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September 17, 2008

Reggie Middleton on Goldman Sachs Q3 2008
by Reggie Middleton

As in Morgan Stanley (The Riskiest Bank on the Street and Reggie Middleton on the Street's Riskiest Bank - Update), Lehman Brothers (Is Lehman a Lying Lemming?), and Bear Stearns (Bear Fight - A most bearish view on Bear Stearns in a bear market and Is this the Breaking of the Bear's Back?), I am bearish on Goldman as well (Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street and Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis). They have carried a very high, and in my opinion, unjustified valuation premium at a time when their business cycle has passed its nadir and the macro environment is crumbling around them as they carry a boatload of bad assets.

In 3Q2008 Goldman Sachs net revenues declined 51% to $6,043 mn compared with $12,334 mn in 3Q2007 as all the segments witnessed steep decline in their revenues.

Investment banking revenues declined 40% y-o-y to $1,294 mn from $2,145 mn in 3Q2007. Trading and principal investments revenues and asset management segment revenues declined 68% and 8% y-o-y to $2,440 mn and $1,174 mn, respectively in 3Q2008. Interest income and interest expense reported a decline of 32% and 34%, respectively to $8,717 mn and $7,562 mn, respectively.

In line with drop in revenues, compensation expenses declined 51% to $2,901 mn. As a result the ratio of compensation expenses-to-net revenues stood flat at 48% in 3Q2008. Non-compensation expenses increased marginally by 1% to $2,182 mn off higher deprecation and amortization expenses with ratio of non-compensation expenses-to-net revenues increasing steeply to 36.1% from 17.5% in 3Q2007 (excpect to see painful cost cutting). Goldman Sachs pre-tax earnings declined 53% to $5,935 mn form $12,549 mn in 3Q2007.

Overall Goldman Sachs net income available to common shareholders' declined 47% to $4,328 mn (or $9.62 per share) from $8,241 mn (or $17.75 per share) in 3Q2007.

Due to increased volatility Goldman Sachs average daily VaR increased 30% to $181 mn over previous year. I saw this coming last quarter, and it is a strong chance that it will blow up in thier face. Reference my post about their previous quarter concerning risk adjusted performance. As it turns out, it was rather prescient:

Risk vs. Reward is what the successful investor looks at when gauging an oppurtunity. The Street and the media are just looking at reward in regards to Goldman Sachs!

We have looked at company's recent quarterly filings and 10K to have a closer view of Goldman Sachs' (GS) exposure. Following are some of our observations:

Value at Risk (VAR) and Risk Adjusted Return on Risk Adjusted Capital (RARORAC)

Goldman has the highest VAR among its peer group of $184 mn, followed by Lehman at distant $123 mn (we all know how well LEH is currently faring). Notably, GS also the highest range (difference of highest and lowest daily VAR during a quarter) of daily trading VAR of $92 million, reflecting significant (read risky) volatility in its trading portfolio. This is higher than $61 mn and $67 mn (for 1Q2008) for Lehman and JPM, respectively. This is also being reflected in the lowest risk adjusted return on risk adjusted capital (RARORAC - a much more grounded measure of risk adjusted return) of 14.8% for GS among its peer group. Just so this doesn't escape anybody, GS has the lowest risk adjusted return on the Street. Simply analyzing earnings (or looking at CNBC) would lead one to believe that Goldman has the highest return on investment, but unfortunately, the world is a bit more complex than an earnings statement or a cable news channel.

Average Daily Trading VAR (in million dollars)	Q208	Q108	Q407	Q307
Goldman Sachs	184	157	138	139
Morgan Stanley	99	97	89	87
Merrill Lynch	NA	65	65	76
Lehman Brothers	123	130	124	96
JPM	NA	122	107	112
Range of Daily Trading VAR (Difference between highs and lows) (in million dollars)	Q208	Q108	Q407	Q307
Goldman Sachs	NA	92	77	68
Morgan Stanley	NA	34	46	36
Merrill Lynch	NA	39	51	32
Lehman Brothers	37	61	107	66
JPM	NA	67	138	64

Risk Adjusted return on risk adjusted capital (RARORAC)	Q208	Q108	Q407	Q307
Goldman Sachs	12.9%	14.8%	16.1%	15.3%
Morgan Stanley	19.7%	19.1%	21.5%	23.3%
Merrill Lynch	NA	31.6%	32.5%	30.5%
Lehman Brothers	14.0%	12.3%	12.0%	15.3%
JPM	NA	54.1%	60.2%	56.8%

Goldman also has the highest adjusted leverage ratio (adjusted asset divided by adjusted equity) of 18.6x (for 1Q2008) among its peer group, reflecting lower equity cushion against any valuation write-down or loss. This highest leverage portends much greater volatility in economic earnigns. In other words, when the win chooses not to blow in their direction, the sh1t will hit the fan that much harder than the rest of the Street

Adjusted leverage ratio	Q208	Q108	Q407	Q307
Goldman Sachs	NA	18.6x	17.5x	18.0x
Morgan Stanley	14.1x	16.0x	17.6x	18.8x
Merrill Lynch	NA	18.2x	20.3x	17.9x
Lehman Brothers	12.0x	15.4x	16.1x	16.1x
JPM	NA	13.1x	12.7x	12.3x

Click here for a worksheet that illustrates the VaR exposure for all ofthe big US brokers in detail: Broker VaR Worksheet (634.49 kB 2008-07-05 09:25:24).

Goldman Sachs level 3 assets to total assets declined marginally to 6.7% of total assets as of August 2008 as against 6.9% and 7.2% 2Q2008 and 3Q2007, respectively.

Reggie Middleton
Reggie Middleton, LLC
Perpetual Interests, LLCTM
http://boombustblog.com/

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Well, I fancy myself the personification of the free thinking maverick, the ultimate non-conformist as it applies to investment and analysis. I am definitively outside the box - not your typical or stereotypical Wall Street investor. I work out of my home, not a Manhattan office. I build my own technology and perform my own research - in lieu of buying it or following the crowd. I create and follow my own macro strategies and am by definition, a contrarian to the nth degree.

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