Goldman Sachs Group (GS)

While the SEC probe might fail to bring a strong case to Goldman, its dirtied reputation has greatly increased scorn for the company from the general public. Goldman has also been criticized by the SEC Panel for failing to cooperate with it during its investigation. The panel claims that GS at first failed to provide necessary information and then provided far too many documents making it impossible to sort through them all.^[1] This continuous criticism of the company could increase the likelihood that Congress will regulate Goldman in order to appease the anger of the public.

The dislike for Goldman and Wall Street as a whole likely helped pushed the Volcker Rule onto the financial regulation bill. Once signed, the Volcker Rule will prevent companies which are federally insured from investing for their own benefit more than 3% of a fund's capital. This rule could severely limit Goldman Sachs which converted to a holding bank during the crisis and heavily engages in such trades.^[2]

The latest news coming out strongly indicates that AIG executives gave back their bonuses under possibly serious pressure from outside sources, including the government itself. Now that’s intervention that financials just don’t want, and if Goldman Sachs Group Inc (NYSE: GS) is any indication, it seems that they’re willing to go to some lengths in order to avoid it.

Goldman Sachs is in chats with U.S. regulators about paying back that $10 billion loan it received from the Fed last fall. While it hasn’t formally applied to give the money back, a source close to the situation said that GS hopes to give it all back in the next couple of weeks.

But it might not be as easy as just cutting a check and handing it over. Peter Sorrentino, who helps manage $13.3 billion at Huntington Asset Advisors in Cincinnati, puts it this way: “The regulators do want to keep all these guys on the same page. It’s like a chain gang; you’ve got them all in handcuffs. If you let some of them out, then you’ve got a couple off the reservation.”

Another concern is that if the government allows GS to pay back its debt to society, other companies who received bailout money will try doing the same, even though they really can’t afford to, thus creating another level of mess to the financial crisis. So right now, though the once-powerful financial might be desperate to get out of the line of fire that AIG has been standing in for months now, it might not have any choice but to take its turn in the public and government sights.

Goldman Sachs (GS) reported a larger than expected loss of $4.97 a share for their 4th quarter ended November 28, 2008 (GS FY 4Q Earnings Release). Analysts and investors were all expecting Goldman’s first loss, but analyst estimates were for a loss of $3.50. Sandler O’Neill analyst Jeff Harte said yesterday evening on Fast Money that he was comfortable with his estimate for a loss of $3.78 a share and thought that that would be closer to right than any estimates towards $5 a share.

This is Goldman’s first loss as a publicly traded company - they went public in 1999 - and the losses are all due to the trading and investing they do for their own accounts. Losses in their Fixed Income, Currency and Commodities (FICC) division were $3.4 billion, $2 billion of that coming from holdings of junk bonds/leveraged loans and commercial real estate backed loans and securities. Another $3.6 billion in losses came from their Principal Investments division. It’s worth pointing out that these are not real cash losses but mark-to-market losses. That is, they have marked down these positions, which they still hold, in accordance with the current market environment. The real value could be higher or lower.

Volatility of investments will impact returns. Goldman Sachs has a much greater appetite for risk than its competitors. While this has been a major driver of profits in the past, it also requires the firm put more value at risk every day than other investment banks. As a result the firm's performance is subject to greater volatility and highly vulnerable to any misjudgments regarding the firm's risk management capacity.

Private equity firms have been going overboard with acquisitions and takeovers recently, and it just isn't sustainable. The private equity industry has been buying more and more companies for higher and higher prices, and PE firms are running out of things to hurl their money at. Remember the dot-com bubble? People throwing cash at companies that, when actually looking at performance, weren't that great? Private equity's dangerously close to heading in the same direction. They've been buying up companies left and right, but at seriously inflated prices. This has been made possible by the tons of easy money made available by investment banks, institutional investors and others. Now that the credit markets have finally tightened, it will be much more difficult for private equity firms to fund good deals let alone justify ridiculous P.E. ratios.

Meanwhile, the investment banks are already struggling, especially Goldman Sachs. Though virtuallyall of the major investment banks have been unable to resist the allure of private equity, Goldman dove in particularly eagerly. Alternative assets (read: private equity and hedge funds) make up 21% of Goldman's total assets under management; Bear Stearns Companies (BSC) has the next largest percentage, with alternative assets composing 15% of its AUM. Goldman is involved with private equity in pretty much every way possible, from underwriting equities and debt to representing the company being acquired. The company doesn't provide many details about its private equity ventures, but as of July 2006, it was estimated that PE contributed 8% to Goldman's Q2 2006 pre-tax earnings, a substantial amount.

Principal investing gains is seen as non-recurring from the perspective of the market. Gains achieved through PIA are not fully accounted for under the company's stock price.

The SEC filed a civil lawsuit against Goldman Sachs, claiming that it had created and sold mortgage securities which were intended to fail. Regardless of whether the suit succeeds or not, GS has lost and will likely continue to lose clients due to its damaged reputation ^[1] Goldman has failed to win the bid to underwrite IPOs already due to its tarnished reputation. In particular, GS was not chosen to underwrite the over $2.54B Booz Allen Hamilton consulting firm. Instead, Morgan Stanley was chosen. Since the SEC suit started, Goldman's average underwriting has fallen 13%. The company's diminished reputation will translate to lost clients and lost revenues.^[2]

The Senate has asked the SEC to look into seven different growing financial practices such as high frequency trading, dark pools, and short selling. Goldman Sachs has heavily relied on these practices to extract large profits. While Goldman has testified to the SEC that these practices bring increased liquidity and efficiencies to the market, the SEC has already proposed a tightening on restrictions on the use of dark pools and more regulation on other instruments is probable.^[1]

In addition, Mr Obama and Paul Volcker, his chief economic adviser, announced a rule which would force banks like Goldman to choose between proprietary trading and their bank charter. This would force Goldman to switch back into a purely investment bank and prevent it from acting as a holding bank.^[2]

Goldman showed an impressive ROE of over 20% in the second quarter attributed to an improving macro environment. The stock has rallied since its low of $47.41 by tripling over the past six months. Now it’s time to move on to the next quarter. Following this V shape market recovery it is hard to maintain this growth heading into the third quarter. GS 2Q results are not sustainable, there will be a capital markets pullback with second half of 09 resembling 1Q results. This financial shakeout has a bit more to go before we can confidently say the deterioration of the global economy has subsided. Analysts estimate GS book value at $100, today Goldman is trading at a 60% premium. Expect the shares to pullback after earnings season is over.