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April 21, 2009

Warning: "What You Dont Report in Your Balance Sheet Can Screw the Average Iinvestor"!
by Reggie Middleton

This is your daily dose of the Goldman Sachs Stress Test Scenario Analysis, Professional edition. I will be releasing the Stress Tests for Wells Fargo, PNC, Sun Trust, Morgan Stanley and the top secret asset managers, insurers, and banks whose identity are for subscribers eyes only over the next day or two (or three - or as fast as I can get them out). Since the subscriber content pipeline is so rich, I have decided to let out excerpts from the Goldman report in dribs and drabs. I will do so until the mainstream media catches the hint: Goldman's Doo Doo smells no sweeter than anyone else's on the Street. As a matter of fact, I find it to have a particularly more intense, pungent odor.

What you don't know can collapse you! A primer on what lurks off the balance sheet...

Goldman Sachs is a very large, very diverse financial operation (although it appears that the vast majority of revenues and profits are emanating primarily from trading operations, hence it is essentially an overpriced public traded hedge fund). A very significant amount of Goldman's assets and operations are not privvy to the average investor or the capricious analysts. How significant an amount, you ask? How about to the tune of US$16 to US$58+ billion. I am getting ahead of myself though. In order to increase implied leverage and minimize collateral and reserve requirements, many entities carry much of their risk off of their balance sheet through vehicles called Variable Interest Entities (VIEs). Why are they doing this? Well, because they can. How are they doing this? Well, let's reference my favorite (okay second favorite - BoomBustBlog carries a bias) open source info hub, Wikipedia: A Variable Interest Entity (VIE) is a term used by the United States Financial Accounting Standards Board in FIN 46 to refer to an entity (the investee) in which the investor holds a controlling interest which is not based on the majority of voting rights. It is closely related to the concept Special Purpose Entity. The importance of identifying a VIE is that companies need to consolidate such entities if it is the primary beneficiary of the VIE.

Criteria

A VIE is an entity meeting one of the following three criteria as elaborated in paragraph 5 of FIN46:

1. The equity-at-risk is not sufficient to support the entity's activities (e.g.: the entity is thinly capitalized, the group of equity holders possess no substantive voting rights, etc.);
2. As a group, the equity-at-risk holders cannot control the entity; or
3. The economics do not coincide with the voting interests (commonly known as the "anti-abuse rule").
4. External links
• http://www.vinodkothari.com/fin46vk.htm
• http://www.bloomberg.com/apps/news?pid=20601103&sid=aFTh5VXP9m0U&refer=news
• http://www.ft.com/cms/s/0/b7e7876a-e564-11dc-9334-0000779fd2ac.html

But "Wait", you may proclaim! "I never see these off balance sheet entities consolidated, measured, quantified, or even mentioned in my brokerage reports, SEC reports, or by may investment advisor or asset manager." Don't worry, don't fret, your brother from another mother has come to your rescue.

Goldman Sachs Unconsolidated Varaible Interest Entities ($ mn) 30-Nov-08 (last quarter)
VIE Assets		Maximum Exposure to Loss in Nonconsolidated VIEs
		Purchased and retained interests	Commitments and Guarantees	Derivatives	Loans and investments	Total
Mortgage CDOs	13,061	242	0	5,616	0	5,858
Corporate CDOs and CLOs	8,584	161	0	918	0	1,079
Real estate, credit-related and other investing	26,898	0	143	0	3,223	3,366
Municipal bond securitizations	111	0	111	0	0	111
Other mortgage-backed	0	0	0	0	0	0
Other asset-backed	4,355	0	0	1,084	0	1,084
Power-related	844	0	37	0	213	250
Principal-protected notes	4,516	0	0	4,353	0	4,353
Total	58,369	403	291	11,971	3,436	16,101
Base case						27.6%

Remember in my last article (Who is the new Riskiest Bank on the Street?) I made clear that leverage can come in more forms than mere plain vanilla loans, hence we include derivatives, commitments and guarantees as well as loans and investments in the mix of exposure. This means that although these assets are held off of Goldman's balance sheet, they are still on the hook as a derivative counterparty, lender (direct or contingent), or a provider of a commitment or a guarantee. These risks are direct and real and rightfully should be reflected in the balance sheet and not the footnotes of a 60 page document.

How real are these risks, you ask (Yeah, I heard you ask that right through your screen)? Well, let's attempt to run through them...

Unconsolidated VIE's ($ mn)	VIE assets	Maximum loss exposure	Maximum loss as % of assets	Default assumptions	Recovery rates	Net losses (in $ mn)
Mortgage CDOs	13,061	5,858	45%	13%	70.0%	527		<-Recoveries stated here are very optimistic Losses and recoveries here may surprise to the downside, but I'll be conservative <- Manna from heaven if they get this!
Corporate CDOs and CLOs	8,584	1,079	13%	4%	90.0%	32
Real estate, credit-related and other investing	26,898	3,366	13%	4%	50.0%	505
Municipal bond securitizations	111	111	100%	30%	100.0%	0
Other mortgage-backed	0	0	0%	0%	0.0%	0
Other asset-backed	4,355	1,084	25%	7%	50.0%	163
Power-related	844	250	30%	9%	70.0%	23
Principal-protected notes	4,516	4,353	96%	29%	80.0%	261
Total	58,369	16,101	27.6%			1,511
Total VIE loss (after tax)						1,058
% Loss on total VIE exposure	2.6%	Be aware that this is off of a US$58 billion base.

Now, keep in mind the reason for GS to hold all of this stuff off

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balance sheet. They pull revenues and profits from these assets while denouncing ownership and attempting to trivialize liability. It's almost as if it were financial engineering magic! Nothing goes in, and just profit pops back out (well, if you read my last report, this would be viewed very differently from a risk adjusted reward perspective, but for now, feeble investors are sated with simple, manipulable accounting earnings).

What's that? Speak up. Yes, you in the background! You know I can read your thoughts through my keyboard. It was a good question. That smart guy inquired, "If Goldman is allowed to carry on operations off balance sheet and the corporate entity collateral and reserve requirements are based off of what was on the balance sheet, then doesn't this allow Goldman to cheat the system? Doesn't this mean that we really don't know what Goldman's real leverage ratio is since there are no leverage numbers for the VIE's?"

Ya' Damn skippy my intellectual blog pundit!

As a matter of fact, the use of off balance vehicles make literally impossible to accurately determine the leverage used by entities such as Goldman Sachs. One thing we can be relatively sure of, though. The actual leverage is greater than the leverage stated by Goldman.

The vast majority of the assets held in VIEs are most likely level 3 assets, and it is a very safe bet to assume excessive leverage was used in financing these assets. Once you adjust for the bullsh1t normally identified as equity in an effort to placate investors and regulators, you will find that you get an adjusted leverage ratio that is much higher than most would consider prudent.

Let's walk though this process in the table below then look at some pretty graphs to bring the point home.

As you can see, Goldman Sachs has a higher Level 3 assets to adjusted equity ratio than Lehman Brothers, and Lehman Brothers was bad enough to drive them out of business.

When comparing the top investment banks, Goldman has - by far - the greatest gross and net exposure to off balance sheet risk. As a matter of fact, it is so great that I will have to dedicate a whole other article to it and Goldman's level 3 exposure.

We will go over Goldman's level 3 exposure in detail tomorrow. For now, I need to work on getting the updated PNC stress test out.

Must read, related content:

1. The Official Reggie Middleton Bank Stress Tests
2. GGP has finally filed Bankruptcy, Proving My Analysis to be On Point Over the Course of 18 Months
3. For those that attempt to argue that short sellers are bad for the market, I bring you GGP!
4. More on the Goldmans Sachs - GGP Connection
5. Who is the Newest Riskiest Bank on the Street?

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

Who am I?

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.

Since I use my research as a tool for my own investing to actually put food on my table, I can stand behind it as doing what it is supposed too - educate, illustrate and elucidate. I do not sell advice, I am not a reporter hence do not sell stories, and I do not sell research. I am an entrepreneur who exists just outside of mainstream corporate America and Wall Street. This allows me freedom to do things that many can not. For instance, I pride myself on developing some of the highest quality research available, regardless of price. No conflicts of interest, no corporate politics, no special favors. Just the hard truth as I have found it - and believe me, my team and I do find it! I welcome any and all to peruse my blog, use my custom hacked collaborative social tools, read the articles, download the files, and make a critical comparison of the opinion referencing the situation at hand and the time stamp on the blog post to the reality both at the time of the post and the present. Hopefully, you will be as impressed with the Boom Bust as I am and our constituency.

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