Betting on Goldman's Future

After the Federal Reserve Board paved the way to transform Goldman Sachs (GS) into a bank on Sept 21, 2008, I expressed doubt that GS was worth its $130 share price at that time. For the next two weeks, GS gyrated wildly around (mostly below) $130 and has not been that high since.

Warren Buffett's sweetheart deal for a piece of Goldman brought a temporary reprieve to the selling. But since mid-October, GS has been on a steady and sure decline to $62 - a near all-time low, and less than half its value just two months ago. GS has been beaten up by persistent analyst downgrades and a growing sense that this decline in the shares means that "something is seriously wrong" with GS. It is a wonder that the on-going liquidation and exit from GS positions has proceeded in such an orderly fashion these past several weeks.

Given the growing negativity surrounding Goldman, I was a bit surprised to read a piece in today's Wall Street Journal by James Stewart titled "How Investors Can Get In On Buffett's Goldman Play." My first reaction was to say "why bother" betting on Goldman's future when even Buffett is now so deep underwater on his GS investment? Why bother when it seems that Buffett has slipped in the footsteps of so many other big money men who have been scalded the last 12 months trying to play value investor in financials?

It turns out that Mr. Stewart is a long-time investor in GS, so he can be excused for wanting to come up with some positive rationale for clinging to those holdings. Stewart's Buffett play is to buy Jan 2010 calls to achieve the $115 strike price on the warrants.

For some downside protection, Stewart recommends nabbing Goldman bonds which are now trading for 80 cents on the dollar. He purchased some bonds yielding 10%. Although such a high yield effectively puts Goldman in junk bond status, Stewart finds comfort in the seniority of these bonds and the government's incentive to do what it takes to keep Goldman alive: "Note that these Goldman bonds are senior to both Mr. Buffett's preferred stock and the government's, which means bond interest and principal gets paid before either Mr. Buffett or the Treasury. Even in the unlikely circumstance that Goldman would be facing default, the U.S. would have a strong incentive to inject more capital into Goldman."

OK. Good point perhaps. Goldman probably has a much better chance of surviving than the other investment bank disasters of 2008 given its direct and active partnership with the Treasury and the Feds. We taxpayers are being generous with corporate welfare, so maybe there is some residual I as a taxpayer can gain from this situation (besides the social good of financial stabilization).

This prospect is enough to get me to look one level deeper. I am not interested in purchasing Goldman bonds since I am not convinced such a purchase is a good way for a retail investor to get some downside protection. So I focus on the options and finding downside protection with them.

Whenever Stewart wrote his article, the Jan 2010 $105 calls were selling for $10. Buying at that time would achieve Buffett's $115 strike. The Jan 2010 $105 calls are now trading at $8.05/$8.55 (bid/ask). That is already at least a 15% loss in just a few days. Given the very real downside risk (and extremely high implied volatility in the options), I think a call spread would be much more prudent.

For example, the Jan 2010 $105/$100 call spread costs at most $1.65 (depending on how you resolve the large bid/ask spreads). So, if GS reaches at least $105 by January, 2010, we get $3.35 upside. That is still $10 below Buffett's strike, and you get a 200% return on the spread while the stock gains 70%. Not bad for a low-risk 14-month investment. There are other spread options with similar cost profiles.

Of course, if you insist that Buffett nailed this one, if you insist that the 50% loss in just 2 months is only a temporary set-back, capping your potential gains at 200% on the calls will not look attractive...even if you need Buffett's warrants to go 14% in the money to achieve the 200% return.

If the downside risks mean nothing to you, then by all means, buy the (expensive) calls outright. But I am arguing for caution by proposing the call spread as a substitute. Even Treasury Secretary Henry Paulson admitted in his recent New York Times Op-Ed that "we are going through a financial crisis more severe and unpredictable than any in our lifetimes." He reiterated this warning in recent testimony before the House Committee on Financial Services: "we have not in our lifetime dealt with a financial crisis of this severity and unpredictability."

So on what basis can you really count on any specific outcome in the stock market just 14 months from now? If you want to pump up the absolute returns on this play, trade in the $8.55 for 5 call spreads. (Note that I am not considering buying puts for long-term protection given their extremely high cost. I am also assuming that someone who wants to consider this play must expect GS to survive the next 14 months and to have a higher stock price by then.)

So what is GS worth? I have no idea, and I am skeptical anyone else can assign a reliable number. GS is trading at almost half its book value, but if we have learned nothing else from this latest financial crisis, we should understand that book value means almost nothing for financial stocks, especially in a crisis economy. What is not created out of thin air can disappear into thin air just as easily.

Now that the Treasury will not use its $700B authorization to purchase toxic mortgage-related assets, we will have to wait even longer for price discovery to work its way into the dark matter of the financial system. In the meantime, Goldman's steady downtrend suggests more downside to come. I will remain on the sidelines: guilty until proven innocent. The next trial (earnings) are another month away on December 18.

Be careful out there!

Full disclosure: No related positions. For other disclaimers click here.

Comments

[investor88:]

Good conclusion "be careful out there".

2008 Nov 19 08:17 AM

[sunil94062:]

You are correct - Buffett seems to have been not so smart, with several of his recent bets - GE for example? Phew - what a disaster?

Shows that he is after all not a genius and surely not as precient as we "pedastal" mount him to be. He looks about as 'small' as any hedge fund dudes or private equity dudes - all mostly mediocre investment pro's.

Goldman, Morgan Stanley, DB and other high-fluted Investment Banks all were giant "Casino's" trolling large unregulated waters, with OPM and probably front-runners of most in-the-money trades and that is how they used their proprietary knowledge to make money. This charade had to end one day and it has.

Now that we know the "color" of this scheme, it is but obvious that the emperor wears no clothes!

Now: How to make money in a regulated world? That is what Blankfein now sees, as does Mack and as does Al Waleed. This gig is over.

True value of this GS franchise, is far less than this $62/share.

I am surprised to read that you do not know what it is worth? It is plain to value it - using a simple DCF model, stretched to 7 or 10 years and using a reasonable discount rate of say 15%, and to my view, GS should hard pressed to be worth about half of what it is trading at. I assume its ability, at best as a Commercial Bank is to make about 200 bps on the total capital it has. Its total capital base is published.

No?

2008 Nov 19 08:39 AM

[Dr. Duru:]

Note that as of typing, my submission contains a few numerical errors on calculating returns. I hope to get them fixed soon (they are corrected in the original piece on my site). The return on the call spread is 200%. And the straight call required Buffet's warrants to be 14% in-the-money to get a 200% return in January, 2010.

Sunil94062: I would love more detail on how you came up with your valuation model...

2008 Nov 19 08:46 AM

[axelrod608:]

> So what is GS worth? > I find it hard to believe that anyone can write an article about Goldman - or any other finco - without addressing the topic of what they have hidden in their level 2 and 3 portfolio of assets/liabilities. The REAL reson banks won't lend to one another is THEY KNOW they all have a lot of garbage there.

If there were true transparency, I doubt you'd find one in ten you'd trust even with your lunch money.

2008 Nov 19 09:42 AM

[HBWOW:]

I believe GS' dealings in the past are finally catching up with them, hence their request to become a BANK (wow, wow and wow). They and Morgan Stanley are a pair to behold and never should they have obtained bank status. (Thanks to GS X employee, Paulson). These two deals with the AIG sinkhole suggest the real reasoning behind the "Bailout". The Boyz then play favorites within the real banking world, picking and choosing based on WHAT???? I also like the preemptive "deals" tried by FDIC which did not work on Wachovia but did work on my NCC (picked up for song by PCN).
NOW the government doesn't want to bail out GM and Ford after the above highly questionable favoritism based dealings.
We the public get to lose stock investment value (holders of these stocks) and at the same time are responsible for the future tax revenue to fund these bailout transactions - double dip.

2008 Nov 19 11:32 AM

[JasonC:]

sunil - um, can you add?

Goldman has a $1 trillion total asset base, and US banks routinely net 1% on assets in ordinary times. In the past Goldman has exceed that by a factor of 1.5 routinely, but ignore that. In ordinary times, one can expect Goldman to earn something like $10 billion. Since they made $11.6 billion in 2007 and $9.5 billion in 2006, this is clearly an achievable figure.

Now, suppose they make nothing for the next 2 years. Suppose they never grow at all, forever. Suppose you require a 15% rate of discount. Then they are worth 6.67 - 1 - .85 times their typical $10 billion earning power or $48.2 billion. The market cap this instant is half of that, $24 billion.

Meaning, the present price discounts a 50% chance of the above zero growth outcome and a 50% chance of an outright bankruptcy and value of zero. And returns an expected 15% on that coin toss, plus any growth in the event of a "heads".

Or, if you want to express it as a higher discounting rate on those cash flow assumptions, then Goldman is currently priced at a 24% rate of discount, plus any growth ever achieved.

The smashed to heck financials are screaming buys unless they go bankrupt. All the current pessimism is unjustifiable in any value analysis, it is the result of pure news and momentum trading perspectives, not value perspectives. They might go bankrupt. Or some might, and some might not. I sincerely doubt half of them will or that those that survive will never grow again, ever.

Value investors are already buying. That isn't calling a bottom but it is calling a level.

2008 Nov 19 12:17 PM

[MichaelZZ:]

BANKING “CRISIS”

One cannot resolve a problem unless one understands the problem.

PROBLEM: Financial institutions have reduced their lending.
The problem results from the impaired equity portion of the balance sheets of these institutions, with the impairment caused by write-downs of their assets (loans).

Due to the losses they have taken, these institutions, by law, have had their maximum potential lending amounts reduced.
The amount they are able to lend is contingent upon the amount of their equity capital (EC), e.g., if an institution has an equity capital of one billion dollars and is able to lend up to 20 times its equity capital, it could lend up to 20 billion dollars.

After taking loan write-downs (losses) of two hundred million dollars, its EC would now be 800 million dollars, thus it would have its maximum lending authority limited to 16 billion dollars, i.e., a constriction of its legal authorization to lend.

This is the crux of the problem.

The institutions have funds, i.e., liquidity. But, without the legal authority to increase lending, they are sitting in stagnant water.

Those who say that one going to one’s ATM for a withdrawal may find a closed sign are, absolutely, lying or ignorant.

If one is a Representative or Senator and is lying, he or she should be Impeached and removed from Office.
Likewise, if that Representative or Senator is ignorant, he or she, apparently, is not, adequately, accepting his or her fiduciary responsibility of understanding a subject prior to advocating or voting for it, thus he or she should also be Impeached and removed from Office.

PAULSON PLAN: Purchase impaired mortgages from financial institutions with taxpayer funds.
Indeed, this would positively affect an institution’s EC, because the impairment (loss) would have been transferred to the taxpayers. This reversal of loss would be achieved by paying face price rather than market price, since if the market price were paid, there would be no effect upon EC.
This contemplated action is anti-capitalistic, immoral, and a method of stealing from taxpayers.
The taxpayers did not cause the capital impairment (this IS the problem, i.e., “It’s the balance sheet, stupid”).

Anyone involved with designing this scheme and voting for it should be incarcerated as co-conspirators to steal from the citizenry.
The scheme’s authors and those who advocate for it would be precipitating an admission that capitalism doesn't work, which is a lie.
Capitalism is the best economic tool ever devised, but as with any tool, it can be and has been abused.
Congress should accept most of the responsibility for creating the economic atmospheric conditions that enabled the abuse.
Further, any resolution of this financial phenomenon will not abate the underlying problems of the economy.
It is not the lack of lending that has damaged the economy. It is the economy, affected by greed, that has damaged the lending, but, of course, if appropriate corrective actions are not taken in regards to this financial phenomenon, our weak economics will be adversely affected.

If the Paulson plan were adopted, it would be the most massive SPE by multiples, the dollar would weaken, interest rates would go up, thus the decline in home prices would be exacerbated, and the EC would require further resuscitations.


BEST PLAN (Recapitalization):
1) Allow some institutions to go the route of Countrywide, Bear Stearns, IndyMac, and Washington Mutual. I, also, like the AIG model.

2) Most rational institutions will do what UBS, Merrill Lynch, Goldman Sachs (just recently with Warren Buffett) have done, i.e., they have raised additional EC, usually by selling preferred stocks.

Months ago, when Merrill sold 6 billion (as I recall the amount) dollars of preferreds paying 9%, I knew they were desperate, and that this was just an early domino.
Goldman Sachs, from what I have heard, is paying Buffett 10% for the preferreds. Keep in mind; this is after-tax money. The only reason for Goldman Sachs to take a desperate (GS also gave Mr. Buffett 43,000,000 warrants to purchases GS common @ $115 per share) action was because it knew it was experiencing an EC impairment and needed to raise additional EC.

Please keep in mind that pain is not all bad. It is a signal that something is wrong and indicates that the source of the pain (problem) must be determined, analyzed, understood, and finally the best alternative action must be taken.
We are experiencing pain regarding this financial phenomenon.

3) As a last resort, it would be appropriate for the government to establish a fund (call it the RTC 2.0 AKA Peoples' Financial Fund) and use those funds to purchase (just as have Mr. Buffett and others) preferred stock from institutions. The fund should follow Mr. Buffett’s lead and demand additional potential remuneration in the form of long-term warrants.
The stock would receive dividends and would have a convertible feature to convert to common stock, at the option of the fund.
Further, until certain parameters were met, the preferred ownership would assume voting control, thus the matter of executive compensation would be moot.
We either believe in capitalism or we don’t.

We will have displayed a pragmatic solution well within the parameters of capitalism.
The U.S. dollar will strengthen.
The next step would be to address the underlying economics with the basic problem being unbridled greed.
We should not have a "shot" stimulant as we did earlier.
We need to eliminate the largess given to the very wealthy, in error, by the Bush tax cuts, and to reduce taxes on the middle-class on a permanent basis.
This will have an immediate positive effect upon our economics and we will be on the path to a rational economy.

Michael Zitterman
Sherman Oaks, Ca.
[e-mail]
[e-mail]
818-988-2792

Concept: These institutions should have gone out and should be going out raising equity capital via common and preferred stock.
Taxpayers' Role: The taxpayers (a taxpayers' mutual fund) should offer funds by offering to purchase preferred stock with favorable conversation features, but with a reasonable buy-back, and substantial warrants to purchase common. These parameters should be more costly to the institutions than the "marketplace" to entice the institutions to raise the requisite funds from private sources, rather than the taxpayers, but the taxpayers would be there as a backstop.

2008 Nov 19 03:30 PM

[dlaw:]

Hmm, do you think Paulson's assessment that we might need some of that TARP money later might have something to do with his knowledge of GS?

2008 Nov 19 07:36 PM

[JasonC:]

"The taxpayers did not cause the capital impairment"

Um, who do you think stiffed the banks for $1 trillion, martians?

The taxpayers are reckless insurance underwriters - they wrote huge acres of credit default swaps on all banks, and they had to intervene to save their position in those swaps. Sure, they called it the FDIC, but that is exactly what it is.

The taxpayers are reckless lenders; they hold CDs at banks, and that is reckless.

Pick which hat you want to be wearing when you take the loss. That the loss is yours is baked in.

Trying to allocated a $25 billion loss to the bondholders of Washington Mutual instead of the FDIC was sufficient to close the bond market for all banks.

You *will* pay for *all* of the costs of the services of capital, or there flat isn't any. Lenders do not pay credit losses. Borrowers pay every cent of them, in higher rates in real terms.

This isn't a policy decision and your political powers and agitations and hatreds are utterly irrelevant in the matter, as are your stridently pointless moralizing principles.

Capital *value* is supported by only one thing, real returns to capital risked. Take away the returns and you pay them twice over plus a doubled risk premium, but you pay them. If you don't, capital evaporates and you will receive none of its services.

Law of nature. You can't repeal it, you can't fight it, you can't command it. The banks will be paid, in full, for every dime of their credit losses past and to spare, or you go straight to hell.

2008 Nov 19 09:51 PM

[Bobco23:]

Great post Michael. You have identified the problem and the solution.


On Nov 19 12:17 PM JasonC wrote:

> sunil - um, can you add?
>
> Goldman has a $1 trillion total asset base, and US banks routinely
> net 1% on assets in ordinary times. In the past Goldman has exceed
> that by a factor of 1.5 routinely, but ignore that. In ordinary times,
> one can expect Goldman to earn something like $10 billion. Since
> they made $11.6 billion in 2007 and $9.5 billion in 2006, this is
> clearly an achievable figure.
>
> Now, suppose they make nothing for the next 2 years. Suppose they
> never grow at all, forever. Suppose you require a 15% rate of discount.
> Then they are worth 6.67 - 1 - .85 times their typical $10 billion
> earning power or $48.2 billion. The market cap this instant is half
> of that, $24 billion.
>
> Meaning, the present price discounts a 50% chance of the above zero
> growth outcome and a 50% chance of an outright bankruptcy and value
> of zero. And returns an expected 15% on that coin toss, plus any
> growth in the event of a "heads".
>
> Or, if you want to express it as a higher discounting rate on those
> cash flow assumptions, then Goldman is currently priced at a 24%
> rate of discount, plus any growth ever achieved.
>
> The smashed to heck financials are screaming buys unless they go
> bankrupt. All the current pessimism is unjustifiable in any value
> analysis, it is the result of pure news and momentum trading perspectives,
> not value perspectives. They might go bankrupt. Or some might, and
> some might not. I sincerely doubt half of them will or that those
> that survive will never grow again, ever.
>
> Value investors are already buying. That isn't calling a bottom but
> it is calling a level.

2008 Nov 19 10:00 PM