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The BoomBustBlog Review of Goldman Sach’s 2nd Quarter, 2010 Performance: I Told You So!
About three months ago, Boombustblog forewarned that GS will
stand out to be the worst hit in the event of trend reversal in the
financial markets and the company will have little means to escape the
implications of the same on its profitability and solvency. The company
generates 60-70% of the revenues from trading activities which is
largely dictated by the unpredictable turn of financial events. While
the financial markets were celebrating the US officially coming out of
recession in the 1Q10, the subsequent Eurozone crisis (see the Pan-European Sovereign Debt Crisis
series) and the slowdown of expectations in 2Q10 has beaten down the
irrational exuberance and the markets experienced spurt in volatility
and drop in prices. The consequent softening of trading revenues in 2Q10
vis-à-vis 1Q10 drove 31% drop in revenues and 82% drop in net income.
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)!
Surges in volatility not only hurt the profitability of GS, but also
raises questions over its solvency. 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.
Subscribers can download my full review of GS’s most recent quarter here: 
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 this overly 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.
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RM nails it again....
As an aside ...you have focused on one of the very reasons rates are so abnormally low....
There are many business models based on the no risk rate of return....If a project seems to be able to deliver a higher return than the no risk rate....then it has a chance of being funded....
But this is exactly the reason why "retirement" for the middle class will never happen....and that their future day one...will be that of servitude....In that they will simply never have the capital to retire because the tools and mechanisms to insure risk can only be utilized by firms such as GS....THE EXACT REASON FOR LOW RATES....Bernanke has missed this aspect....
This GS model needs to be pared down...such that "normalcy" of rates can return...and that years of hard work CAN be rewarded....
Or else the Princeton Harvard Yale club permanently seals the fate of those that are NOT IN THE CLUB....
In fact this is beginning to smell a lot like New Orleans and the COTTON days....
Or one can just look at what happened to the Estancias, French Chateaus, and Haciendas of old...and the once upon a time land aristocrats....
History repeats itself....but in a different way....
ie Are WMT and the GS models really good for the US middle class....?
Answer....NO
Think so ????
THINK AGAIN....
"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."
Then bank assets must not be allowed to depreciate. How illiquid does a central bank have to be before its credit approaches zero? I don't know but Gideon Gono would have a better idea than most.