The S&A Digest

Editor's note: In October 2007, Porter started writing about Goldman Sachs... and why the most revered bank on Wall Street was going to fail. When the subprime crisis began, every bank in the world took massive writedowns on their mortgage debt... except Goldman. Were Goldman's employees really that much better than everyone else on the street, or were the bank's accountants a little more "creative"?

Eventually, Porter was proven right. Goldman Sachs' stock fell from a high of $250 in November 2007 to below $50 in November 2008. It ran to the government for a bailout and became a commercial, deposit-taking bank, under the watch of the FDIC. Apparently, the company's traders really don't "walk on water."

October 16, 2007: For the last year, we've been telling Goldsmith that Goldman Sachs (GS) must soon take a huge charge against earnings – more than $1 billion – because of inevitable mistakes made by its trading group and the huge amount of leverage the company employs (debt totals $431 billion).

Young Goldsmith seems to believe Goldman's traders walk on water... and thinks we're only jealous. But we've lived through a few of these cycles. We already know what Goldsmith will soon learn: Pride goeth before the fall. It is only a matter of time before Goldman admits its excesses, like Merrill Lynch (MER) did two weeks ago, writing off $5.5 billion in profit.

In the last quarter, Goldman Sachs reported trading revenues of $8.23 billion, a 70% increase year over year. But Goldman's cash-flow statement shows it lost $18.9 billion on operations and borrowed $23.7 billion during the quarter to stay afloat. We surely don't understand everything about high finance... but we're fairly certain that borrowing more money each quarter and losing it on operations isn't sustainable forever.

Jim Chanos, the famous short seller, wondered aloud at Jim Grant's investment conference last month how Goldman is able to continually report blockbuster profits. Analysts speculate that it is exaggerating the balance sheet value of its illiquid mortgage investments. We can't say when Goldman will come clean, but we do know how: painfully.

The situation at Goldman reminds us of the last big debt bubble – the telecom debt bubble of 1996-2001. Every long-distance company in America was losing money, reams of it, as long-distance prices collapsed. There was only one exception: WorldCom, which continued to report positive earnings even as all of its competitors experienced losses. Investors who bothered to look at WorldCom's cash-flow statement saw something quite different than what the company put in its earnings press releases: $11 billion in cash losses during 2000 alone.

October 30, 2007: What's most interesting to me about the whole mortgage mess is the share price of Goldman Sachs: It hit a new high yesterday. Which do you believe is more likely: The managing directors at Goldman Sachs are incredibly superior to every other investment bank in the world, or the firm simply hasn't come clean yet with the real value of its mortgage holdings?

November 5, 2007: As we've noted in these pages previously, either the managing directors of Goldman Sachs have all sold their souls to the devil in exchange for unlimited financial power, or their share price is destined for a large correction. All of the major Wall Street banks engage in essentially the same strategies. They all trade the same markets... and they have all piled into highly rated mortgage debt. These "pools" of mortgage loans were spiked, like the punch bowl at a cotillion dance, with highly toxic subprime debt. Some of the "dancers" have already been fined for public drunkenness.

To date, Goldman has avoided marking down its assets – but it is only a matter of time. According to Bloomberg, Goldman has more subprime debt outstanding than Credit Suisse, which has almost $10 billion; Citigroup, with $6.8 billion; or JPMorgan Chase, with $7.8 billion. Goldman ranks 10th among 118 issuers, based on the amount of subprime loans still on the market. Which firms have the biggest exposure? Lehman has $33 billion and Morgan Stanley has $28.8 billion. Below... a chart comparing the relative share price of Citigroup (in red) to Goldman Sachs (in blue).

November 7, 2007: Once Goldman Sachs employees cash their Christmas checks, they'll be able to buy Bear Stearns. Goldman has set aside $16.9 billion for salaries, benefits, and bonuses through August, enough to buy $14.7 billion Bear Stearns, the fifth-largest U.S. bank.

Goldman's pay pool already eclipses the $16.5 billion for all of last year, and analysts expect Goldman's earnings to increase 16% over last year's record numbers. Call us naïve... but we doubt the mortgage problems that have spread around the world and into nearly every financial company will spare Goldman – no matter the current size of that bonus pool.

Shares of Bear Stearns and Goldman used to trade largely in tandem – they're both in the same business and, often enough, even in the same big trades. We figure they still are... but the market hasn't realized it yet. Below is a chart of the relative changes in the share price of Bear Stearns (in blue) and Goldman Sachs (in red).

November 9, 2007: Morgan Stanley now expects a $3.7 billion mortgage writedown and a $2.5 billion hit to earnings in the fourth quarter – and these losses come despite the fact that derivative traders at Morgan Stanley actually bet that subprime mortgages would fall!
So... even the banks that were "smart" about the risks of subprime are taking big losses...

Again, we wonder what that will mean for Goldman Sachs, the biggest, "smartest" investment bank of them all. As you can see from this chart, Goldman hasn't taken the plunge... yet.

November 12, 2007: While Canadian paper mills are hitting bottom, one of Wall Street's "paper mills" has remained strangely untouched by the mortgage crisis – Goldman Sachs. By now, you must be familiar with our argument: Like a rubber ducky floating in a toilet, Goldman's stock must soon spiral down into the cesspool of the mortgage debacle.

What might explain Goldman's curious immunity from a big mortgage-related charge against its book value? We've learned the firm is setting aside more than $16 billion for this year's bonus pool. But... how big would the bonus pool be if Goldman were to take a big ($5 billion to $10 billion) write-off before the end of the year? We don't know exactly, but we would venture to guess: several billion dollars less.

Reuters reports that if Goldman doesn't take a big loss on its mortgages, Blankfein will get a $75 million bonus this year, up $20 million from last year. Goldman's co-presidents, Gary Cohn and Jon Winkelried, will get $70 million each. It's hard to believe shareholders would agree to pay one president $70 million... and Goldman's got two of 'em! Shareholders are about to get what they deserve...

Now that we've identified Goldman's motive for masking the size of its mortgage losses, we've been searching for the weapon. How has Goldman hidden its losses, we wonder? We've been playing a game of Wall Street Clue. "It was Colonel Mustard... in the library... with the wrench..." No, it was CEO Lloyd Blankfein, in the boardroom, with illiquid bonds that can't be priced.

An entire category of financial assets (called "Level 3 assets") are so illiquid they can't be accurately priced. To make up for the lack of a true market for these assets – which include certain kinds of securitized mortgages – Wall Street uses computer models. (Reminder: When your broker starts talking about a computer model, grab your wallet.) Or, in other words, these big banks are allowed to "pick a number" for the value of these Level 3 assets. Guess which big Wall Street bank has the largest pile of Level 3 assets as a percentage of its equity? That's right, Goldman Sachs.

November 13, 2007: Maybe we're wrong about Goldman Sachs... "We continue to be net short in these markets," claims Goldman's bonus-in-waiting CEO Lloyd Blankfein in response to a question at an investor conference. He also said Goldman will not take any significant writedowns on mortgage-related assets.

OK... maybe it's not mortgages that Goldman will trip over. But there's something down there, we'd bet. Why are we so sure? Over the last three years, Goldman Sachs reported net income totaling $19.6 billion. On the basis of these "profits," the managers took their bonuses and their glory as Wall Street's smartest investment bank. Meanwhile, Goldman produced no net cash flow. In fact, cash flow over the last three years is negative $93.6 billion. There's a $113.2 billion disparity between the amount of cash the company produced from operations and the amount of profits it claimed via its accounting. Even when you factor in all of the returns from its investments (which produce negative operation cash flow), you still end up with a net negative number... –$800 million. I've got no doubt that Goldman has the world's smartest accountants. In fact, I wonder how many of them used to work at Enron...

February 15, 2008: You might recall our skepticism on Goldman Sachs' accounting...

How, we wondered, could one investment bank manage to be on the right side of every trade, year after year? Goldman Sachs isn't Lake Wobegone, and its traders can't all be above average. Given a choice between believing Goldman has found a way to train and retain super-human traders, who are never wrong, and believing that Goldman has the very finest accounting department on Wall Street, we choose to believe in the accountants.

And... we're not the only skeptics anymore. Now, even the Wall Street Journal is asking a few tough questions. For example, Goldman holds $43 billion worth of leveraged loans, which don't have a liquid market anymore. How should these loans be valued? Judging by the publicly traded pools of leveraged loans, you'd have to guess a discount of 15% to 20% to net asset value. And Goldman owns $12 billion in private-equity investments. Judging by the share price of other private-equity firms (like Blackstone) and the prices of private-equity targets (like Harmon), you'd have to guess the real price of these investments is now down between 40% and 60%. That amounts to $4 billion to $8 billion
– at least – in losses alone. Sooner or later, Goldman – like all of the other investment banks have already done – will have to take a huge writedown. Until it does, we still think it's a good short.

March 7, 2008: It looks like Goldman Sachs CEO Lloyd Blankfein is gearing up for a loss. In a recent Forbes interview, he said, "If you're on a beach and a tsunami hits, you'll drown whether you're a small child or an Olympic swimmer." He also said, "I'm always imagining how much worse the headline about Goldman will be when we screw up if we have a quote out there claiming magnificence."

I couldn't imagine things getting much worse. Already, Goldman had protesters outside one of its holiday parties singing "Goldman the Two-Faced I-Bank" (to the tune of "Rudolph the Red-Nosed Reindeer") and "Frosty the Goldman" ("Frosty the Goldman/Was a very crafty soul"). Shares of Goldman Sachs touched a 52-week low of $157 today.

March 17, 2008: After swearing up and down that it did not have exposure to the mortgage mess, Goldman Sachs released earnings today and announced it had lost $1 billion on residential mortgages. Oops. Goldman's net income plunged 53%.

April 9, 2008: Goldman reported a 39% increase in its Level 3 assets this quarter. Level 3 is the toxic stuff: subprime mortgages, securities backed by commercial real estate, and other highly illiquid investments. Goldman is now carrying $96.4 billion of Level 3 assets on its balance sheet. The entire bank is only worth $76 billion.

September 22, 2008: Over the weekend, the SEC allowed Goldman Sachs and Morgan Stanley, the last-standing Wall Street investment banks, to convert from securities firms (regulated by the SEC) to deposit-taking lenders (regulated by the Fed). As bank holding companies, Goldman and Morgan will be forced to drastically reduce leverage and instead raise capital through retail deposits.

The move raises two interesting questions. First, who in his right mind would put his savings in either of these banks? And second, what will the Fed's banking regulators say about Goldman's accounting?

September 24, 2008: Last night, Warren Buffett announced Berkshire Hathaway (his holding company) would take a $5 billion position in Goldman Sachs. Before you rush out to buy Goldman's stock, you should consider a few points...

First, you can't buy the kind of stock Buffett got on any market, anywhere in the world. Berkshire Hathaway is buying $5 billion of perpetual preferred stock with a 10% coupon. These shares are senior to both Goldman's other preferred stock and its common stock. That means no other shareholders will receive any dividends until Buffett has been paid his 10%, in full, each year.

And that's not all... To sweeten the deal for Buffett, Goldman agreed to include a warrant (a long-term call option) that entitles Berkshire Hathaway to buy an additional $5 billion in regular common stock, at $115 per share. (Goldman's trading for about $130 now.) Thus, if Goldman can turn things around, Berkshire will receive an enormous payday down the road. It will be entitled to buy stock at $115, no matter what the price has risen to five years from now.

I've watched Buffett carefully for nearly 15 years. And this is probably the best deal I've ever seen him get, which tells me Goldman was in even worse shape than I'd imagined.

October 1, 2008: Buffett likes to say of the financial industry, "You never know who is swimming naked until the tide goes out." We'd been convinced for a long time that Goldman Sachs was "swimming naked." And when the tide finally went out, we were right.