Goldman is Ratcheting Up VIE Risk!!! More So Than the Top of the Bubble! Many Thought the Enronesque Days of “Hide the Sausage” Accounting Games Were Over

Note: Go through your sell side analyst’s quarterly update and if you don’t find these tidbits of information thoroughly explained, but instead see a Goldman fan boy(girl) cheering section, come back and subscribe to BoomBustblog. At the very least, we tell it like it is!

My opinion and updated valuation for Goldman and its 3rd quarter performance is available for download to all paying subscribers: File Icon GS 3rd Quarter 2010 Update. I will also be releasing large portions of our proprietary modeling to professional subscribers in the very near future to enable further analysis of Goldman and their fellow big banks. While I can’t spill the beans on the entire contents of the subscription document, there are a few issues and observations (as usual) that I would like to make public.

To begin with, I must commend Goldman’s management. They do a helluva job massaging numbers and attempting to right their ship, particularly in relation to some other banks. Anecdotally, I’m aware of their losing some talent on the equities side but I am sure they have no problem replacing it. There is also the issue of their subprime servicing unit, Litton Loans, which I am sure will bring them nothing but heartache in the near to medium term, but at least that aspect of the business has been recognized by the sell side, if not under appreciated in terms of potential risk. Despite its small size in relation to Goldman’s aggregate operations, it carries with it material reputation risk as well as the prospects for significant litigation and more.

Now, on to the aspects which the sell side decided not to cover – or somehow overlooked. Goldman was applauded for having strong accounting earnings. In Four Facts That BANG JP Morgan That You Just Won’t Hear From The Sell Side!!!, I warned of the danger at looking at accounting earnings as if they were actually a legitimate barometer of a companies actual economic value. If that were the case, wouldn’t accountants be the best investors in the world? I will delve into the folly of relying strictly on accounting earnings later on this missive as well, particularly in regards to a company with management as crafty and capable as Goldman – but before I do let’s realize that even those accounting earnings were down significantly from previous periods…

Trading revenues under pressure

Goldman Sachs posted Q3 net revenues of $8.9bn, a y-o-y decline of 28%. This is despite strong growth recorded at its investment banking and the asset management division which grew at 24.5% and 7.0%, respectively. The decline was principally led by dismal performance of the trading and principal transaction segment which declined 36% y-o-y as a result of weak market conditions. The decline in overall revenues despite strong growth recorded elsewhere underscores the importance of trading revenues in Goldman Sachs overall performance. Historically, trading and principal transaction segment contributed c60-65% of total revenues underpinning inherent risk in Goldman’s business model which is nothing short of a corporate hedge fund. We have expended considerable ink in demonstrating the overvaluation of Goldman Sachs and the volatility inherent in its revenues, particularly as they have been so dependent on trading – as many hedge funds are. As a matter of fact, I have been issuing this GS warning since 2009 when Goldman had perfect trading quarter and record trading profits. Reference last quarter’s quarterly update: 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!

Given the regulatory pressures pertaining to banks’ prop trading as a result of Dodd-Frank regulation and the Volker rule, Goldman Sachs is shrinking its propriety trading business. Recently, Goldman Sachs closed its proprietary trading desk in New York with Kohlberg Kravis Roberts (KKR) hiring nine traders from Goldman Sachs. With the egression of prop trading, GS would definitely lose some of its charm (premium multiples) and more fundamentally speaking the impact of bottom-line would be material considering the dependence of prop trading on the bank’s aggregate results. According to Bloomberg, it is estimated that nearly 10% of total revenues are derived from proprietary trading.

Goldman, unlike the rest of the street and practically the rest of the I banking world, is ratcheting up off balance sheet risk!!! Why is BoomBustBlog the only one inquiring as to WHY??? We have a few reasons in mind… And to think, many thought the Enronesque days of off balance sheet “hide the sausage” games have come to an end…

Although, Goldman Sachs capital ratios have improved it has nothing to do with reduction in risks weighted assets. Risk weighted assets to the corollary have increased to $444bn as at end Sep 2010 from $409bn and $380bn as at end Sep 2009 and end Sep 2008. One of the key reasons for the increase in capital ratios have been dilutions. To give a perspective, Goldman Sachs diluted shares outstanding have increased by c25% since beginning of 2008.

Click to expand…

VIE loss exposure still increased compared to pre-crisis levels

Maximum loss exposure from unconsolidated VIE has increased compared to pre-crisis levels. Although loss exposure as proportion of VIE assets have declined due to dramatic increase in assets, absolute loss exposure has actually increased. In addition, we are also concerned about dramatic increase in GS’ VIE assets during a time when companies globally are talking about de-leveraging. Goldman Sach’s VIE assets have increased to $110 billion as of June 30, 2010 from $67bn as of December 31, 2009 while maximum loss exposure from unconsolidated VIE have increased to $18.5bn as of June 30, 2010 from $18.1bn as of December 31, 2009. Maximum loss exposure from unconsolidated VIE as proportion of tangible equity was 30% as of June 30, 2010, a marginal decline over Dec 2009 due to an increase in shareholders’ equity.

Is Goldman Ratcheting Up Its Risk Profile In and Attempt To Recoup the Nearly Guaranteed Loss of Bonus Earning Power of FICC and the Prop Desk??? If So, the Equity Owners Will Be the Bag Holders (Again) If the Shit Hits the Fan (Again)…

As excerpted from Four Facts That BANG JP Morgan That You Just Won’t Hear From The Sell Side!!!“

…accountants have not been – and currently are not, trained in the economic realities of corporate valuation. They are trained to tabulate business operations data. There is a marked and distinct difference. That difference is as stark as night and day for investors, yet despite this stark difference, Wall Street still reports corporate performance metrics strictly in accounting terms, and the media (both mainstream and the more specialized financial media) simply follow suit. Hence we hear much about easily manipulable and manageable accounting earnings, revenues, operating margins, earnings per share, etc. These measures are highly flawed in a variety of ways, with the primary flaw being that they do not account for the efforts both required and undertaken to achieve them. Basically, they measure JUST HALF (and coincidentally, the positive half may I add) of the risk/reward equation that should be at the root of every investors move. Long story short, they do not account for, nor do they EVEN RESPECT, the cost of capital. This concept ties in closely with Chairman Bernanke’s current course of action as well as the ZIRP discussion later on this missive demonstrates (capital offered at zero cost causes reckless abandonment of risk management principles which eventually causes crashes – yes, more crashes). Acknowledgment of the cost of capital enforces a certain discipline on both corporate management and investors/traders. Without respect for such, it is much too easy to create and portray a scenario that is all too rosy, since we are only looking at rewards but never bother to glance at the risks taken to achieve said rewards. I reviewed this concept in detail as it relates to bonuses and compensation on Wall Street in The Solution to the Goldman (and by Extension, the Securities Industry) Compensation Dilemma.

Net revenues, net profits, and earnings per share are totally oblivious to what took to generate them. As a result, anyone who adheres solely to these metrics is probably oblivious as well to what it takes to generate these measures. It’s really simple, put more money into the machine to get more money out – damn the risks taken, or the cost of the monies used. This has been the bane of Wall Street for well over a decade, is the direct and sole reason for this current crisis, and is the reason why bonuses based upon revenue generation alone engender systemic risk. Just sell more, do more, to get a bigger bonus. It doesn’t matter what you sell or who you sell it to, as long as it blows up AFTER the bonus is paid. This short term-ism is now so deeply ingrained within the investor psyche as to allow companies’ to rampantly destroy economic shareholder value with the abject blessing of the shareholders, with cheer leading by the analysts – as long as those accounting earnings per share keep rolling in higher and higher!

Ignoring the cost of capital inflates returns by default, because those returns were never costed in the first place. The problem is, ignoring something does not make it go away. Capital does have a cost whether you acknowledge it or not, and if you ignore that cost you may skate for awhile but eventually it will come back to reassert itself, and often with a vengeance towards the wayward investor.

This material tilting of the risk/reward equation would be obvious to most and many, if they would look at the true economic numbers and stop following accounting numbers!

In What Do Goldman Sachs and B.B. King Have in Common? The Thrill is Gone…,, I made the following note:

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 ) .

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Goldman is Ratcheting Up VIE Risk!!! More So Than the Top of the Bubble! Many Thought the Enronesque Days of “Hide the Sausage” Accounting Games Were Over

Is Goldman Ratcheting Up Its Risk Profile In and Attempt To Recoup the Nearly Guaranteed Loss of Bonus Earning Power of FICC and the Prop Desk??? If So, the Equity Owners Will Be the Bag Holders (Again) If the Shit Hits the Fan (Again)…

Recommended recent reading from Reggie Middleton’s BoomBustBlog in the investment banking space…

More on Goldman Sachs

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Goldman is Ratcheting Up VIE Risk!!! More So Than the Top of the Bubble! Many Thought the Enronesque Days of “Hide the Sausage” Accounting Games Were Over

Is Goldman Ratcheting Up Its Risk Profile In and Attempt To Recoup the Nearly Guaranteed Loss of Bonus Earning Power of FICC and the Prop Desk??? If So, the Equity Owners Will Be the Bag Holders (Again) If the Shit Hits the Fan (Again)…

Recommended recent reading from Reggie Middleton’s BoomBustBlog in the investment banking space…

More on Goldman Sachs