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  • Are The Modern Impatient Investors To Blame For Goldman's Depressed Valuations?

    In the past year, Goldman's stock has fallen some 30 per cent. It trades for just 0.7 times book value, which says that investors either think that Goldman can't earn enough to cover its cost of capital, or that its assets are overstated or liabilities understated. Consider this: Except during the financial crisis, Goldman's market capitalization was last around $50 billion back in the fall of 2005. Back then, Goldman had $670 billion in assets, and $27 billion in shareholders' equity. Today, Goldman has $951 billion in assets, and $72 billion in shareholders' equity.

    Another way to think about Goldman's valuation is that the firm effectively has $300 billion in cash and close cash equivalents on its balance sheet. You can get to that figure by adding cash, Level 1 assets, and Level 2 assets that could be easily liquidated. Goldman has total long-term and short-term debt of $220 billion, and a market value of $50 billion. In other words, the market is giving Goldman very little credit for the ongoing earnings of its business, and Goldman has a lot of dry powder relative to the opportunities it has. (A caveat: Goldman's immense derivatives business would gobble up lots of cash were the firm to be hit with credit downgrades.)

    Among its banking peers, Goldman isn't unique or even the worst off - Bank of America trades at about 60 per cent of book value and Citigroup at just over 50 per cent. Analysts question whether these banks can earn their cost of capital. Last month, Philip Purcell, the former CEO of Morgan Stanley - and the architect of the megamerger between Morgan Stanley and Dean Witter - wrote a piece in the Wall Street Journal arguing that shareholders would get better value if the big banks broke themselves up. He chalked the sinking stocks up to the "mismatch" between volatile investment banking and trading businesses on the one hand, and "safer, more client-centric businesses" like asset management and banking and credit cards on the other hand. Others who have called for a breakup of the big banks cite the essential unmanageability of these giant, risky firms.

    But Goldman hasn't suffered the blatant management missteps of its peers, at least from a bottom-line perspective; moreover, it's hard to see how splitting up is an option for Goldman. Unlike a Citi or a BofA, Goldman lacks the pieces in which to break. Although Goldman is now officially a bank, it doesn't do much that resembles banking as we know it. True, Goldman does have an asset management business, but it has succeeded despite less-than-stellar performance. A good chunk of its value is precisely because it's part of Goldman Sachs.

    So what's the problem, and is there a solution? There are a number of more constructive theories, all of which could be true. One possibility is that the black-box nature of Goldman Sachs is no longer acceptable to investors, in which case Goldman could work to make itself more transparent - a Lucite box! Another is that the ongoing threat of legal liabilities, in particular, the Department of Justice investigation into Goldman's behavior during the crisis, is weighing down the stock. A third is that given the myriad uncertainties in world markets, of course Goldman's stock is going to suffer. Market participants say that Goldman is no longer taking risk the way it once did. But as soon as the clouds lift, normalcy - i.e., the risk-taking and the mega-profits of the pre-crash years - will return.

    Yet another possibility, though, is that the world has changed, and Goldman either needs to shrink - or show investors how it can reinvent itself. New regulations are one reason. Despite frenzied lobbying, regulations from higher capital requirements to whatever iteration of the Volcker Rule emerges from the murk of D.C. will add cost and lessen opportunities. But the more important reason is that Europe, Japan and North America, which analyst Meredith Whitney wrote in a report accounted for 80 per cent of Wall Street's revenues over the last decade, are all in a massive, lengthy deleveraging process. Yet during that period, over a third of Wall Street's revenues came from debt capital markets, and in turn, over 40 per cent of that came from the issuance of financial debt. Even more, at the big banks, a huge per centage of the debt they sold at the peak was their own. (In Goldman's case, Whitney says, 40 per cent of its total debt capital markets business in 2006 was the issuance of its own debt.) Less debt equals less profit. (In response to Whitney's question on the Investor Day, Goldman said it doesn't make money issuing its own debt.)

    Goldman gets a bigger chunk of its profits from outside the US and Europe than others do. But while Asia and Latin America are growing quickly, they are still relatively small. And it's hard to tell how much of Goldman's derivatives business, which has been a huge chunk of its profits, was tied to the issuance of debt. In a world where debt in the developed world has to decrease, a world where everything can't be turned into a derivative, maybe the robust return on equity Goldman produced is a thing of the past.

    While Goldman people are the first to say that there is no certainty about anything today, the firm - not surprisingly! - rejects the idea that the market wants it to liquidate. You can see the firm's optimism in its headcount, which is now about 32,000. True, that's down some 8 per cent from last year (and Goldman has cut costs more aggressively than headcount reflects), but it is still up about 9,000 from the end of 2005. Goldman executives have argued that even if Europe - European banks in particular - do need to delever, there could be a silver lining, which is that companies in Europe, which traditionally have relied upon loans from banks, will now instead sell debt in the capital markets, thereby spelling opportunity for firms like Goldman. There's also an argument that while Goldman's return on equity of 12 per cent in the first quarter (which, in fairness, was a big improvement on the 3.7 per cent Goldman posted in 2011) is a fraction of the stunning 40 per cent returns it posted at the peak, a 12 per cent return on equity, if sustainable, is not so terrible in a zero-interest-rate world.

    If you look at the firm over the decades, its real business model has been to be wherever there's money to be made, to turn on a dime to get there, and to find a way to adapt and prosper no matter what the conditions. But even Goldman admits that in the meantime, investors have to be patient - and patient is one thing that most modern investors are not.

    Tags: GS, Banks
    Jul 12 8:58 AM | Link | Comment!
  • Spain And Italy – Entrenched In A Predicament!

    The Greek election came and went without much in the way of market reaction. It would appear that "Mr. Market" is tired of hearing about Greece and has now moved across the Mediterranean to Spain.

    But for all the wailing and gnashing of teeth over the country's finances, even Spain is a relatively minor problem if tackled correctly. At 69%, Spain's current debt load as a percentage of GDP is actually lower than that of Germany, France or the United Kingdom. And even if the planned bank bailout from earlier this month adds another $100 billion, total indebtedness will be roughly in line with these Western European peers.

    Should Spain need a full sovereign bailout due to its short-term funding needs-and it is looking increasingly likely that it will-a Spanish bailout would be affordable under the existing bailout mechanisms in place. Unless Europe's leaders are even more inept than the most cynical of us could imagine, it won't be Spain that derails the European project.

    No, the real crisis that will eventually determine the fate of the European Union is not Spain and it's certainly not Greece. It's Italy.

    With a GDP of $2.2 trillion, Italy is the 8th largest economy in the world, slightly smaller than Brazil but larger than Russia, Canada or India. But the Italian government bond market is the 3rd largest in the world, after only the United States and Japan.

    Italy's outstanding government debt amounts to 120% of GDP, making Italy the most indebted of all industrialized countries save Japan or Greece. When it comes to spending money they don't have, it would seem that Italy's politicians can compete with the best in the world. And given Italy's lackluster growth rates of the past two decades, the country's ability to pay those debts should be called into question.

    Spain and Italy are on odd sort of mirror image. Before the crisis, Spain's government was considered to be a model of responsibility, and its government debt load was among the lowest in Western Europe. Spain's current predicament was not brought on by government spending run amok but by a real estate bubble and bust that wrecked the country's large banking sector. In Italy's case, the private sector is fine. The country's banks are, for the most part, in decent health and conservatively financed. It is wanton government spending that called Italy's credibility into question.

    The issue of timing is also very different. Spain's short-term outlook is desperate; the country is struggling to close a yawning budget deficit without killing an economy that is already on life support, but its longer-term outlook is not particularly bad. In Italy's case, it is the short-term picture that isn't particularly bad. Excluding debt service, the country's current budget is close to being balanced, and its immediate borrowing needs are modest. But without growth, Italy's debts become harder and harder to pay.

    But while we have two very different countries with two very different sets of problem, we have one crisis-a crisis of confidence.

    The bond market is indicating a pronounced lack of confidence in Spain and Italy and in the European Union itself, as we can vividly see by the rising bond yields on Spanish and Italian debt. A couple points should be made about this, however.

    Contrary to popular notion, the "bond market" is not an all-knowing, all-powerful collective intelligence that sifts through the economic data and prices the respective bonds accordingly. It is a collection of emotional buyers and sellers who react to each other far more than to fundamental data.

    Financial theory would tell you that bond prices change to reflect changes in the underlying fundamentals. But as any good trader knows, that relationship also goes the other way. Price movements take on a life of their own and change the fundamentals. A country that could easily finance its expenses at 4% interest may find it difficult to do so at 6%. The country thus becomes "riskier" and now requires an even higher interest rate to compensate investors for the risk…which in turn makes the country riskier still. The predictive power of the market is often no more than self-fulfilling prophecy.

    Let's return to Italy. Italy was able to amass its gargantuan debts precisely because the bond market priced yields so attractively. But what the bond market giveth, the bond market taketh away, and now Italian 10-year yields have crept up to crisis levels close to 6%. In Spain, the yield has crept above 7%.

    So, how is this vicious cycle broken?

    Frankly, it's not easy. You need a "big bazooka" blast to shock the bond market into reverse. In the case of Europe, you would need either a public commitment from the European Central Bank or one of the bailout facilities to buy as many bonds on the open market as it took to lower yields to a sustainable level.

    Germany has resisted this approach, rightly pointing out that doing so takes away the incentive to cut government spending. Angela Merkel seems to believe that the only way to convince the problem states of Europe to get their houses in order is to threaten them with bond market oblivion.

    Unfortunately, there are limits to how far this exercise can go, and we are quickly reaching those limits. Germany needs to commit itself to stabilizing the Eurozone, and it needs to do so quickly.

    As bearish as this article might seem, I am actually quite bullish on select European stocks. The crisis has created some fantastic opportunities to buy Europe's best multinational blue chips and prices we may never see again.

    Jun 24 11:55 PM | Link | Comment!
  • Germany, Not Greece, Should Exit The Euro

    All the debate about the pros and cons of a Greek exit from the euro area is missing the point: A German exit might be better for all concerned.

    Unless Europe's leaders take some kind of radical action, such as adopting and executing some of the many reform ideas they have floated, the currency union is headed for disintegration.

    The problems of Greece, Ireland and Portugal have spread to Spain, the fourth-largest economy in the euro area. Italy is probably next. The other members of the currency union can't afford to bail them all out. Further loans will serve only to exacerbate the fundamental problem of too much debt and add to the growing enmity between the strong northern tier and its wards to the south. Without healthy economic growth -- and Europe is now back in a recession -- multiple countries will have to restructure their sovereign debts. Greece's agonizing two-year restructuring experience suggests that doing several more would be extraordinarily difficult, if not impossible.

    A Greek exit from the currency union would make the situation even worse. There is no mechanism to decide, or deal with, whichever nation might be next, and even that presumes that exits could be managed. The more terrifying prospect is that the other afflicted countries might exit in an uncontrollable panic, complete with bank runs, failures and general disarray. The accompanying repudiation of hundreds of billions of euros in debt would overstrain the European financial system, even Germany's. The global economy would be paralyzed as everyone wondered which domino would be next to fall.

    German Exit

    What, then, might a German exit do? With integration and multiple restructurings so unlikely and withdrawal of the weak members so fraught, it might actually be the best of all available options.

    A single, powerful nation would have the best shot at executing a relatively swift exit that would be over before anyone could panic. No agonizing over who exits and who doesn't. Stripped of its German export powerhouse, the euro would depreciate sharply, but would not become a virtually worthless currency, as, for example, any re-issued Greek drachma surely would. With the euro devalued, a Greek exit and devaluation would be relatively pointless. So, no contagion or bank runs. With new exchange rates making all the non-euro financial havens prohibitively expensive, and with the threat of forced conversion into devalued national currencies removed, depositors in southern Europe would lose their impetus to run.

    Germany's exit would provide immediate benefits to all the remaining euro-area nations. The currency depreciation would radically improve their trade competitiveness -- exactly what many observers have said the weaker nations in the south need most. The euro area's balance of payments would improve, providing sorely needed funds to service its external debt. The benefits would accrue to the euro area as a whole, as opposed to serial exits at the weak end of the spectrum, which would crush one weak nation after another, with each exit increasing pressure on the next candidate.

    Other relatively strong euro-area nations, such as the Netherlands, would probably pause before following Germany's lead. If they left, they would lose the trade advantages offered by the newly depreciated currency, and would have to bear all the costs and complications of reintroducing their own money.

    The cheaper euro, of course, would be bad for foreign investors holding euro-denominated assets. On the bright side, the losses would be simultaneous in timing, spread evenly across creditors, and more moderate in the southern European countries than they would be in a euro-exit scenario.

    Vital Interest

    Certainly, there are problems not purely related to currency, including Spain's real-estate bust and its impact on Spanish banks. Here the devalued currency might bring fresh foreign investment. Nevertheless, governments might have to bail out certain European banks struggling with bad assets or whipsawed somehow by the euro's devaluation. Collective support might be required for Greece and others. Germany would still have reason to assist: Its exit from the euro would not diminish its vital interest in the survival and success of the European economy.

    While polls suggest that most Germans would be happy to have their old currency back, Germany would not escape unscathed. Its exports would contract as the new exchange rate made German goods much more expensive abroad. It would be vilified for violating the orthodoxy of Europe's post-World War II drive toward integration.

    Nevertheless, such a bold move might stave off disaster today, and it wouldn't necessarily signal the end of the European project. Famously, American revolutionaries "ran away to fight another day," and they ultimately won. The U.S. Constitution succeeded brilliantly after the first attempt at union, the Articles of Confederation, failed.

    Indeed, a German exit today might set the stage for a strong reunion tomorrow. Having learned their lessons and come to terms with economic reality, the nations of the euro area might do a better job of integration the second time around.

    Jun 11 11:54 PM | Link | Comment!
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