Goldman’s Q3 Results: Fool's Gold?

This may turn out to be nothing, but if it turns into something…

There are rumblings that Goldman’s (GS) stellar Q3 earnings should be revised significantly downwards, due to the large % of Q3 earnings that came from a paper gain on illiquid derivatives, which Goldman valued via their own internal models. At question is a $2.62 paper gain on derivatives that may have been valued incorrectly and/or that Goldman may either have a hard time selling or collecting the gain from the institution “holding the bag”.

From Fortune:

Goldman's stock has gained 13% since its earnings came out, as investors have bought into the notion that the bank is a cut above its peers and is able to weather, and even profit from, tough market conditions.

But that view could get revised, now that it can be seen in the numbers that a large proportion of its third quarter profits were 'unrealized' - i.e. paper gains, and not hard cash payments from fully closed out trades - and came from financial instruments that Goldman values largely according to its own estimates.

"The opaqueness of Goldman's balance sheet makes us immediately question how they made money in the quarter," says Charles Peabody, analyst with Portales Partners.

Much of the focus is on Goldman's trading revenue, which totaled a spectacular $8.23 billion, up 70% on the year-earlier quarter. Part of that increase was due to a bold bet that made money if mortgage-backed bonds and financial instruments tied to mortgage values fell in price. Of course, because of the credit crunch, they did plunge in value, netting gains for Goldman that the banks said "more than offset" the losses it saw on the mortgages it was holding.

[…]

The interesting data comes from disclosures in the filing about 'level 3' assets and liabilities, which are securities and derivatives that can't be valued according to observable prices in liquid public markets. Because of their illiquidity, Goldman has to attach values to them chiefly according to in-house models and estimates.

[…]

And Goldman reaped huge gains within the level 3 pot in the third quarter. For example, it made a net gain of $2.94 billion from level 3 derivatives, financial instruments whose value is based on the value of underlying securities. And get this: $2.62 billion of that gain was unrealized. Was that amount unrealized because there's no way illiquid level 3 derivatives could be cashed out at the prices Goldman attached to them?

"Common sense tells me that a lot of their losses were real and a lot of their gains were paper, and that's something we'd like to know more about," says Portales' Peabody.

Indeed, if that level 3 derivatives gain does include the stupendously prescient bet against mortgages, it deepens the mystery over what type of institution is on the other side of that trade, effectively holding the losses. In other words, if hedge funds - which operate with thin capital and high leverage -- are on the other side of a large part of this mortgage bet holding the losses, it may not be easy for Goldman collect all it is owed.”

In other words, we don’t really know how exactly these “gains” were generated, and/or if Goldman valued their level three derivatives properly, nor do we know if they could even collect the money in the first place.

Good times.

But let’s not pick on Goldman Sachs too much, as it remains to be seen how this will all play out. Furthermore, it stands to reason that a lot of the other Brokers are in the same boat. As I’ve noted previously, financial sector earnings quality for Q3 and for the past 3-6 quarters needs to be heavily scrutinized, due to the heavy investing in debt securities that were valued by “mark to model”.

All that being said this could turn out to be nothing, but if it turns into “something” it will turn into a big mess. After all, when we accept earnings that were generated via “mark to model” methods, we are effectively creating a “Fox in the Hen House” situation, where we politely take the Fox’s word that he’s not eating all of the chickens and is just guarding the Hen house from those other Foxes.

Sources:

Fortune: “Questions arise about Goldman's blowout quarter” – Peter Eavis, October 15, 2007

Disclosure: as of the writing of this article, the Author didn’t own a position in Goldman Sachs.