Wednesday, April 15, 2009

A Parting Look (Shot?) at Goldman’s “Blowout” Earnings Report

Sit tight, this will be a longish entry, but I think it’s worth trying to tie up some loose ends on the puzzle of Goldman’s moonshot on first-quarter earnings. My initial take was a bit naive and incomplete, though the suspicion was well-placed.

Investors may wonder why Goldman doesn't want them looking closely at what powered its great numbers. CFO David Viniar was notably vague during the analysts’ conference call when speaking about the division that reaped the bulk of the quarterly revenue (Zero Hedge has the transcript here).

The answer is simple: the bank itself appears to deserve very little credit for its resounding success. Goldman is like the two-year-old toddler nominally holding the baseball bat, while Uncle Sam, who’s really doing the swinging, whacks the ball and says, “Attaboy, Johnny, you just smacked one!”

First, look at the grim reality. Division by division, the first quarter was largely a flop at Goldman. Asset management crapped out (down 29 percent). Investment banking took a dive (down 30 percent). Principal investments stunk ($1.41 billion of losses, ugh, and that’s the bank’s brain trust putting its own money at risk).

The lone shining star: fixed income, currency and commodities. This group did blindingly well. It engineered a sudden turnaround that seemed to defy the laws of financial physics, like if all the molecules in your car suddenly vibrated in sync and the vehicle hopped ten feet in the air. FICC had $6.56 billion in net revenue (after losing $3.4 billion the quarter before).

Immediately something began to smell funny. You sort of wonder what Goldman's results would have looked like if the U.S. wasn’t helicoptering in bushels of almost-free money (uh, that’s for the major banks -- you little guy there, get back, hands off) and infusing tens of billions into AIG. Would the numbers have been horrible? Or maybe even horrible squared?

Let’s look at these two pieces separately, AIG first. How did Goldman make out like a bandit from taxpayer-subsidized AIG? Below is one way they probably did. Notice direct payments aren’t involved here, but the U.S. taxpayer still wears the “I’m a Chump” apron at the end of the day. This terrific insight appeared in the comment section of Naked Capitalism (a great blog with a smart, cynical, financially savvy readership). Read the original below, if you can -- it’s technical -- then I’ll translate at the end:
Want to follow the money? Here is the simple math... and this relies only on facts that either: a) are known in publicly traded markets; or b) Goldman has admitted.

1) CDS on AIG before September 2008 traded at ~200bps running plus 0 pts upfront. Today it trades at 500bps running plus 40pts upfront.

2) Goldman Sachs had $13B of super senior CDOs insured by AIG. Prior to AIG going thermonuclear and becoming an ongoing ward of the state, Goldman Sachs owned three things:
a) $6.5B of super senior CDOs naked exposure to AIG;
b) $6.5B of cash collateral in a margin account due to ongoing posting of margin against the position by AIG; and
c) $6.5B of CDS on AIG purchased for 200bps running spread to hedge their exposure in "a"

The government comes into AIG and makes Goldman whole on the super senior CDOs that they had insured with AIG (i.e., they pay them the $6.5B from "a" and Goldman gets to keep whatever margin they were already holding from "b"). At this point, Goldman has $13B of cash **AND** they own $6.5B of CDS on AIG.

Well now, given what's happened at AIG, the CDS is trading at 40pts upfront. Goldman sells the $6.5B of AIG CDS at $40-00... thereby pocketing $2.6B additional cash.

In a trade where they have $13B of exposure, Goldman pockets $15.6B of cash.

The math is strikingly simple but they get away with it nonetheless. And no one calls them out. And no one makse them return the money. And the stock market gets itself into an orgy when they say they're "going to pay the TARP money back". They raise $5B of capital yesterday and say the rest is going to come from "other sources". Well guess where $2.6B of that "other sources" comes from?? From the same taxpayers they're paying back via the windfall profits they made from the AIG transfer.

The killer is that, in pieces, they've admitted the whole thing. But no one with any sort of soap box will put the pieces together and call them to account. It makes me sick..
Okay, here’s the simple version: Goldman owned a bunch of asset-backed securities known as CDOs (collateralized debt obligations). It wanted to protect itself against losses on these investments, so Goldman did a couple of smart things. First, it “insured” the CDOs through AIG. If the CDOs lost value, AIG (the insurer) would have to make up the difference. So basically if the bank had a CDO worth $100 million, which then plunged to $80 million, AIG would kick in the other $20 million.

Then Goldman did a second smart thing -- really smart. It understood that holding an insurance policy is no good if the insurer goes belly up. So it took out insurance on the insurer. It did so by buying credit default swaps on AIG. What that means in practical terms: if the CDO value falls by say half, AIG has to make up the difference. If AIG declares bankruptcy and can’t pay, no problem: Goldman gets the same amount of money through settlement of the credit default swaps.

(If you like ghoulish analogies: Goldman drinks AIG’s blood while it’s alive, but gets to partake of the proceeds from selling its organs if the insurer dies. Goldman at this point doesn’t give a damn whether AIG lives or dies. In the financial world, this is being well-hedged.)

So you may be thinking: Well, good for Goldman. They covered the angles. And this is true. Except the U.S. taxpayer happened to indirectly throw them a “gift” of $2.6 billion during the actual playout of the little credit drama that ensued.

How? Goldman bought the credit default swaps (to guard against AIG’s failure) before the insurer had its infamous September meltdown and hasty federal bailout. So Goldman got a pretty decent price, as the insurer appeared to be in the pink of health. In September, AIG was revealed to be deathly ill, in a state akin to multiple kidney failure with an IV drip. (And of course the cost of buying credit default swaps on AIG, in the market at large, soared.)

Now here’s where the taxpayer “gift” comes in -- but the beauty of it, from where Goldman sits, is that it’s indirect. No messy fingerprints. Woo hoo!

Say AIG had croaked in September and wasn’t able to pay the insurance on the CDOs as they sank in value. No problem for Goldman: it just exercises the credit default swaps on AIG and is made whole, and life goes on. But what happens when the U.S. government intervenes to prop up AIG? The government funnels money to AIG, which in turn pays off Goldman, making Goldman whole. Either way you get the same result right?

Not quite.

In scenario number two, Goldman still has those cheap credit default swaps on AIG. Ordinarily the bank would have held on to them to hedge against a possible failure of the insurer. Now, thanks to the visible hand of Uncle Sam, it doesn’t need the swaps. It can resell them into a market where they’re worth more -- a lot more.

So Goldman walks away with -- ka-ching! -- an extra $2.6 billion, the author says. I can't vouch for his math, but his line of reasoning looks pretty solid. (To put that $2.6 billion in perspective, that sum is 40 percent more than Goldman’s entire reported profits for the first quarter.)

Get that? Without government intervention in AIG, Goldman sees $2.6 billion less in profits on this CDS trade alone.

(For more on how Goldman benefited in other ways on its CDOs from the U.S. takeover of AIG, see this Wall Street Journal article.)

Okay, here’s the second piece. Cheap money. Last year Goldman transformed from an investment bank to a commercial bank holding company. It could certainly see the writing on the wall (or knowing how well Goldman has infiltrated the Treasury, it was probably told what the writing on the wall was going to be).

Being a major U.S. bank today means being able to get your hands on lots and lots of cheap money. Pick a multi-billion-dollar credit facility, any multi-billion-dollar credit facility! It’s acronym soup over at the Fed these days. Here’s a summary from Peter Morici:
The Federal Reserve has provided the banks with lots of cheap funds through its various emergency lending facilities and quantitative easing.

The Federal Reserve has permitted the banks and financial houses to park vast sums of unmarketable paper on its books—securities made nearly worthless by the misjudgment and avarice of bankers. In return, the Fed has provided these scions of finance with fresh funds, cheaply, that they may lend at healthy rates on credit cards, auto loans and even mortgages.
The banks get almost-free money (apparently using their toxic asset crap as collateral), then they turn around and lend. But at cheap rates that will benefit their customers, so that’s good right? Well, that was the idea anyway. Continuing with Morici:
While the Fed cuts the banks slack, the bankers are busy turning the screws on their debtors by raising credit card rates and fees, and harassing distressed borrowers with all the zeal of the Roman army sacking Palestine.

It takes good banking skills to borrow at three percent and lend at five and make a profit.

It takes much less business acumen to borrow at two and lend at five and make a profit, and that is exactly what has happened. The extra fees are just gravy.
So Goldman also got a big boost from higher-than-normal spreads in the credit markets. The big banks are getting a really good deal on borrowing right now and giving a not-so-good deal when they lend, then slipping the fat profits in their pockets.

(Earning season game: watch the interest margins for the big banks as they report. The spread will probably be nice and wide, assuming they're making enough loans for the impact to show up.)

Meanwhile the lending picture remains grim. Lending among the major banks (flush with TARP funds) fell 2.2 percent in February. In this CNBC story Donald Trump says that banks "virtually laugh” in the faces of loan seekers, no matter how creditworthy they are.

And the beat goes on. But at least let's recognize what's happening here. Goldman should include a footnote to their first-quarter earnings, acknowledging their success was due to the banking industry’s favorite uncle, Sam. Or should he be renamed Uncle Sugar?