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Monday, 09 August 2010 13:59

What Do Goldman Sachs and B.B. King Have in Common? The Thrill is Gone...

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From Bloomberg: Goldman Sachs Lost Money on 10 Days in Second Quarter

Goldman Sachs Group Inc. , the bank that makes the most revenue trading stocks and bonds, lost money in that business on 10 days in the second quarter, ending a three-month streak of loss-free days at the start of the year.

Losses on Goldman Sachs’s trading desks exceeded $100 million on three days during the period that ended on June 30, according to a filing today by the New York-based company with the U.S. Securities and Exchange Commission. The firm also disclosed that trading losses surpassed its value-at-risk estimate, a measure of potential losses, on two days.

In "The BoomBustBlog Review of Goldman Sach’s 2nd Quarter, 2010 Performance: I Told You So!" I took the time to remind readers and subscribers that Goldman Sachs, despite adulation in the press and the sell side, barely covers its cost of capital in ROE. This means that the firm is actually a lot riskier (economically) than many either realize or admit. It also brings into question the volatility of Goldman's trading practice which has been the firm's bread and butter over the last couple of years. A picture is worth a thousand words, even if we haven't levered up 22x...

The chart below demonstrates how the volatility of the revenues from the trading and principal investments trickles down into volatility of the total revenues and profits of Goldman Sachs. I don’t call Goldman the world’s most expensive federally insured hedge fund for nothing!

If those that follow me remember, I was bearish on Goldman long before became popular, and profitably too (as the media and analysts fawned all over this company)!

Now, considering that Goldman [is] Said to Shift Principal Strategies Into Fund, they may have a problem siphoning strategic prop flow information from client activities to boost their own performance. After all, how else can you have 100% winning days several months in a row? Even so, if we reminisce:

GS’s considerable leverage provides a means (the lever) of high returns to shareholders when asset prices are appreciating but the same becomes a very material economic concern when the asset prices lose value. With low trading revenues, GS has little cushion to absorb write-downs on these assets, leading to erosion of equity. As of March, 2010, the GS’s investments portfolio amounted to $339 billion (nearly 566% of the tangible equity). Referencing my previous posts, “Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let’s Take a Look” and “When the Patina Fades… The Rise and Fall of Goldman Sachs???“, we can reminisce over the fact that Goldman BARELY earns its cost of capital on an economic basis, and that’s before considering the potential horrors which may (and probably do) lay on the balance sheet (for more on BS horror, reference Reggie Middleton vs Goldman Sachs, Round 2 ) .

GS return on equity has declined substantially due to deleverage and is only marginally higher than its current cost of capital. With ROE down to c12% from c20% during pre-crisis levels, there is no way a stock with high beta as GS could justify adequate returns to cover the inherent risk. For GS to trade back at 200 it has to increase its leverage back to pre-crisis levels to assume ROE of 20%. And for that GS has to either increase its leverage back to 25x. With curbs on banks leverage this seems highly unlikely. Without any increase in leverage and ROE, the stock would only marginally cover returns to shareholders given that ROE is c12%. Even based on consensus estimates the stock should trade at about where it is trading right now, leaving no upside potential. Using BoomBustBlog estimates, the valuation drops considerably since we take into consideration a decrease in trading revenue or an increase in the cost of funding in combination with a limitation of leverage due to the impending global regulation coming down the pike.

gs_roe.jpggs_roe.jpg

Subscribers can download my full review of GS’s most recent quarter here: File Icon GS 2Q10 review. It is a recommended read, for we have performed some sleuthing and believe we may have conclusive evidence that the solvency of thisoverly marketed hedge fund investment bank is again at risk, just as it was in 2008. For those who wish to partake in our services, you may subscribe here.