Goldman Sachs: Perils in the Fine Print

Moody’s downgraded Goldman Sachs (GS) on Tuesday. But that long-term rating cut did nothing to dampen the enthusiasm of investors who were buoyed by the fact that Goldman’s fourth-quarter loss of $4.97 a share did not signal an impending disaster (see conference call transcript).

Quite obviously, the proposition that a government-backed Goldman Sachs will survive the credit crisis is being confused by the “former” investment bank’s capability to generate credible earnings. Tuesday’s closing price ($76) constitutes an excellent opportunity to establish or, to add on to, short positions. The fine print within the 8-K filing provides ample cause for bearishness through 2009.

The 8-K filing (Footnote 6) clarifies that fair value asset measurements (SFAS NO. 157) utilized in Tuesday’s report represent “preliminary estimates” only and that such measurements are subject to adjustments in the Annual Report (Form 10-K) for the fiscal period ending November 28, 2008. In other words, investors will have to wait for a few more weeks to find out (a) what quantum, if any, of the $340 billion of Goldman’s Level 2 assets are at risk of being transitioned to Level 3 in the face of the post-August 29 deterioration in market conditions and (b) to what extent the $66 billion worth of Level 3 assets have already inherently damaged capital-adequacy ratios and earnings guidelines analysts are deriving from the 8-K filing.

For that matter, Goldman’s entire balance sheet is, in many respects, a moving target; the Tier 1 ratio of 15.6% and total assets of $885 billion are both subject to revisions, or significant qualifying statements, in the next Annual Report. Needless to add, the waters are being muddied by Goldman’s strategy of transforming itself into a bank, without any specifics in the public domain, and by the false perceptions, in this recessionary environment, that mere reductions in borrowing costs will create improved spreads on lending which, in turn, will generate real returns for shareholders.

In September, Goldman secured a $5 billion preferred-stock investment from Warren Buffett’s Berkshire Hathaway (BRK.A) and raised $5.75 billion by selling common shares (at $123 per share) to investors. Then, in October, Goldman received $10 billion from the government. But how much of this additional capital will be sucked up by losses on its asset portfolio as the recession deepens, and how much will (or, can) be employed productively? Any bullishness on Goldman Sachs is without validity until this key question is answered.

Goldman’s Chief Financial Officer, David Viniar, himself aptly summed up the near-term outlook for Goldman Sachs in an analyst conference call: “We’ve done what we needed to do now, and whether we shrink or grow next year is going to be largely dependent on what happens in the world.”

So place your bets accordingly today. Because the 8-K reveals that the future shapes of Goldman’s core businesses do largely depend on what happens in the world. For example, investment banking revenues ($1.03 billion) for the fourth quarter were down by 48% from a year earlier, and by 20% from the third quarter. Management admitted that the transaction backlog is now “significantly lower” and that there is no indication whatsoever that any turnaround in the downward trend is imminent at any point in the foreseeable future.

Most critical of all is the 8-K’s failure to address the manner in which the fourth quarter negative revenue number ($4.36 billion) relating to “trading and principal investments” has been cushioned by the bailout packages supporting Goldman’s counterparties on Wall Street, by delayed rating downgrades, by mortgage debt relief and by sharply lower benchmark interest rates. Or perhaps Goldman Sachs has now simply become a classic example of the Bernanke-Paulson “finger-in-the-dyke” vision of boldly betting on the unkowns: if you keep the firm operating long enough, somehow, events will ultimately remedy the most fundamental of flaws in asset valuations.

Disclosure: Author holds a short position in GS

Comments

[Think-About-It:]

Rakesh,
Thank you for your thoughtful overview of GS. Now I will have to do some digging.

Do you think there a better short candidate in the financial space?

2008 Dec 17 11:35 AM

[freefall51:]

Rakesh,

I noted recently that you came up with some insightful blogs. I added you to my watch list.

Thanks.

2008 Dec 17 05:26 PM