Thursday, 24 July 2008 01:00

Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis

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

·
Money Panic

·
Bear Fight

·
The
Breaking of the Bear

·
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)

·
Liquidity vs Insolvency

·
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:  pdf GS Report_072108-2 (361.18 kB 2008-07-24 15:20:25).
As an added bonus, I'll throw in the Goldman Sachs Ambac/MBIA insured ABS, MBS and CDO inventory just for good measure. This will come in handy when reading the portion of the report that details the declining asset value and high Level 3 concentrations of the Street's Golden Boys. See icon GS ABS Inventory (1.22 MB 2008-02-25 06:48:56).

III.
INVESTMENT SUMMARY

Until 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 SUMMARY

Until 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 points

Banks'
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. {mospagebreak}


III.
Valuation

Considering the volatility of earnings of financial
and banking institutions, and their relative balance sheet strength to
withstand the current deteriorating macro-economic conditions, we believe
relative valuations based on a P/B approach will reflect the company's current
valuation better than valuations based on future stream of income based on DCF
and P/E approaches. Using an average 2009 adjusted P/B multiple of 1.27x (after
applying a 25% premium for the sake of conservatism, recognizing that the
market places a premium on the Goldman Sachs brand), we calculate GS' per share
valuation at $144.2, representing a 21.1% lower valuation from its current
price of $182.8.

image009.gif

Adjusted P/B based valuation

We have valued GS
based on adjusted P/B multiple. Based on adjusted P/B of 1.02x for 2009 for its
peer group and applying a premium of 25%, GS' valuation comes to $148.5 per
share (excluding loss from unconsolidated VIE's, again in an effort to come to
a conservative conclusion), with a downward potential of 18.8% from the current
share price of $182.8. It is quite likely that losses will emanate from
unconsolidated VIEs.

Including losses from
unconsolidated VIE's of $1.5 bn (after-tax), GS book value per share for 2009
is expected to be $113.6. Based on P/B multiple of 1.27x (2009 P/B multiple of
peer group and a 25% premium), GS fair value per share is approximately $144.3
with a downward potential of 21.1% from current share price of $182.8.

image010.gif {mospagebreak}

IV.
Investment Highlights

Valuations likely to be impacted by continuing tumbling of the US financial sector

Collapse of
Freddie Mac and Fannie Mae indicating no-near end of the financial crisis:
Rapidly dwindling confidence in the US financial
sector following widespread losses and write-downs in the underlying securities
held by financial and banking institutions has necessitated a revisit to the
valuations these institutions are trading at. A sharp rise in credit default
swaps (CDS) for some of the largest commercial and investment banks in the US
over the last few weeks indicate a lowering investment confidence at the
current level of valuation. With Freddie Mac and Fannie Mae losing about 80% of
their value this year off rising mortgage worries in the form of increasing
delinquencies and defaults, the problems in the financial market seem far from
over.

Spreads for financial corporate bonds, measuring
investors' risk appetite, have widened to their highest level in two years to
344 basis points over US Treasuries, indicating a larger probability of further
distress. With returns from the banking and financial sector not expected to
improve significantly over the next 12-18 months, the period of negative returns
will continue at least till the end of the second half of 2008 and probably
through 2010, in our view.

Decline in price
multiples for investment banks to continue off expected widening of spreads and
increasing write-offs:
Morgan Stanley,
LEH and ML, which were trading at an average two-year forward P/B multiple of 1.39x
at the beginning of this year, are now trading at 1.02x. The trend in declining
valuation is expected to continue till losses off write-downs and loan losses
of investment banks decline to the pre-sub prime crisis level and investors'
confidence in the financial and capital markets is reposed. We expect GS'
valuation to follow the decline in peer group multiples in the near-to-medium
term, and estimate a downside of 21.1% in its current price of $182.8. Amid
escalating inflation pressure and widespread write-downs witnessed by banks, which
has forced Fed into a "tennis-neck" syndrome, a perfect solution to the current
crisis has not yet come to light
.

Goldman Sach's towering market risk
reflects the company's high stakes gambit on the fate of the global financial
markets

Rising trading
risk off consistent increase in VaR:
Goldman Sach's consistently rising trading VaR indicates
the increased volatility that Goldman Sach trading portfolio is exposed to amid
current deteriorating capital and financial market conditions. Goldman Sach's
average daily VaR (at 95% confidence level) increased a significant 38.3% to
$184 mn in 2Q2008 from $133 mn in 2Q2007. This was much higher than the 2Q2008
figures of $99 mn for Morgan Stanley and $123 mn for LEH. In 2Q2008 VaR for Morgan
Stanley increased by a modest 2.1% over 1Q2008, and declined 15.4% for Lehman,
in contrast to a 17.2% increase for Goldman Sach. The company also stands to
lead its peers in terms of ‘VaR as a percentage of equity shareholder's equity'
at 0.41% (up from 0.36% in 4Q2007), next only to Lehman. With financial and
capital markets continuing to remain volatile and uncertain in a very, very difficult
macro-economic environment, Goldman Sach's high level of VaR is likely to test
its ability to withstand an expected increase in losses in its trading
positions.

image011.gif

Based on latest
quarterly filings. Merrill Lynch has not
yet disclosed its VaR numbers

In May 2008, Goldman Sach's VaR peaked to $214 mn with
an average VaR of $194 mn (with a potential of wiping off 0.43% of
shareholder's equity once in every 20 trading days), up from $171 mn in
February 2008. Also, the fact that Goldman Sach's trading losses incurred on a
single day exceeded its one-day VaR on three occasions during 2Q2008 compared with
two in 1Q2008 indicate a higher likelihood of trading losses for Goldman Sach
in the second half of 2008.

The chart below shows a comparison of Goldman Sach and
Morgan Stanley (arguably, the Streets 2nd most prolific proprietary
trading house) based on number of days their trading losses increased their
respective VaRs in last four reported periods. While Morgan Stanley witnessed
trading losses (higher than its VaR) on more days (numerically) in 3Q2007 and
4Q2007 as compared to Goldman Sach, the trend has been reversed in the first
two quarters of 2008, indicating a riskier trading portfolio for Goldman Sachs.

image012.gif

The increase in
other market risks for positions not included in reported VAR acts as an
additional dampener on value:
Beyond the realm of normal loss expectations
denoted by VaR which is based on historical data, there are other potential
undirected and unpredicted market risks not captured by VaR. These market risks
stem from Goldman Sach investments in debt, real estate, equity, unspecified
special purpose vehicles (SPEs) and other investments subjected to transfer
restrictions and/or illiquidity, and are measured by a potential reduction in
the asset value of the investment or performance of the investee entity. The
potential risk in loss of value of these investments for Goldman Sach in 2Q2008
was $5.7 bn, a staggering 66.2% increase from $3.5 bn in 2Q2007. These risks
and liabilities apparently have not been factored into the valuation of Goldman
by those entities and pundits who fail to perform full forensic analyses, or
who simply follow the crowd.

image013.gif

In addition to the market risk, Goldman Sach is
exposed to several non-market non-quantifiable risks including counterparty
credit risk and funding risk. The CDR Counterparty Risk Index, which measures
counterparty risk of major credit derivative dealers increased to 179.4 basis
points on July 15, 2008, the weakest since March 2008 when Bear Stearns had
collapsed. Increased counterparty risk and heightened volatility in the capital
markets could result in higher trading losses for Goldman Sach which derives
nearly 30% of its revenues (before netting off interest expense) from its
trading desk. I'd like to add that this proportion of revenues will probably
increase as fee based services and securitization services ebb and dwindle to
next to nothing, respectively.

image014_copy.gif

Based on
latest quarterly filing from Goldman Sachs

Goldman Sach's higher leverage ratios
represent high financial risk

{mospagebreak}

Goldman
Sach's scores low among its peers in terms of financial risk reflected by
adjusted leverage ratio:
Goldman Sach's has
always been in a tight spot when compared with its peers based on adjusted
leverage ratio. Given the level of caution displayed by the investor community,
high financial risk emanating from a relatively higher leverage ratio is likely
to dent Goldman's position compared to its peer group. Although growing concerns
from shareholders and regulators over a relatively high leveraged balance sheet
drove Goldman to trim down its assets by about $100 bn in 2Q2008, bringing down
the adjusted leverage ratio to 14.7x from 18.6x in 1Q2008, Goldman Sach has not
been successful in bringing down its adjusted leverage ratio to levels reported
by its peers.

 

image015.gif

Based on latest quarterly filings
*Reported figures

NR- not
reported. Merrill Lynch has not reported its adjusted leverage and total assets
in the Q2 2008 earnings release on July 18, 2008

Massive off balance sheet exposure
through unconsolidated Variable Interest Entities could result in losses in the
form of commitments and guarantees

Goldman Sachs has substantial off-balance sheet
exposure to riskier assets like CDOs, CLOs and real estate securities held
indirectly through its unconsolidated VIEs. As of May 30, 2008, the total
exposure (in terms of maximum loss to Goldman Sachs) stood at $22.2 bn,
representing 50% of its total shareholders equity. This was significantly
higher than 26% and 4% of shareholders' equity for Morgan Stanley and ML,
respectively, in 2Q2008.

image016.gif

image017.gif

Of Goldman Sachs' total maximum loss exposure of $22.2
bn, nearly 40% is contributed by mortgage CDOs, with a substantially higher
loss rate ratio of 46.6%. Amid current dismal state of the CDO market triggered
by US housing woes and further aggravated by liquidity pressures, potential
losses from unconsolidated VIEs alone could nearly wipe off half the company's
shareholder's equity under the worst case scenario. In the wake of the tough
times expected in the mortgage and asset backed markets, we expect Goldman Sachs
to incur about $1.5 bn of its losses from unconsolidated VIEs, translating into
loss rate of 2.2%.


Despite transfer of assets into the level
2 category, Goldman Sach's level 3 assets remain the highest among its peers.

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

·
Money Panic

·
Bear Fight

·
The
Breaking of the Bear

·
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, 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)

·
Liquidity vs Insolvency

·
Bear Stearns Bear Market, Revisited

image018.gif{mospagebreak}

At the end of 2Q2008, Goldman Sach's level 3 assets
stood at 198% of tangible shareholder's equity, next only to Morgan Stanley at
226%. Earlier, in 1Q2008 Goldman Sach's level 3 assets to adjusted equity had
peaked to 258% before reducing in 2Q2008 due to transfer into level 2 assets
(note that this was not a disposition of assets, but an accounting transfer -
the risk is still on the books). However, despite very aggressive efforts to
reduce its level 3 assets through a combination of accounting moniker transfers
and sale transactions, Goldman Sachs still had a sizeable 7.2% of its adjusted
total assets in level 3 assets in 2Q2008, which was still the highest among its peers.
Level 3 assets, which are traded very thinly and with no observable market
price thus has valuations dependent on management assumptions, are most vulnerable
to mark-to-market write-downs. Level 3 assets write-downs for Goldman Sach,
which were until now shielded from loss by favorable derivative positions (and
gains resulting there from), could increase in the future with widening of
credit spreads off deteriorating macro-economic and financial market
conditions. We expect Goldman Sachs to report losses of $2.1 bn and $3.6 bn
from level 2 and level 3 assets in 2H2008 and 2009, respectively. {mospagebreak}

image019.gif

NR- not reported. Merrill Lynch has not reported its level
3 assets and total assets in the Q2 2008 earninGoldman Sach release on July 18,
2008

image020.gif

image021.gif

Relatively
high level 2 assets as a percentage of tangible shareholders equity:
In 2Q2008, Goldman Sach's level 2 assets increased
39.0% y-o-y to $562 bn despite a 9.5% q-o-q reduction over 1Q2008 as a result
of sale of assets, and stood at 1,422% and 52% of its tangible shareholders'
equity and total adjusted assets, respectively. This was significantly higher
than the figures of 892% and 27% for Morgan Stanley, and 730% and 26% for
Lehman Brothers, in 2Q2008. If one were to compare this to the now defunct Bear
Stearn's level 2 and 3 to tangible equity positions, it would be most
unfavorable, indeed.

image022.gif

image023.gif

NR-
not reported. Merrill Lynch has not reported its level 2 assets in the Q2 2008
earnings release on July 18, 2008

Possible
rise in losses in level 3 mortgage backed securities:
Following significant sell-offs in residential and
commercial mortgages in the second quarter of 2008, mortgage backed securities
accounted for 22.9% of Goldman Sach's total level 3 assets in May 2008, as
against 25.9% in February 2008. However, asset sales were primarily in
commercial mortgages and prime residential mortgages while the levels of the
riskier Alt-A and subprime securities were more or less maintained. Any further
widening of spreads off a speculation of increased losses and write-downs by
financial institutions and banks could trigger another, significant markdown of
asset-backed securities, particularly in Alt-A and sub prime categories. As
such, the remarkable decline (or more accurately, the lack thereof) in total
mark-downs of $0.9 billion in level 3 cash instruments (primarily comprising
losses on bank loans, bridge loans, corporate debt securities and other debt
obligations) in 2Q2008 from $2.9 billion (primarily comprising losses on
mortgage backed securities) in 1Q2008 is not expected to repeat at least in the
last two quarters of 2008.

Also, it is worthwhile to note the ABX indices
consistently continue to fall amid rising housing woes and fast declining
prices, raising concern over more write-offs in the coming periods.

ABX AA index

(Jan 10, 2007
to July 17, 2008)

CMBX AA spread index

(Jan 10, 2007
to July 17, 2008)

image024.jpg

image025.jpg

Source:Markit

Tough times anticipated in Goldman Sach
core businesses in light of the continuing slowdown in the global capital
market activities

Global
M&A slowdown is mirrored in Goldman Sach's slowing M&A deals:
Tightening global credit situation and growing
economic uncertainty, resulting in a significant pull-down of M&A deals in
the first half of 2008, have had a significant impact on Goldman Sach's
investment banking revenues. In the first half of 2008, revenues from Goldman Sach's
advisory services declined from $1,570 mn to 1,463 mn in the corresponding
period in 2007. The number of deals completed by Goldman Sach declined from 575
in the first half of 2007 to 368 in the comparable period of 2008. Weakening
corporate balance sheet, decreasing appetite for global M&A and perception
about further fall in valuation multiples, particularly in the emerging
economies, are holding up M&A transactions. In addition, with capital
market activities not expected to revive in the near-term, revenues for Goldman
Sachs from its investment banking business will be impacted in the second half
of 2008 and early 2009, in our view.

Equity
and debt underwriting hit by global IPO and bond issuance slowdown:
Fast declining stock market valuation multiples and
weak economic outlook have put-off a number of new equity and debt offering
planned for the first quarter of 2008. According to the Global IPO trends
report 2008 by Ernst & Young, globally only $40.9 billion was raised
through 236 IPOs in the first three months of 2008 as against $287 billion
raised through 1979 IPOs in whole of 2007. This
is a very significant slowdown that will hurt all in this space, from the leader
to the laggard, and it gets worse
. According to the data released by
Dealogic, the number of IPOs completed globally dwindled to just 188 in the
next three months of 2008. The situation is much worse in the US where the number of IPOs
(excluding REITs and SPACs) filed from January 1 to June 20 in 2008, fell to 56
from 140 in the similar period in 2007. Further, during the period the number
of IPOs hitting the market fell to just 23 from 91, while the number of IPOs
postponed or withdrawn due to adverse market conditions rose to 41 versus 13
last year.

Goldman Sachs witnessed a sharp fall in its
underwriting revenues, declining to $1,394 mn in the first half of 2008 from
$1,867 mn in the first half of 2007. The number of equity offerings completed
by Goldman Sachs in the first two quarters of 2007 stood at 31 as against 34 in
the first half of 2007. Although these numbers are dismal, they have yet to
match the drop witnessed in the actual equity offering market available to
underwrite, hence we see a sharper drop in revenues.

On the debt side, Goldman Sachs underwrote 123 new
offerings in the first half of 2008 compared to 194 and 312 in the first half
and full year of 2007, respectively. While the US
mortgage-backed securities issuance plunged 81.1% to $117.8 billion in the
first six months of 2008 from $622.1 billion in the same period last year, US
investment-grade corporate bond issuance witnessed a slowing trend, declining
31% q-on-q in the first quarter of 2008. The trend is not expected to reverse
in the near future as market sentiments remain subdued, the credit markets in
general are deteriorating and valuations are not perceived as attractive at the
current levels.

{mospagebreak}

Continuing
crisis in the global capital markets likely to impact trading and fee based
revenues:
The global investment landscape
continues to be hit by inflationary pressures in various economies of the world
as well as by the mortgage crisis in US. While on the one side, food and oil
price induced inflation is likely to threaten the global economic growth, on
the other side the housing crisis in US continues to haunt the US market and
cause a spill over effect on markets in other parts of the world, both in terms
of a contagion and as a catalyst for most of the major developed and many of
the emerging markets have their own housing bubble to contend with. As a
result, a high level of caution and skepticism is likely to stay at least till
the end of the year 2008.

This, in our view, will have a serious bearing on Goldman
Sach's trading revenues off slowing capital and financial market activities.
Further, the asset management business of Goldman Sachs is likely to get hit by
reduced investment activities and movement in assets under management from high
margin equity segment to relatively low margin fixed income and money market
segments.

Goldman Sach's asset quality has
downgraded over the past two quarters

Proportion
of lower rated over-the-counter (OTC) derivatives has witnessed an increase over
the last two quarters
: Of Goldman Sach's total derivative position as of May
2008, which comprised nearly 29.3% of total financial instruments as against
23.3% and 28.2% as of November 2007 and February 2008, respectively, around 89%
is OTC traded. Without the aid of centralized clearing exchange, we have the introduction
of counterparty risks, opacity in pricing/valuation and liquidity issues. Over
the last two quarters, the proportion of OTC derivatives rated below A/A2 has
increased from 21.6% in 4Q2007 to a significant 29.2% in 2Q2008, raising
concerns over deteriorating quality of Goldman Sach's derivative positions.

image026.gif

Although
the mortgage backed exposure shrunk substantially, some of the more risky
components remain intact
: After
substantial and aggressive asset dispositions in 2Q2008, mortgage-backed
securities accounted for 9.1% of the total financial instruments owned against
10.4% at the end of February 2008. The net reduction of $14 billion in the
mortgage backed securities primarily resulted off about $4 billion and $2.5
billion of sales in the residential and commercial real estate backed
securities, respectively, and net decline of $7.6 billion in the other loans
backed by commercial and residential real estate collateral. However, a closer
examination reveals that the reduction in the residential-backed securities was
primarily in the prime segment while the more vulnerable Alt-A and sub-prime
securities did not witness any significant decline. Further, while the
reduction in the commercial real estate-backed securities was entirely under
the level 3 assets, the reduction in other loans backed by real estate
collateral was almost entirely under level 2.

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Last modified on Thursday, 22 July 2010 00:53

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