How to Profit from Goldman Sachs

Due to the credit crisis, the investment banking model is broken. Current stand alone investment banks are racing against the clock to find reliable funding source for their outsized portfolios. That being said, investment banks are voracious capitalist market makers with tremendously talented people. Goldman Sachs (GS), the highest class of the bunch, has produced many powerful government officials and has led the world in financial innovation and ability to make profits facilitating markets.

How can you profit from this situation?

Recently Warren Buffett, at a pivotal time for GS, invested $5B in perpetual preferred shares of Goldman Sachs yielding 10% at par. If I were to read the tea leaves on why Warren Buffett made this investment, I would say Warren believes that despite all of the problems that Goldman Sachs has, its track record as a profit machine will attract a white knight. Thus even if the credit crisis were to continue relentlessly and deplete all on-hand resources for GS, at some point prior to any default event a buyer will take the company private, making all preferred shareholders whole in the process.

What examples do I have for this thesis? Think about Warren Buffett and Salomon Brothers. That position started with an initial investment in preferred shares of the investment bank also. Second, look at the arrangement that PIMCO holds with Allianz (AZ) as an independent subsidiary of Allianz insurance conglomerate. PIMCO has no liquidity problems despite having just as many leveraged positions.

This being said, no one can predict when the white knight will appear. In the process, Goldman could lose another 25%, or 50% or even 75% or more of its stock price prior to being rescued. The common stock holds the greatest risk in this case, even though all classes of securities in the capital structure would suffer greatly.

Thus the position proposed is the following:

• Long - Goldman Sachs A Series - Non-Cumulative Preferred Securities - Floating Rate
• Short - Goldman Sachs - JAN 10 $55 put contract (Or if you do not use options then short GS common shares directly at above $84/share)
• Buy 1 put contract for every 100 preferred shares purchased (Or short 100 shares of common for every 100 shares of preferred purchased)

Any investor should "leg" into this position. Buy puts at below $9 and buy the A series at $9/share or below.

Disclosure: The author is currently long GS preferred A Series and short GS common using puts.

Comments

[Vox Rationalis:]

The more I look at this article, the sillier it gets.

"If I were to read the tea leaves on why Warren Buffett made this investment, I would say Warren believes that despite all of the problems that Goldman Sachs has, its track record as a profit machine will attract a white knight."

This is not why Berkshire made the investment. Perhaps this scenario played a small role in the risk assessment, but I find it fanciful to believe that Berkshire placed any significant likelihood on GS needing a "white knight."

The reason for the investment was quite straightforward. Blankfein asked Buffett what it would take for him to invest, and Buffett described the offer he could not refuse.

How about taking Buffett at his word, and taking the investment at face value? "Goldman Sachs is an exceptional institution," Buffett said. "It has an unrivaled global franchise, a proven and deep management team and the intellectual and financial capital to continue its track record of out performance."

And the terms for the $5B investment? 10% annual dividend until GS decides to retire the issue for $5.5B, plus warrants for $5B of GS common at $115 exercisable at any time before September 2013.

And then there's the pricing. Buy the preferred below $9? The preferred closed Friday at $13.41. It has closed below $9 for exactly 2 days - ever. There have been exactly 6 days when it traded for $9 or less. So, sure, if it ever gets to $9 (where it would be yielding better than 10.4%), it's a buy. But I wouldn't hold my breath waiting for it to lose a third of its value.

Now, the sub-$9 put. The Jan10 55 strike put (YFTMK) skyrocketed from September to November, peaking at 22.75 on November 21, unsurprisingly on the same day the common and preferred bottomed. These puts closed the year at $9.17, so there's no reason to think they won't go a touch lower.

But the combination of the sub-$9 preferred and the sub-$9 put? Ridiculous. Note that when the preferred has been sub-$9, the least one could have bought YFTMK for was $11.9 on September 18. More recently, when BSPRA was sub-$9 for three days in November, YFTMK traded up from the $18-range it had been in for a week to the $22 level.

The point of pairing these two would be to reduce risk. Since there is no chance of getting these two investments at $9 simultaneously, one would have to buy one and then have it appreciate dramatically before the other would fall enough to reach the target price. If it were me, I would be selling at that point rather than buying protection.

Jan 05 09:06 AM

[Lockstep In...:]

Mr BS,


1) Regarding the Buffet's preferred investment: If Buffett thinks that GS will continue to be able to pay the preferred, then it is logical to get on the same level of the capital structure. The comparing the terms Buffett got with your own is irrelevant when you are looking at the security of your own investment. The key thing is making sure GS pays out even through short selling attacks and economic uncertainty.

2) As for the price proposed for buying the preferred, it seems we are at odds of how to observe the market condition. With every major credit event in 2008 there was increased uncertainty of leveraged institutions to stay solvent. There will be more in 2009, and with each one there will be another opportunity to buy income securities at an increased discount. So what if GS-A has bounced up because of Treas-Corp yield spreads in the last two months? One major BK event in the market will cause the spreads to explode again. This will be the time to buy. This is the logic in the preferred price I put forward.

3) The put price is a great place to get in from a technical perspective and in terms of value. The key for me is my belief that the markets have more credit blowups coming sooner rather than later. In which case, $9 YFTMK are cheap.

4) As for the order of the purchase, I don't think pair positions need to be purchase simultaneously. I don't have VaR measures constraining my positions, so I can be more lenient with approach.

Remember the premise, GS is on a time clock to completely overhaul to a much less profitable business model. There is only downside from a income perspective, but the market valuation is the part to be hedged using different parts of the capital structure. The preferreds happen to be the volatility most similar to the common shares of GS.

Jan 05 06:08 PM

[jhadec:]

Did Buffet make his investment before or after the government infusion?

Jan 05 06:24 PM

[Vox Rationalis:]

"Regarding the Buffet's preferred investment: If Buffett thinks that GS will continue to be able to pay the preferred, then it is logical to get on the same level of the capital structure."

Fine! But giving a suggested buy price that's more than 30% less than the current price is close to meaningless.

"[C]omparing the terms Buffett got with your own is irrelevant when you are looking at the security of your own investment."

Wait a second - didn't you JUST WRITE "If Buffett thinks that GS will continue to be able to pay the preferred, then it is logical to get on the same level of the capital structure"?

"One major BK event in the market will cause the spreads to explode again. This will be the time to buy. This is the logic in the preferred price I put forward.

I believe your premise is flawed. There's not likely to be another major bankruptcy among financials; the feds made that pretty clear with their actions related to Citi. But let's go with it anyway - you're saying there will be a bankruptcy and GSPRA will dive as it did three times last year. Fair enough - I think you won't see that level again, but I'm just another amateur with an opinion.

"The key for me is my belief that the markets have more credit blowups coming sooner rather than later. In which case, $9 YFTMK are cheap."

Again, fine, I understand why you think YFTMK is cheap. But suppose you buy YFTMK at today's price of $7.65. Now, fast forward to your inevitable major credit event that drives the preferred down 33% to $9, your target buy price. What happens to YFTMK? It's likely to be back to $15 or so. Unless, of course, we've gotten meaningfully closer to expiration, in which case it won't get as high.

So then what do you do? Would you still find the puts to be cheap, or would you hold them as a (very expensive) hedge against bankruptcy after you buy GSPRA? I would almost certainly be selling the puts, as my assessment would likely assign a very small likelihood of GS falling under $40 (consider that book value - which is probably somewhat high - is currently more than $100/share). I also, as said before, would find GS preferred at 10.4% to be a very compelling proposition.

By the way: Long GS, USB, PGF, UYG.

Jan 06 01:16 AM

[Lockstep In...:]

To BS...

I see you are starting to understand my position more.

Let me clarify some things to give you an even better perspective.

I think I should have been more accurate in describing credit events rather than BK because credit events will occur in times of distress and gov intervention (i.e. Freddie, Fannie) and cause just as much harm as the BK itself to the credit environment.

1) Preferred pricing

If you think putting in a price 30% lower than today's price is meaningless, once again, you have not been watching the behaviour of the income security markets recently. Every time there has been a major credit event this year corporate security spreads blow out wider. Do you actually think GM, Chrysler, or AIG getting government infusions will not end up with a credit event for the bond holders there? Do you appreciate what that will do to the confidence in the credit market as a whole? You, my most appreciated commenter, are nieve.

2) "I believe your premise is flawed. There's not likely to be another major bankruptcy among financials;"

Oh really? What about the institutions that did not get TARP? What about European banks? What about Asian banks (i.e. the Citigroup South Korean subsidiary that needed a $1B infusion just weeks ago)?
What about hedge funds that are counterparties on baskets of CDS that are facing massive redemptions?

More importantly, as I mentioned above, credit events such as the bailout of Freddie and Fannie, AIG, Citi are just as damaging to the income security market. So you do not need the bankruptcy to happen, just the threat of a major institution facing problems is enough to cause spreads to widen. Just watch Bank of America, Wells Fargo, and JP Morgan this year. There will be a short attack on all of them during the year.

3) What happens when you own the puts and the credit event occurs?

This is where we differ on the outlook for GS. I don't look at book value for GS, that is irrelevant. It is operation with leveraged positions with no access to working capital, only equity to sell. It is a broker with huge counterparty risk, political risk, and directional risk that no public information can quantify. $40 is not a hard milestone to reach with a major blow up.

I just want my puts to be hedged as the stock falls. Sure I will probably wind down my puts as it falls, that is only prudent. But I also want to benefit from the "white knight event". Both scenarios are from MHO very likely.

Jan 06 03:17 PM

[Lockstep In...:]

Jhdec, Buffett made his investment before the government did.

Jan 06 03:22 PM

[Vox Rationalis:]

"I think I should have been more accurate in describing credit events rather than BK..."

Okay, you want to broaden your original assertion to include undefined "credit events." Fine.

"...credit events will occur in times of distress and gov intervention (i.e. Freddie, Fannie) and cause just as much harm as the BK itself to the credit environment."

You don't think Lehman's bankruptcy was more disruptive than AIG's non-bankruptcy, or than FRE and FNM's receiverships? Really? I mean, maybe the government's treatment of FRE and FNM preferred, which was clearly a mistake, but otherwise?

"Do you actually think GM, Chrysler, or AIG getting government infusions will not end up with a credit event for the bond holders there? Do you appreciate what that will do to the confidence in the credit market as a whole?"

Do you actually believe the market's not already pricing in this likely bond holder "credit event"? Of course it is. And let's look at how the market's reacting to the infusions. Most GM debt is trading at a discount of no less than 75%, but it's a far cry HIGHER than it was before the government infusion. GRM is trading at 40% of face value - close to twice what it was before the bailout. The market clearly thinks it more likely than not that GM will not repay this $1B issue when it comes due in LESS THAN FIVE MONTHS. The market is much further ahead, in terms of managing the risks, than you give it credit for. Pun intended.

"You, my most appreciated commenter, are nieve."

You, my backhanded complimenter, need a spellchecker.

"ME: There's not likely to be another major bankruptcy among financials. YOU: Oh really? What about the institutions that did not get TARP? What about European banks? What about Asian banks (i.e. the Citigroup South Korean subsidiary that needed a $1B infusion just weeks ago)?"

1. Name a major financial that did not get TARP. I don't think there are any.
2. The European banks have received very TARP-like capital infusions (with more onerous terms) from their governments.
3. Don't you think the $1B infusion by the South Korean government indicates an unwillingness to let its banks go bankrupt?

"What about hedge funds that are counterparties on baskets of CDS that are facing massive redemptions?"

First off, I wouldn't call ANY hedge fund a "major financial." Secondly, what exactly do you think the big deal would be here? There's no default of the underlying, so the CDS are not payable. The fund would have to liquidate positions, might even go bankrupt. So what?

"...credit events such as the bailout of Freddie and Fannie, AIG, Citi are just as damaging to the income security market."

Nonsense. The bankruptcy of LEH was the tipping point for the panic of 2008. Without the defaults of LEH debt and the related CDS, the cascading runs on anything financial would not have occurred.

"So you do not need the bankruptcy to happen, just the threat of a major institution facing problems is enough..."

"Problems" will not cause investors to run for the hills - not anymore. Without the threat of bankruptcy, which I believe to be pretty much off the table among the major financials, there will be no panic-driven run on these securities.

"This is where we differ on the outlook for GS. I don't look at book value for GS, that is irrelevant."

Book value is irrelevant? How about tangible book value of $88? Irrelevant too, right? You might find it to be overstated (as I believe I indicated I do), but irrelevant? Well, that's pretty telling.

"It is operation (sic) with leveraged positions with no access to working capital, only equity to sell."

1. GS leverage is lower than many financials. From their latest filings, Tier 1 capital was 15.6% at GS, 11.4% at USB (both including TARP).

2. What makes you think GS has no access to working capital? Why do you think GS can't issue debt? Do you think it unable to sell stock? Based exactly on what? This is hardly a given, and seems so crucial to your argument, it deserves some explanation.

"It is a broker with huge counterparty risk, political risk, and directional risk that no public information can quantify."

Then how do you know it's "huge"?

"$40 is not a hard milestone to reach with a major blow up."

You think a price 20% lower than the lowest-ever close, more than 50% lower than current, isn't a hard milestone to reach. Interesting. What do you think an appropriate valuation for GS is today?

"I also want to benefit from the "white knight event". Both scenarios are from MHO very likely.

I guess we shall see. Your puts are now right around $9, which means the stock needs to drop to 46 (just under the all-time, intraday low) for them to break even at expiration.

Jan 07 02:39 PM

[sponger:]

Well, you gentlemen have been at it enough now, don't you think? Regardless of the intracacies of current common and strike prices, and the ins and outs of virtue as a pair trade, the notion of buying GS preferred and buying puts on the common or shorting it is not a bad idea. Even today (1/15/09) and yesterday we saw enough volatility in the finance sector to illustrate continuing turmoil owing to a failed TARP program and delayed transparency in marking to market. I agree with the writer that such turbulence will continue, so it could make sense to leg into this or a similar position. I, for one, would be more tempted to use more expensive ITM puts but save money with a somewhat shorter time frame. .

Jan 15 03:24 PM