How Much Are Goldman's Level 3 Assets Worth? 20 comments
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Wow, lots of stories Friday about the “shocking” earnings miss (and lowered forecast) by GE (GE). MarketWatch said, “GE’s warning pokes hole in recent sentiment that credit crunch has passed” and “The rebound had been fueled by renewed sentiment on Wall Street that the worst of the credit crisis — including the threat of spiraling financial bankruptcies — was past.”
A story on CNN said, "'My guess is that earnings forecasts for 2008 are still pretty high relative to the economic reality,' Davidson said."
I have one word for Mr. Davidson - Duh!
As I posted just yesterday, I don’t think we’re anywhere close to a bottom yet, and the earnings estimates for 2008 and 2009 are way too high. Eventually, stock prices adjust to reflect earnings, and sometimes the adjustment process is long and painful - as we all learned in 2000 through 2003.
All the stories about Goldman Sachs’ (GS) and Lehman's (LEH) CEOs saying that they can see the light at the end of the tunnel - while simultaneously upping their own writedowns - are crap. If the CEOs are so good at predicting the future, why couldn’t they tell us what losses their own companies were going to have?
Speaking of Goldman, I think the glitter is coming off. This past week it announced that the amount of “Level 3 assets” increased from $69 billion to $96 billion during the first quarter. If you haven’t been keeping score, “Level 3 assets" are those for which there’s basically no market, no one wants them, so Goldman is stuck with them.
It's kinda like having a house that’s “worth” $1 million, but no one will buy it, so you’re stuck with the mortgage payments - but you can say you have a $1 million house. That is, at least until you have to sell it because you can’t make the payments any longer - then it suddenly becomes a $500k house - and you just lost $500k.
It also means that the value of those assets is a 100% guess. In effect, Goldman is saying “we think we might have $96 billion in assets, but we really don’t know what they’d be worth if we tried to sell them. They might be worth $96 billion (but we’re almost certain that that’s not right) but they might be worth 3 cents on the dollar. We don’t have a clue, so we pulled that $96 billion number out of our butt.”
Level 3 assets are, by definition, “hard to value.” In fact, they are impossible to value, because no one will buy them. So companies use a “mark to model” method to come up with a number. Since “mark to model” varies depending on the model used, we’re back where we started - no one has any idea what these assets are worth.
You may be asking why it’s a bad thing that the value of the assets rose so much in one quarter, and that’s a good question. Wouldn’t it be a good thing if my $1 million house went up to $1.5 million in one quarter? The answer to why it’s bad is that it’s a made up number. I know that this is probably getting old but you need to understand it - NO ONE WILL BUY IT AT ANY PRICE RIGHT NOW!
Your next question is probably something like “Why would Goldman make up a higher number for these assets if that’s viewed as a negative?" Another good question, but the answer is easy. You see, if you claim that your assets are worth more, you can use them as collateral so you can borrow more money.
Kinda neat, isn’t it? Goldman increased its ability to borrow by $27 billion in just one quarter. But who would take these Level 3 assets as collateral you ask? You’re on your “A” game tonight dear reader - another good question.
The answer is that there’s only one place to go to borrow against these assets that no one will buy - the Fed. You and me (via the government) are loaning Goldman billions of dollars by allowing it to give (I’m going to make up some numbers here - let’s call them “Level 3″ numbers) the Fed $10 billion in Level 3 assets. In exchange, the Fed gives Goldman $10 billion in Treasuries.
So you and I are now on the hook for $10 billion of basically worthless assets, while Goldman now has $10 billion of nice safe Treasuries. Nice trick, ain’t it? That’s the Federal Reserve’s new Term Securities Lending Facility [TSLF] in a nutshell.
That’s one of the ways that the Fed is propping up the banks and brokerage houses right now - short of an indirect buyout like they did with Bear Stearns (BSC) anyway. But sooner or later, the losses from these made up Level 3 assets need to be accounted for.
The only question remaining is who will pay for the losses - the banks who made the risky loans, the investment houses that took the risky loans and leveraged them, or the taxpayer. My best Level 3 guess is that we’ll see a combination of the above, but taxpayers will eat a significant chunk of the losses.
As a result, the Fed will have to print more money to pay the bills, so the dollar will continue to fall, and the stock market will drop in inflation adjusted terms - and quite probably in real terms as well. Within the next 12 months, Dow 9,000 is much more likely than Dow 15,000 in my opinion.
Disclosure: None.
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This article has 20 comments:
is expained so simply that everyone can understand.
you should be invited on networks and capitol hill .
keep posting these analysis .
The increase in Level 3 assets is mostly due to the freeze in the leveraged buyout market. Goldman wrote down the value of those commitments when the debt was moved to Level 3. As the buyout market recovers, the loans may be upgraded to Level 2. A substantial percentage of Goldman's Level 3 holdings are private equity and real estate investments. While those typically fall into the Level 3 category, assets such as leveraged loan commitments shift from one level to another depending on market conditions. Quote from Goldman: ``We take issue with the notion that all assets in Level 3 are hard to value,'' said van Praag. ``Given the disclosure rules, it is inevitable that any firm with a large private equity and real estate portfolio would have significant Level 3 assets.'' All the investment firms have adopted FAS 157 which requires public companies to disclose a breakdown of their asset valuations. Under the rule, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets fall into the Level 3 category when there aren't even any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses.
While I would be the first to admit that the risks associated with the investment banks are clearly elevated, I found your article to be alarmist, full of hyperbole, and written in a juvenile style that no doubt is reflective of your own investment objectives.
Your vituperation is 'juvenile' and you might want to be somewhat more 'reflective' of what you just wrote.
This is an example of the alarmist hyperbole that 'pelican' talked about. Do you ((prague) have any proof that he (GK) doesn't have any positions directly or indirectly on these stocks. Why doesn't he (GK) say it then.
There is not a ready market for mortgages right now because none of the banks trust each other's valuation. In other words, Goldman's mortgage valuations could be just fine, but the market is "frozen" from mistrust. That doesn't happen in real estate markets.
Goldman also is not "giving" level 3 assets to the Fed. The Fed is allowing financial firms to use them as collateral in order to help "unfreeze" the market and rebuild trust. The level 3 assets are still on Goldman's books and any ultimate writedown will have to be absorbed by Goldman's capital.
In the interest of full disclosure, I have long-term puts on Goldman and the other investment banks, but it is not a big part of my portfolio. The Fed is buying time for the banks to raise capital and get their affairs in order so I think you'll see a gradual deterioration in their stock prices as they slowly come to grips with the real value of their level 3 assets and with the reality that they'll no longer be allowed to operate at a very profitable - but exceedingly risky - 30 and 40 to 1 leverage ratio going forward.
Combine those 2 factors with a recession their risky loan behavior has helped to create and you have a recipe for future stock declines...
Good job, well written.
"Goldman also is not "giving" level 3 assets to the Fed. The Fed is allowing financial firms to use them as collateral in order to help "unfreeze" the market and rebuild trust. The level 3 assets are still on Goldman's books and any ultimate writedown will have to be absorbed by Goldman's capital."
What happens if GS goes bankrupt? Doesn't that mean that the Fed can't get back the money it loaned to GS? Doesn't the Fed get stuck with whatever collateral it was given for the loans in this scenario? And if the collateral is worthless (a lot of it is) or even just worth 20% of the "model value", doesn't that mean that the Fed, and hence the taxpayer, has exchanged cash (in the form of loans) for worthless junk, and the value of the dollar (and hence the lifesavings of every American) goes down the tubes?
As for the idea of GS going bankrupt - just look at Bear Sterns.
Erin Callan appeared on Bloomberg TV Friday and was quite candid; she might eventually earn Lehman a better multiple given her attempts at transparency.
Goldman's valuation relative to the other brokers is the big issue. Perhaps Goldman deserves a premium, but it is likely too generous at the moment.
here is a link to Erin's TV appearnce friday-judge for yourself.
tinyurl.com/54plds
Personally, I think that $140 level in GS will hold, but it might be tested again. Stock might be due for a bounce soon though-last week was horrible for the shares.
What you forgot to mention is that the accounting rules were changed last month. Banks may now value these assets at what they believe they are worth, not what they are actually worth. The rule change allowed banks to value these assets based on criteria other than the market if they bank believes that the market price is not correct based on distressed sales of those assets.
So for the housing example in the article. If your neighbor sold his house for $500k if you believe that he sold it becuase it was a distressed sale you can still value your house at $1mil. Hmmm, that seems crazy.
Bottom line. The government has fixed the rules in favor of the banks. The entire banking system is insolvent. If banks were forced to sell their assets at today's price they would all go under. What the government is doing is buying these banks time. Every quarter the banks make money (not abolute of course), these profits the banks make will be marked against losses they will declare on these Level 3 assets. Every quarter that goes by the banks will continue to make money on their ongoing business. This profit will be offset by continued losses for years to come. But that is the plan.
Put more simply. If you owed the bank a million bucks and could not pay it back at the end of the year you would be bankrupt, but if the bank gave you twenty years to pay it back you could do it if you had income. That is where the banks are. They have built in income, and it is being increased by the Fed cuts, and that income will eventually pay off these losses. The question is how long? These write downs are here for years.
I will say it again, when these bankers, home builders or monolines open their mouths only one of two things comes out: bad news or lies.
However, the Fed IS taking steps to prevent GS and the other banks it's lending to from going under. drmalaka is correct that the Fed is buying time for these banks to write down the loans gradually against future profits and also to raise new capital.
That is why I have long-term puts against them. The Fed will keep them from collapsing which could send the financial markets into a tailspin, but the Fed CANNOT keep their stock from gradually dropping to a price more reflective of their true market value in a changed world...
1) I have no position) long or short) in GS or any other financial stocks. SeekingAlpha requires a disclosure when you post here, and my disclosure for this post said "None".
2) According to the Fed website at:
www.newyorkfed.org/mar...
What collateral is eligible for pledging?
Eligible collateral will be determined by the Federal Reserve and presently includes all collateral eligible for tri-party repurchase agreements arranged by the Open Market Trading Desk (“Schedule 1”) and AAA/Aaa-rated private-label residential mortgage-based securities (MBS) and commercial MBS, as well as agency collateralized mortgage obligations (CMO) that are not on review for downgrade (“Schedule 2”). Schedule 2 also includes everything in Schedule 1.
I may be wrong on this, but it looks to me like they're taking almost anything as collateral.
3) I have zero inside knowledge of the terms of any Fed transaction.
4) General clarification to some comments:
Let's say you have $1 million equity in your house, and you take it out in a HELOC. You take that $1 million and put 10% down on 10 other $1 million properties - and you depend on the renters to make your payments. You with me so far?
What happens when just one renter doesn't pay?
You suddenly can't make the payments on $9 million worth of debt. That's called leverage, and that's what the banks and investment houses are facing.
At this point the assets are worth what someone will pay for them at auction. How much is that? Who knows - they have some value, but (as you said) know one knows how much they are worth. I wouldn't pay 50 cents on the dollar for them. And since NO ONE will buy them AT ANY PRICE right now - they're worthless as assets.
That's the problem these banks have today. And some big names will not be around 1 year from now. If I knew which names would be gone, I'd be on an island somewhere in the Carribean.
5) User 129099: See #2 above. Level 3 assets can be rated AAA - they're level 3 because no one cares about the rating, they're toxic piles of paper that no one will buy. So they're "mark to model".
6) Other than 20% of a 401k being in a S&P 500 index fund right now, and about $3k long in Novagold (NG) I have no position in the US stock market. The rest of my money is long in money market accounts, bond funds, and international growth stock funds.
See my blog at:
www.effor.com/blog/ for more of how I view things.
Gary Kramer
I agree with most of what you said, particularly that the premium is coming off GS. I have friends who work for GS, and they are very worried.
Here is another analogy: You bought a house for 670,000 but two years later it is appraised for 1 Million Dollars. (spoken like Mike Myers).
But then you find you have termites, and you call out the inspector/pest control guy--but they cant look at the foundation--they can only look at the upper floors.
And you ask him--well what will it take to kill the termites? And he cant tell you, he's not allowed to look at the foundation. And you get the hosue appraised again, and you ask the appraiser--what is my house worth? And he says between $50,000 and $900,000, depending on what it costs to fix the foundation. We may have to destroy the whole house ($2 buyout).
Its toxic waste, but I prefer "termites in the foundation" metaphor and no one knows (except perhaps the banks) how bad they are.
Unlike in real estate, however, that have full disclosure laws when you buy a house, when you buy a bank stock, you have no idea whats in the foundation, or on the balance sheet. (or off the balance sheet).
We may see GS hit 125. I also believe that DOW 9000 is more likely in next 24 months, than DOW 15,000.
Disclosure: I have now position in GS, short or long.
My question: What do regulators do for a living?
I use point & figure charts to make price movement projections, and I think that I am pretty good at make these assessments (modest, aren't I :).
For the record, the Dow, the S&P 500 and NASDAQ all project to that level. Of course, this assessment may be wrong, but to invalidate this projection, one has to argue for a roughly 4500 point Dow up move.
The one thing regarding point and figure charts is that you lack a time scale as to when the forecast will occur.
My fundamental, seat-of-pants, assessment is that the next down move will start in the May - June time period. The rational for this time forecast is that most of the financing of business related loans will be up at that time, based on most financing is a 12 to 18 month workout. Many of the lenders are not comfortable with facing law suits if they do not honor their agreements. The number of new business loans, at higher interest rates, will not be enough to keep the economy going at its present pace.
This will show up as a significant increase in unemployment numbers at that time.
I am long 4 of the different short etfs, for example PSQ, (small position) - no stock shorts.