S.C. Bernstein: Goldman Returns Affected by Leverage After All

Remember last month, when Lloyd Blankfein used this slide at an investor conference to argue that Goldman Sachs’ (GS) ROE doesn’t depend on lots of leverage, so the company’s returns wouldn’t fall as it slimmed down its balance sheet as it transitioned to becoming a bank holding company? We didn’t buy it either. Anyway, S.C. Bernstein’s Brad Hintz has the goods (sorry, no link):

Bernstein has found that Goldman's gross leverage ratios and quarterly ROE, since 2000, are closely correlated. Specifically, over Q1 '00 – Q3 '08, ROE and Gross Leverage have a correlation of 66%, while the firm's net leverage and quarterly ROE have a correlation of 65%.

The correlations improve significantly when we exclude four data points that represented outliers in terms of the market environment and returns for those respective quarters. Excluding these data points (Q2 '05, Q4 '06, Q1 '08 & Q3 '08), the correlation between gross leverage and quarterly ROE improves to 88% (from 66%). This means that the R-squareds jump from 43% to 77%. This stands in contrast to the company's recent claim that Goldman's move to lower leverage will not impact its ROE. [Emph. added]

Hintz then adds Goldman’s management might know this, too:

After all, basic arithmetic argues that ROE and leverage are somewhat correlated. And the investment bankers at Goldman are certainly aware that Modigliani-Miller1 found that there are advantages for a firm to be levered so long as the corporation can deduct interest payments from its taxes. This means that a leveraged company – like Goldman – will have a return on equity that is sensitive to changes in the value of its capital assets.

Makes sense to me! In any event, here’s Hintz’s version of Blankfein’s scatter diagram. It comports a lot closer to the generally accepted view of reality than the one Blankfein presented at the Merrill conference last month: