All Eyes On Goldman Sachs

All eyes are on Goldman Sachs Group (GS), which beat the Street's estimates by ten cents a share with fiscal third quarter earnings of $1.81 a share. 

Analysts had expected $1.71 a share. However, the profit drop was Goldman's worst year-to-year decline since going public in 1999, versus its track record of posting the best profit record on Wall Street in the last two fiscal years.

Goldman is reporting profits as the worst tsunami in the history of Wall Street continues to submerge entire companies, the latest being the damaged American International Group (AIG), Lehman Bros., (LEH), the biggest Wall Street bankruptcy in history, the near-death experience of Merrill Lynch and its eleventh hour deal to sell itself to Bank of America (BAC), all coming fast on the heels of the government's rescue of Fannie Mae (FNM), Freddie Mac (FRE) and Bear Stearns. 

Goldman, one of two remaining independent investment banks down on Wall Street still standing, along with Morgan Stanley (MS), has been trading at 52-week lows. Goldman's stock is down, but once traders parse through its results shares could get a bump up.

Like the result of Wall Street, Goldman's earnings look dismal compared to last year's results when the housing and credit bubble was just starting to deflate. Overall, profit results are expected to be seasonally weak on Wall Street as the fiscal third quarter is historically frail. 

Profit Results Down

Goldman's net income came in at $845 mn, down a record 70% from $2.85 bn, or $6.13 a share in the same period a year earlier. Revenue came in at $6.04 bn, less than the $6.23 bn expected. Goldman made it into the black, and, given its hands on management of analysts' expectations, has beaten consensus estimates for the last 13 quarters.

As global equity markets weaken, Goldman is seeing lower trading volumes, a big keystone to its earnings. Revenue from equities trading, investment banking, which includes M&A advisory services, as well as equity and bond underwriting all fell versus the year-ago period.

"This was a challenging quarter, as we saw a marked decrease in client activity and declining asset valuations," Goldman Sachs chief executive Lloyd Blankfein said in a statement.

Goldman's Writedowns

Goldman reported a total of $1.1 bn in writedowns on leveraged loans and hedges, mortgages and mortgage-backed securities and commercial mortgages and related asset-backed securities. The firm dumped $4 bn in mortgage securities at prices that were "higher this quarter," and that it has slashed its leverage loan exposure to $8 bn from $52 bn a year ago.

Fox Business reporter Ken Sweet, who listened in on Goldman's earnings conference call, reports that Goldman's chief financial officer, David Viniar, says: "Goldman Sachs has not emerged completely unscathed" from the problems affecting all of Wall Street, adding, "we are protecting our franchise at all costs."

Moving Rapidly to Deleverage

All of Wall Street and the banking sector, notably Citigroup (C), are moving quickly to delever their balance sheets, a leveraging that was riproaring fun as it juiced profits to stratospheric heights during the credit bubble, gearing themselves up as much as 40 to 1 (borrowings versus assets). But those reckless borrowings are now vaporizing profits earned over the last several years.

Goldman's leverage ratio is still pretty high at an estimated 24 to 1, higher than commercial banks at about 20 to 1, plus it too has remaining real estate assets and other credit exposures on its balance sheet.  

Goldman is moving rapidly to delever its balance sheet at a time when the credit markets remain in blackout mode.

Also, return on tangible equity at Goldman, an important profit figure on Wall Street which shows what it earns on its hard assets (which excludes ephemera like the value of its stakes in preferred shares or other mushy intangibles like goodwill) was 8.8%, about a third of the 23.5% second quarter result, Fox Business's Sweet reports. That hurts.

Viniar notes too that "the Federal Reserve's actions this weekend lowered our liquidity risk as well," as the firm's "access to liquidity has always been broad, [but] this has broadened our access further."

Merging With a Bank?

On the earnings conference call, Viniar tossed cold water on the idea that Goldman would merge with a commercial bank, and whether investment banks need the capital cushion of a bigger bank player, as was the case with Merrill Lynch's deal to sell itself to Bank of America.

Specifically, Viniar said Goldman has not considered merging with a bank, noting that the problems with other investment firms "instills a lot of fear in the marketplace."

Not Exposed to Lehman and AIG

AIG had its credit ratings cut last night by Standard & Poor's and Moody's, triggering fears that AIG will need to raise funds to post more collateral.

Goldman and JPMorgan Chase (JPM) were reportedly being asked by the US government to help steward a $70 bn to $75 bn credit lending facility to buoy AIG, a lending facility that could hurt their firms' credit quality down the road. Viniar's comments seemed to indicate that Goldman would not put up the money for AIG.

Goldman "didn't put money in Lehman" and "don't believe the stories about AIG." Viniar then added that he "cannot comment on what we're doing with AIG, they are important clients," but that the problems at Lehman and AIG "would be immaterial to our results."

Goldman's Kryptonite

But while investors believe that Goldman chief executive Blankfein has legs you would want to hang onto in a hurricane, due to his firm's trading prowess and white-shoe client base, one of the last of the independent bulge bracket brokerages still faces headwinds.

And watch out for Goldman's toxic, most illiquid assets, assets it pricetags on its own because the markets are frozen solid for them.

These assets amounted to $68 bn, or 6% of its total assets, in the third quarter. That $68 bn is down slightly from $69.2 bn as of November 2007, as the decade of excess is still being unwound.

There's a danger zone here. This illiquid Kryptonite swamped Goldman's net worth (assets minus liabilities) of $45.6 bn.

The iced-over assets included mortgage and other asset-backed loans, bank and bridge loans, leveraged loans, corporate debt securities and equities, convertible debentures as well as cash instruments and derivatives. (Goldman says the amount of illiquid assets it's responsible for is really $58 bn, or 5% of total assets, as the $10 bn is financed by non-recourse debt from investors.)

Goldman does note that it's got $102.3 bn in liquidity.

Still, a look at Goldman's footnotes shows how this kryptonite, its so-called level 3 assets, are deteriorating in value, and how Goldman is working to hedge these bad bets.

For the first six months of  last year, Goldman recorded $781 mn in paper gains from these assets, which were offset by any losses in other assets. But for the first six months of this year, Goldman disclosed these assets dropped in value by $1.49 bn, as these sums have eroded dramatically.

Though Goldman was out earlier with this red flag result last summer, reporting sooner as new accounting rules loomed, like most Wall Street firms, Goldman doesn't report an updated figure for it in its profit releases or on its earnings calls, waiting to do so weeks from now when it has to file its latest quarterly with the Securities & Exchange Commission.

Despite all this, Goldman is still considered the best in breed, having dodged most of the credit crisis's bullets with smart bets to avoid the paper Kryptonite causing acid reflux all around Wall Street. It also didn't take on as much water as its competitors in the form of leverage to do its business.

Morgan Stanley Reports Tomorrow

Morgan Stanley is expected tomorrow to post earnings of 77 cents a share on $6.28 bn in revenue, and expect earnings of $1.10 and $7.42 bn in revenue next quarter.

The US economy may really hit the skids in the fourth quarter, a consensus of economists indicates, the capital markets are weakly sliinking along, as the issue of solvency now is the order of the day, with liabilities sawmping assets.

Profit margins are withering fast as a salted snail all across Wall STreet, and I've already reported to you that sales are down two-thirds in the first half versus the year ago period but expenses are down just 10% during the first six months, as the fat marbled through operations remains to be cut, Meredith Whitney, Oppenheimer analyst, notes.

A barren, wintry feeling is setting in, but it's not a financial nuclear winter just yet, because the stalwarts Goldman and Morgan may remain beacons showing the way out.