Goldman Sach's Stress Test: Breaking Ranks with the Crowd Once Again!

By: Reggie Middleton | Tue, Apr 14, 2009
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Nearly one year ago I made clear to all, for absolutely free, that Goldman Sachs was akin to an overpriced hedge fund. The bulk of their profits come from proprietary trading, as do the bulk of the their economic risk added. I first started going bearish on Goldman in July with a flurry of puts with the share price at about $180. Everybody and their mother told me how shorting Goldman would be disastrous. Well, I need a few more disasters like that for my account this year. Take a looksee:

I have recent research on Goldman, marking assets to what I believe to be realistic marks to be expected from the PPIP program, for my subscribers:

Goldman Sachs Valuation Model updated for PPIP - Retail 2009-04-04 19:50:51 333.54 Kb

Goldman Sachs Valuation Model updated for PPIP - Pro 2009-04-04 19:52:21 564.75 Kb

Well, the story significantly predates PPIP, and at the end of this article I will release my stress test results for Goldman Sachs. Drum roll, please....

In June of last year I made it clear that Goldman was trading on name brand premium only, and a premium that was quite undeserved. This premium was paid by those who don't like to run numbers and observe correlations, two activities which happen to be my specialty. See "Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street", from which I have excerpted the justifications for my bearish moves:

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' exposure

  • GS' level 3 assets as percentage of its equity at 258% is close to highest figure of 274% among its peer group. Its level 3 assets proportion to total asset has increased consistently from 5.7% in 2Q2007 to 8.1% in 1Q2008.

  • It is also worth noting that approximately 25% of its OTC derivative credit exposure (comprised in level 3 assets) is rated BBB and lower.
OTC Derivative Credit Exposure ($ mn)
  Feb-08 % of total Nov-07 % of total
AAA/Aaa $15,387 15.6% $14,596 20.7%
AA/Aa2 $33,820 34.2% $24,419 34.7%
A/A2 $25,291 25.6% $16,189 23.0%
BBB/Baa2 $9,724 9.8% $6,558 9.3%
BB/Ba2 or lower $13,354 13.5% $7,478 10.6%
Unrated $1,236 1.3% $1,169 1.7%
Total $98,812 100.0% $70,409 100.0%
  • In March 2008, Standard & Poor's affirmed Group Inc.'s credit ratings but revised its outlook from "stable" to "negative.

On a positive side, the investment banks' has been able to withstand the current turmoil in the credit market and has been the best performing banks when looked at mark-to-market writedown of its asset portfolio. I must note that it is my belief that this immunity to the markdown mania was achieved by the very risky trading in hedges and opposing positions. This is most likely what drove up the risk comonent in their economic capital. In 2Q2008, the writedown in cash instruments and other assets was more than offset by gains in derivative contracts. It also seems to have one of the lowest exposure exposure into Alt-A and subprime asset categories.

However, recent change in some of the variables (level 3 assets, VAR, adjusted leverage ratio) indicate that the bank may be susceptible to slowing capital market activities and further deterioration in the credit and financial markets.

Needless to say, Goldman has earned itself a full forensic analysis. I will report back when I have the results.

Now Back to the Present

Well, now its time to revisit Goldman, for they are still significantly overpriced given the amount of risk they take. Remember, risk is the price for reward and many investors simply overpay. Those investors who will be paying $120something per share for the third or fourth equity offerring in 12 months from a company that is loaded with overleveraged, rapidly devaluing assets in an awful macro operating environment, that has just been saddled with a significant amount of new operating restrictions due to their new status as a commercial bank holding company and the acceptance of TARP, not to mention the fact that this company is now just essentially a big hedge fund are case in point - paying $1.50 worth of risk for a $1's worth of reward. It seems cheap when the risk doesn't come up with snake eyes, but keep rolling those dice...

Goldman is just a big, over priced hedge fund now! It says so clear as day in my blog posting nearly one year and 300% (or so) in short profits ago and right in their most recent quarterly earnings announcement!

From Bloomberg on Goldman's most recent earnings:

Goldman Sachs Group Inc., the sixth-biggest U.S. bank by assets, plans to raise $5 billion to repay (code words for DILUTE currently beat up shareholders, many of whom are nursing 50% losses already) U.S. government rescue funds (Hmmm! Why did you need or even accept "rescue" funds, not to mention 10% preferred money in a 5% environment from Buffet! Sounds to me like you needed to be rescued!) after posting profit that exceeded the most optimistic Wall Street estimates.

The New York-based bank said today it will use proceeds from the common stock offering plus "additional resources" to redeem the $10 billion it got from the U.S. Treasury's Troubled Asset Relief Program. [They are robbing Peter to pay Paul! They cannot afford to pay back the TARP now, but they are doing it to avoid pay restricitions. Why should the government even allow it??!!! If you are going to pay back money, pay back Warren Buffet's money. It is costing Goldman nearly twice what the TARP money is costing, and the TARP is insisting on cutting compensation costs, which is effectively making the money even cheaper. I am not a lawyer, but I sense a shareholder law suit building merit here. It is obvious to me that management is acting in management's best interest and not the best interest of the shareholder by failing to adhere to the prudent man rule. I don't want to hear the argument that they need to retain XYZ talent either. That is the same talent that had them running, hat in hand to Buffet @ 10% in a 6% environemtn, taking TARP with the inevitable strings attached, and becoming a commerical bank on Wall Street at risk of offereing free toasters to open up savings accounts. Mayhap they may be better off finding a new pool of talent under a new compensation structure. The old one didn't seem to work out that well. The company hasn't been public that long, yet would have been driven out of business save the government's expedition of the bank charter and the TARP funds. Just think about it!] The company said it earned $1.81 billion, or $3.39 a share, in the first quarter as a surge in trading revenue [code worded: our hedge fund operations are practically taking over the entire company since hedge fund style trading is the only thing that is making money. I hope nobody looks at the risk/reward metrics that Reggie Middleton is posting on his Blog. I also hope nobody looks at the valuation given publicly traded hedge funds, private equity funds and asset managers these days, either] outweighed asset writedowns, beating the $1.64 estimate of 16 analysts surveyed by Bloomberg.

Chief Executive Officer Lloyd Blankfein, 54, is raising capital to shore up finances [really, 'cause when I add up the numbers, it looks like you are raising just barely enough to pay back the government] and repay government money the bank got in October after the bankruptcy of Lehman Brothers Holdings Inc. Goldman Sachs was the most-profitable Wall Street firm before converting to a bank last year and posting its first quarterly loss since the company went public in 1999.

"The only toxic thing on their balance sheet is the TARP and they want to get rid of that as soon as they can," said Gary Townsend, president of Hill-Townsend Capital LLC. in Chevy Chase, Maryland. The earnings show "they're taking enormous market share away from virtually everyone else." [I'll tend to disagree with you here buddy. The TARP is worth just as much now as when it was issued, actually probably more with cash dividends. Can you say that about all of the private equity, MBS, ABS, CDO, leveraged loans, equity, commodity and fixed income derivatives that GS has on its balance sheet? You should have some salt and pepper handy for when you are forced to eat those words, buddy! Let's see if GS will get away with offering the Treasury 50 to 80 cents on the dollar to pay back the TARP ]

The company, which changed its fiscal year to end in December instead of November, also reported results for the month of December today. They showed the bank lost $780 million, or $2.15 per share, as losses in fixed-income trading and principal investments overwhelmed revenue from other units. [Uh huh! Just as I warned above. You keep rolling those dice and you will come up with snake eyes eventually. This company is just big hedge fund, plain and simple. See my VAR and RAROC notes above. To think, the multiple that people are about to pay for this company's stock given the risk that they are taking to achieve rapidly decreasing and highly unstable profits. In addition, don't we have a littel earnings arbitrage here, with this spare month of reporting dangling (with losses big enough to ruin the taste of desert), it appears that GS has managed to sneak the less than stellar news past most pundits in the fiscal year switch. How about adding the December results into the first quarter. Wouldn't that make sense? But then again the result wouldn't have that accounting shenanigan kick to it, would it?]

Book Value

Book value per share rose to $98.82 at the end of March from $98.68 in November [well, there's economic (or real) book value then there's accounting book value, which is just about as real as your local lobbyist's get well wishes - see my stress test results with FASB fantasy attachments below or you can see my FASB Fantasy Instruction Manual], and return on equity, a gauge of how effectively the firm invests earnings, was 14.3 percent in the first quarter, the company said.

First-quarter revenue was $9.43 billion. Fixed-income trading revenue was a record $6.56 billion, 34 percent higher than its previous mark, as client-driven income outweighed an $800 million loss on commercial mortgage loans, excluding hedges.

Goldman Sachs benefited as the gap between what banks pay to buy fixed-income securities and the price at which they sell, the so-called bid-ask spread, almost doubled to 19 basis points in six months, according to data compiled by Bloomberg. [and what will happen to these earings if these spreads collapse back to mean levels??? This is not sustainable!]

Equity Trading

Every other business unit had lower revenue compared with the first quarter of 2008, or reported a loss. [Let me repeat this line so it sinks in for everybody: "Every other business unit had lower revenue compared with the first quarter of 2008, or reported a loss." HMMM! So, spreads blowout in the last six months of trading (out of 10 years of being a public company) which results in what is apparently a one time (maybe two or three at the most) gain in profits which is probably backed by some of the highest VAR and lowest RAROC and any other risk weighted reward metric available's measure while the rest of the entire company did worse, much worse or took a loss. Just as I told you in the beginning, Goldman Sachs is a big, overvalued HEDGE FUND with a big private equity arm. Why don't you guys look at what valuations similar funds are trading at. Here's some hints: Man Group, Plc (hey, go ask the Brits), Blackstone (just ask the Chinese), and Fortress. Now, compare that with what you are about to pay Goldman so they can pay back their "Rescue" money in order for upper management to recieve larger bonuses. If investors thought more, or read BoomBustBlog more, I think they would be a lot wealthier!]

Equity trading revenue was $2.0 billion as slower activity outside the U.S. meant the firm generated fewer trading commissions than a year ago.

Investment banking revenue of $823 million compared with $1.17 billion in the first quarter of 2008, reflecting a decline in leveraged finance activity and fewer mergers and share offerings. [With investment banking fees being only 13% of trading revenue, no wonder why GS is not calling itself an investment bank anymore. It is not. It is a trading company with a small investment banking arm, as is evident from its revenue breakdown. In other words, its a HEDGE FUND! Yeah, that's righ! I said it again. I wouldn't bet anything of value that you see it again before you finsih reading this missive, either!]

Asset management fees slumped 28 percent to $949 million as assets under management fell 3.3 percent. Securities services, which include the firm's prime brokerage unit, made $503 million, 30 percent less than the first quarter of 2008.

Goldman Sachs had a $1.41 billion net loss from principal investments, including a $151 million loss from the firm's investment in Industrial and Commercial Bank of China Ltd. [and this was with significantly added freedom granted by the Fantasy Accounting Standards Boards, aka FASB]

The bank set aside $4.71 billion to pay compensation and benefits, 18 percent more than the first quarter a year earlier. The expense totaled 50 percent of revenue, up from 48 percent in the first quarter last year. The number of employees, which fell 7 percent during the quarter to 27,989, is 12 percent lower than the first quarter of last year. [Let's put this into perspective for all of the small business men and womand and fellow entrepneurs out their who can't understand this pay for no reward fee structure talk. Goldman has reduced revenues, reduced profits and losses in every business segment except for the highly risky and highly unpredictable fixed income trading (that's right, I'm saying it again - HEDGE FUND - business, and they are paying a Moby (my) Dick, Whopping Whale style, 260% of thier (only one profitable business unit, that is probably not sustainable) profit to employees this quarter, after taking a flat out loss last quarter, and apparently smoothing over the fact that they would have taken a loss this quarter if they didn't shift the fiscal year by a month and benefit from the Fantasy Accounting Standards Boards, aka FASB new rules. And on top of all that, they are issuing $5 billion of common equity to dilute existing shareholders to pay back the TARP so they can pay out even more in executive compensation, all the while leaving the much, much more financing in place. Listen boys and girls - I won't even pay myself 260% of my profit, and I don't have public shareholders to answer to. Then again, I guess neither does Goldman since no one is bitching besides me. You guys can talk about my man Obama all you want, but it appears that his idea of reigning in Wall Street executive compensation has a whole lot more merit than it is given credit for. See Obama Actually Did Wall Street a Favor, The Wall Street Pay Dilemma Really Shouldn't Be Much of a Dilemma at all! and I Went to a Fight and a Compensation Committee Meeting Broke Out! - Class, Compensation & the Street]

Assets Rose

Total assets on Goldman Sachs's balance sheet rose 5 percent from the end of November to $925 billion as of March 27. Of that, about $59 billion qualified as "Level 3" assets, which are the hardest to value, down from $66 billion at the end of November. [Assets rose, despite the fact that more than 2.6x the retained earnings were paid out as compensation and nearly all business units declined or took a loss. I think it's safe to say that leverage increased here fellas. I doubt if equity cash bougth these assets. Think about it boys and girls, increased trading activity leads to higher short term profits in an illiquid, spread blown highly volatile market. This bank grows its balance sheet to take advantage of it in a leveraged fashion. Can anyone see the risk of a blow up here, or is it just me?]

Goldman Sachs raised $5.75 billion by selling shares at $123 apiece in September in an offering that started after the company announced that Warren Buffett's Berkshire Hathaway Inc. bought $5 billion in preferred stock.

A month later, Goldman Sachs was among nine financial institutions that shared $125 billion in the first payments from the Treasury's $700 billion bailout program.

"A stock sale would be a good thing for the government; it would be a good thing for Goldman Sachs or any other bank which was able to do it, especially if they were also able to repay the TARP," said Roy Smith, a finance professor at New York University's Stern School of Business and a former partner at Goldman Sachs. [Now there's an unbiased opinion if I ever heard one!] "They would be free of the high cost of the dividend paid in after-tax dollars and the other restrictions, which everybody realizes they would like to get out of." [But wouldn't they be freer, if they paid off the higher cost Buffet dividends? As I said, about as unbiased as it can get.]

Rivals Pressure

If Goldman Sachs returns the TARP money, it may pressure other banks to follow suit or risk appearing dependent on the government, Brad Hintz, an analyst at Sanford C. Bernstein Co. in New York, said before today's announcement. [Or they may risk looking like they are putting the shareholder's interests before management's, but why mince words?]

"The right thing for government officials to do will be to delay the GS repayment until a significant group of banks are able to repay simultaneously under some organized plan," Hintz said. [Actually, the right thing to do would be to delay all repayments until they can be made prudently and in the best interests of the shareholders, and not the interests of management.]

Blankfein said last week at a conference in Washington sponsored by the Council of Institutional Investors that the U.S. funds Wall Street firms received wasn't intended to be "permanent capital."

'That Minute'

"The minute that an institution is allowed to return the money and is capable of returning the money, while still carrying out its obligations and its role in the capital markets effectively, then it should do it that minute," Blankfein said. [Hey, you're about as unbiased as that other Goldman guy, aren't you?]

Goldman Sachs has gained 55 percent this year to close at $130.15 today in New York Stock Exchange composite trading. The price is more than double the stock's closing low of $52 on Nov. 20.

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Since I ramble a bit in this post, I will put the stress test results in a follow up post to make the articels a little shorter.

 


 

Reggie Middleton

Author: Reggie Middleton

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Reggie Middleton

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