman, not a trader. (In fact, he has only worked as a trader briefly.) Yet he turned out to have a rare knack for managing traders, partly because he’s so quick-witted. Even others with sharp minds note just how fast Blankfein is. Steve Schwarzman, CEO of Blackstone, likens Blankfein to tennis great John McEnroe in that he has an “incredibly fast neural path between seeing and reacting.”

Nor does Blankfein sacrifice thoughtfulness to speed. “He has a remarkable ability to be both impatient and reflective,” says Richard Gnodde, who is co-head of Goldman‘s business in Europe, the Middle East, and Africa. Any issue “is like a diamond is his hand, and he’s spinning it around, looking at it from every facet”

Blankfein also has a trader’s ability to rethink a position (witness Goldman‘s deft moves in the mortgage market). “It’s not about hanging onto a predisposition,” Blankfein says. “The best traders are not right more than they are wrong. They are quick adjusters. They are better at getting right when they are wrong.” Perhaps that quality helps explain why Blankfein is not complacent. “Lloyd is incredibly confident,” says Dan Loeb, the CEO of hedge fund Third Point. “But he doesn’t take either Goldman Sachs or his position for granted.”

Wherever he went, Blankfein made money, and at Goldman, he who makes the money rises. In 1994, Blankfein was appointed co-head of J. Aron. In 1997, he was named co-head of a new division that combined Goldman‘s fixed-income operation with J. Aron’s currency and commodities business in a unit labeled FICC. In 2004, Blankfein became Goldman‘s chief operating officer. In the spring of 2006, when Hank Paulson unexpectedly resigned to become the 74th Treasury Secretary, Blankfein became the 11th CEO of Goldman Sachs.

One criticism has dogged Blankfein throughout his career: that he is cliquish, with a “you’re either with me or you’re against me” attitude. Many high-level bankers left the firm after Blankfein took over. And it’s true that Goldman‘s two chief operating officers, Gary Cohn and Jon Winkelried, are longtime Blankfein colleagues who share certain physical characteristics. “Do you have to be a white male with male pattern baldness and have spent a significant portion of your time at Goldman in FICC?” asks one former partner. To address that issue, I ask Blankfein—a history buff whooften carries a pile of books on vacation—about Abraham Lincoln, who, as recounted in Doris Kearns Goodwin’s book Team of Rivals, surrounded himself not with friends but with those whowanted his job. Blankfein knows the book well—”It’s a great management book,” he says—but he rejects the contrast, saying, “I think I would have done what he did and picked the best people.” He continues, “I promote the people who do well and make them my friends. I gravitate to the people who are talented.” Then he adds, “But I’m not sure I would have had Lincoln’s graciousness in not having to say, ‘I’m right and you’re wrong’—his discipline in not having ground their faces into their mistakes. It takes a lot of discipline not to let people know how smart you think you are.”

As his power increased, Blankfein learned to control his sense of humor. He had—and in some quarters still has—a reputation for being caustic. “Even on the management committee, I was aggressive in expressing my views, figuring I had to lean hard just to budge the firm a bit,” he says. “You have to be aggressive if you’re trying to move a big concrete block. But my seniority gives my views weight, and then if you use more than apinky, you’ll move that block a lot further than you want to.” Now, he says, “I can’t be provocative for the sake of provoking. And I sometimes miss that.”

Photograph by Ben Baker

After the chairman’s forum in London, Blankfein heads to India, where Goldman Sachs has just opened an office, a trip that gives him the chance to ask, “Is there a deli in Delhi?” more than once. Blankfein attends the opening ceremony decorated with a red bhindi on his forehead and wearing a garland of flowers. As he walks through the new offices, a TV on the wall happens to be broadcasting a speech by Hank Paulson. “Our ancestors are looking down at us,” quips Blankfein.

At a lunch for managing directors at Mumbai’s Indigo restaurant, Blankfein fields questions from roughly two dozen men (they are all men). To get things going, Blankfein asks, “Do you have any advice for me?” “Don’t f— up,” says one MD. When the laughter subsides, another MD asks, “What do you worry about most?”

“The vagaries of life,” Blankfein responds. “You have to be lucky. You can make a lot of your own luck, but you have to be lucky.” He adds: “I worry that we’re too smug, and then I see everyone wringing their hands over the worry that we’re too smug, and then I think we’re too nuts, and we’re destined to have unhappy lives, and we’ll always be miserable strivers.”

The trip to India is just another sign that, under Blankfein, Goldman Sachs is staking much of its future growth on the emerging economies of Brazil, Russia, India, and China, or BRIC, as a Goldman economist dubbed them. The firm is also putting teams on the ground in the Middle East and South Africa. Already, non-U. S. markets account for more than 50% of Goldman‘s revenue. The heart of Goldman‘s business strategy, says Blankfein, is “chasing GDP around the world.”

Indeed, Goldman has no choice if it is to meet its aggressive, even grandiose, goals. Ask Gnodde about the firm’s challenges, and he says, “How do we get more revenues in 2008 and 2009?” Ask Cohn why Goldman is going global, and he says that the key question was “How do we grow?” Cohn says that generating 20% growth in revenues, not each and every year but as an average over a cycle, is “a mantra around here.”

But as the managing directors at lunch well know, emerging economies can plunge as rapidly as they soar. Few if any companies have ever sustained 20% annual growth for very long, and many have died trying. As John Weinberg, one of the former leaders whose picture Blankfein sees on the 34th floor of his building, used to say, “Trees don’t grow to the sky.”

Nothing has contributed more to the Goldman mystique than the firm’s market-defying performance during the mortgage meltdown of 2007. That’s especially true because Goldman takes more risk than many of its peers, which is why skeptics (including some short-sellers) thought Goldman would take a bigger hit in a bad market. Obviously, it didn’t turn out that way.

There’s no simple explanation. “People are looking for the magic formula,” says David Viniar, Goldman‘s CFO. “There isn’t one.” Goldman spotted the problem early because it is fanatical about pricing its holdings at their current market value—even at times forcing traders to sell part of a position to establish a price. Because of that, the firm’s books were showing losses on mortgage securities by late 2006. “At this firm it doesn’t escape people’s attention when you lose money for days in a row,” says Viniar.

On Dec. 14, 2006, some 20 people, including Viniar, the heads of FICC, the heads of the mortgage business, and various people from the controller’s side—the people who verify the prices at which traders are marking their books—met in a conference room for 2 1/2 hours. (To show respect, Goldman refers to these people not as the “back office” but as “the Federation.” When I first hear the phrase, I say, “Like Isaac Asimov!” Blankfein quickly corrects me. “That’s The Foundation. Don’t test my knowledge of literature.”)

The result: The firm should have “a bias to be short,” as Viniar puts it. It isn’t easy to short a house, but Goldman found a way. It pulled back the lines of credit that it offered to mortgage originators, meaning that it slowed the pace at which it purchased mortgages. It began to sell off its inventory of securities that were backed by mortgages. Goldman also hedged its risk by buying derivatives that would pay off if mortgages began to default.

And so last fall—when other Wall Street firms began to write off billions of dollars—Goldman posted what analyst Whitney called “Yes, we are that much better than our peers” results. Blankfein, true to form, worries about lording it over his peers. “I really think we are a little better,” he says. “I will fight you if you say we’re just like everyone else. But I think it’s only a little better. It’s not as much as recent events would suggest.”

Goldman‘s success in dodging the subprime bullet renewed criticism that the firm puts its own interests ahead of its clients’. But Goldman says it stopped selling securities crafted out of problematic subprime mortgages after April, and that its customers were institutional investors who—theoretically—understood what they were buying. Viniar draws an analogy to the equity market. He says that Goldman may underwrite an offering for Ford at the same time that the firm’s traders are short the S&P 500. “We disclose what the risks of owning Ford are, but we don’t disclose that we’re short equities,” he says. “The risks of owning Ford over a long period of time are different from a trading view of equities.” He adds, “The idea that a trading view should inform whether or not we underwrite a security is just uninformed.”

Blankfein, who is normally so willing to consider all sides of an issue, doesn’t think the criticism has any validity. “We make money when we do our jobs well,” he says. “We take risk, we get compensated. Would an insurance company that went broke after Hurricane Katrina be more moral than one that didn’t?”

And Blankfein has other things on his mind. As he’s the first to admit, there’s no way to know whether Goldman will dodge the next bullet. “They have put themselves right in the center of what’s going on,” says Griffin, which means that Goldman is vulnerable to the market’s unpleasant surprises. You could argue that one quarter of subpar results might actually help Goldman by infusing a dose of hard reality into its seemingly magical numbers. Or, as I heard Blankfein say in India, “If everybody thought we were only here to make the most money for ourselves, who the hell would want to be on the other side of us?” One thing seems clear: Lloyd Blankfein will never run out of things to worry about.