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Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis |
| Written by Reggie Middleton | |||||||||
| Thursday, 24 July 2008 | |||||||||
Page 1 of 7 Here is my detailed opinion on Goldman Sachs. Be sure to review my precursor to this report: Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street. Anybody who is interested in how I think should read this report carefully. I believed GS to be significantly overvalued to begin with, and sporting a high share price wards off the small time bears and short sellers, not to mention the SEC put option assignment through the prejudicial short seller rule protection, combined with the recent and totally non-fundamental financial industry rally has created a shopping opportunity for me in which I stocked up on puts. Needless to say, I am quite bearish and heavily short. Below is sneak peak of from the guts of the opinion.
About half of the reduction in the level 3 assets resulted from transfer to level 2 assets: In 2Q2008, Goldman Sach's reported level 3 assets declined 19% to $78 bn from $96 bn in 1Q2008 primarily due to $12.6 bn of transfers and $2.2 bn of assets sale. In spite of this, Goldman Sachs continues to have the highest level 3 assets among its peer group, 13% higher than its closest competitor Morgan Stanley whom I had granted the title, the Street's Riskiest Bank. The highest level 3 asset level had belonged to Bear Stearn's, and I had sternly warned of this company's potential failure in January of '07, see Is this the Breaking of the Bear?. My short position was established in November of '07 and by the time of their collapse, it was my portfolio's largest position. There are similarities between some of the weaknesses in Bear Stearns and Goldman Sachs. See some of the background reading available from my blog (keep in mind that these articles pre-date the collapse of the share price of these companies by months at the very least): · Banks, Brokers, & Bullsh1+ part 1 · Banks, Brokers, & Bullsh1+ part 2 · The Riskiest Bank on the Street · The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! . · I know who's holding the $119 billion dollar bag! (Goldman has the third highest exposure to these insolvent guarantors, look at the 1 yr charts for numbers 1 and 2!) · Here comes the CRE Bust (Quip on Lehman Brothers) · Is Lehman a Lemming in Disguise (from a conributing individual investor) · Bear Stearns Bear Market, Revisited
Now, on to the opinion report. The HTML version here does not include the assumptions and pro formas (an additional 10-12 pages of supporting data), and the graphics are admittedely distorted. No need to fret, registered users of the blog can download the full fidelity, high resolution printable copy here: III. INVESTMENT SUMMARYUntil now Goldman Sachs (GS) has withstood the ripples effect of plummeting financial and capital markets, and widespread losses and write downs in the US mortgage backed securities market. Almost all of its peers including Merrill Lynch (ML), Morgan Stanley (MS) and Lehman Brothers (LEH) posted huge losses off write-downs in their trading and investment portfolios in the first two quarters of 2008 while GS has been able to contain its losses off relatively better quality of its assets, and managed to offset these from gains off its more favorable derivative positions. With problems in the financial markets expected to continue beyond 2008, we expect the operating performance of GS to be impacted by the deteriorating global macroeconomic environment given its high exposure to level 3 assets (197.6% of tangible shareholders equity) and high leverage (adjusted leverage of 14.7x). In addition, a continuous rise in its VaR (a measure of potential loss in value of trading positions due to adverse market movements) as a result of increased volatility and widening of spreads in the underlying investment assets could dampen GS trading revenues (currently being the highest amongst its peers group and comprising nearly 30% of its revenues before interest expense). Moreover, we believe that lackluster M&A business volumes could further lead to softening of investment banking revenues in the near-to-medium term. Based on our relative valuation of GS vis-à-vis its peer group, we have arrived at a per share valuation of GS at $144.3, implying a potential downside risk of 21.1% from its current per share price of $182.8.
III. INVESTMENT SUMMARYUntil now Goldman Sachs (GS) has withstood the ripples effect of plummeting financial and capital markets, and widespread losses and write downs in the US mortgage backed securities market. Almost all of its peers including Merrill Lynch (ML), Morgan Stanley (MS) and Lehman Brothers (LEH) posted huge losses off write-downs in their trading and investment portfolios in the first two quarters of 2008 while GS has been able to contain its losses off relatively better quality of its assets, and managed to offset these from gains off its more favorable derivative positions. With problems in the financial markets expected to continue beyond 2008, we expect the operating performance of GS to be impacted by the deteriorating global macroeconomic environment given its high exposure to level 3 assets (197.6% of tangible shareholders equity) and high leverage (adjusted leverage of 14.7x). In addition, a continuous rise in its VaR (a measure of potential loss in value of trading positions due to adverse market movements) as a result of increased volatility and widening of spreads in the underlying investment assets could dampen GS trading revenues (currently being the highest amongst its peers group and comprising nearly 30% of its revenues before interest expense). Moreover, we believe that lackluster M&A business volumes could further lead to softening of investment banking revenues in the near-to-medium term. Based on our relative valuation of GS vis-à-vis its peer group, we have arrived at a per share valuation of GS at $144.3, implying a potential downside risk of 21.1% from its current per share price of $182.8.
IV. Key pointsBanks' valuation likely to be impacted by continuing tumbling of the US financial sector: Continuing financial crisis, further reinforced by collapse of Freddie Mac and Fannie Mae, is likely to hit US banks' valuation as widespread negative sentiments continue to grip the markets. The dwindling investor confidence is reflected by record high corporate bond spreads and plummeting price multiples. Banks including investment banks like Goldman Sachs are likely to be adversely hit as the risk attached to such businesses are expected to get re-priced. In addition, the specter of significantly increased regulation is coming down the pike, compressing leverage, hence margins in an attempt to quell the potential for systemic financial market disruption.
GS' high market risk reflects the bank's high stakes on the fate of the global financial markets: GS' relatively high and consistently rising trading VaR and its increased exposure to other market risks (not represented by VaR) indicate increased volatility that GS trading portfolio is exposed to. The current volatile financial and capital markets will certainly test GS' ability to withstand probable increases in losses in its trading portfolios in the coming periods.
High financial risk reflected by adjusted leverage ratio: GS scores relatively low among its peers in terms of the adjusted leverage ratios, representing higher financial risk. Although the second quarter saw a noticeable fall in GS' adjusted leverage ratio to 14.7x from 18.6x in 1Q2008, following a $100 bn trim down in total assets, the ratio still remains higher than those of its peers.
Massive off-balance sheet exposure of probable losses from unconsolidated Variable Interest Entities (VIEs): With GS' maximum exposure to loss in unconsolidated VIEs standing at $22.2 billion, representing nearly 50% of the total shareholder's equity, compared to similar figures of 26% and 4% for Morgan Stanley and ML, respectively, GS assumes a far higher off-balance sheet risk. Further, the exposure is in some of the riskier and troubled asset categories like CDOs, CLOs and real estate securities, held indirectly through its unconsolidated VIEs, which is likely to dent GS' performance in coming periods.
Illiquid level 3 assets forming a relatively higher proportion of adjusted total assets: With a relatively high level of level 3 assets as percentage of total assets and as percentage of shareholders' equity compared to its peers, GS could run risk of higher write downs, particularly on mortgage backed securities, as spread continue to widen and investors appetite for risk continue to decline. Although these ratios witnessed a decline in the second quarter of 2008 due to transfers to level 2 assets, GS continue to have sizeable exposure in high risk Alt-A and subprime residential mortgage-backed securities.
Tough times anticipated in GS core businesses: GS' core businesses are likely to get hit by continuing global slowdown in the capital market activities. Slackening M&A, IPO and bond issuance activities are likely to impact the investment banking revenues while lower investors' risk appetite and continuing negative returns in equities will probably slow-down GS' trading and fee-based asset management income, in our view. The exception to this would be those proprietary and client driven volatility trading desks that attempt and may succeed at benefitting from extremes in volatility. This is a dual edged blade though, for these trading strategies often carry higher inherent risks, higher VaR, and lower risk adjusted returns than the more plain vanilla businesses. Basically, when the doo doo hits the fan in these businesses, it tends to splatter farther than normal - splashing any business units that may be standing around.
GS' asset quality
has declined over the past two quarters: The proportion of non-investment grade securities in
GS' trading and investment portfolio has increased over the last two quarters.
Though GS' liquidity position remains strong, exposure to riskier assets raises
concerns about write downs in the near future. This is expected to be
exacerbated in the very near future due to the fact that there are no longer
any insurers who have, and who are wrapping derivative securities that have a
AAA or Aaa rating that is not on negative watch for prospective downgrade. This
translates into a literal dearth of high end investment grade derivative
instruments that relied on monoline insurance wraps. It also means that the
implicit leverage inherent in overcollateralization (a method of pursuing a
higher credit rating for security by pledging more than 100% collateral to a
deal) may very well come home to roost in unexpected ways. |
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