What Goldman's Earnings Say About Risk-Taking

Goldman Sachs Group (GS) has just come out with a quarter that will please everyone.

Unfortunately, this was telegraphed by recent analyst calls with above-estimate forecasts.  The investment banking giant -- a.k.a. “bankless” bank-holding company -- posted earnings at $4.93 a share versus $3.54-a-share estimates, on revenues of $13.76 billion versus estimates of $10.6 billion.

The result is notable because Goldman, almost alone among financial companies, has been taking on risk in recent months, rather than shying away from it.

The Earnings Results

"While markets remain fragile and we recognize the challenges the broader economy faces, our second quarter results reflected the combination of improving financial market conditions and a deep and diverse client franchise," Chief Executive Lloyd C. Blankfein said.

Goldman’s profits, up 65% versus a year ago, came on the back of a sweet 46% run up in net revenues to $13.8 bn. The huge gain came in net revenues primarily came from trading and principal investments with a 93% gain. Another growth area for the company was a large rise in net interest income.  This was $2.04 billion, which compares to $1.28 billion a year ago.

Investment banking was stronger than recent quarters, but down 15% from a year ago.  The big drop was in financial advisory operations, which saw a 54% decline.

However, Goldman’s second quarter profits enjoyed a paper gain from the firm’s investment in ICBC bank in China, a stake that added 28% to Goldman’s $3.4 bn bottom line for the quarter.

Overall, Goldman’s results included a $426 million dividend related to the repayment of $10 billion in loans from the Troubled Asset Relief Program. Excluding that, earnings were $5.71 a share.

Goldman was one of 10 big banks that repaid its funding from TARP, paying back the $10 billion it got from the Treasury Department last year after it got its charter as a bank holding company in September. It also got the FDIC to insure $22 bn in debt it had issued.

Many banks had said they wanted to pay the TARP money back as soon as possible because of restrictions imposed by the government, including on executive pay. Morgan Stanley (NYSE: MS) and Goldman Sachs fully transitioned to bank holding companies to get access to TARP funds.

The company’s Tier-1 capital ratio is listed as 13.8%, and it issued its book value as being $106.41, with tangible book value $96.94 at the end of the quarter.

Taking On Risk

What is obvious here is that Goldman Sachs is living up to every bit of its expectations on how it is routinely and systematically taking money out of the markets in its trading activities -- which was already known based upon recent reports.

But Goldman has been facing danger from its heavy exposure to the stock markets, which have been volatile in recent months, and its "book" of so-called distressed investments, which includes everything from troubled auto loans in Thailand to struggling golf courses in Japan.

While others are shying away from risks, Goldman is courting them. A common measure of risk-taking at Goldman and other banks is known as value at risk, which estimates how much money a firm might lose on a single day. At Goldman, that figure rose by more than 20% in the first quarter. Analysts predict Goldman’s V.A.R. ran high in the second quarter as well.

What’s Good for Goldman…

In addition, Goldman benefited from a number of government policy moves and bailouts related to the financial crisis.

For instance, American International Group (NYSE: AIG) paid out $12.9 billion to Goldman to cover Goldman’s massive bets against U.S. subprime loans, a bailout sum for Goldman that made it whole, 100 cents on the dollar.

In this deal, Goldman also managed to get 100% of the face value of collateralized debt obligations that the Federal Reserve purchased so AIG could avoid having to pay out on its insurance contracts on those securities

That’s a full 100% that the U.S. taxpayer paid Goldman, even though those securities were likely worth much less on the dollar. Goldman and other counterparties were paid by the taxpayer through AIG’s “conduit” for losses, losses that didn’t yet occur.

And it got the taxpayer money here despite the fact that Goldman repeatedly said it was fully hedged and that its exposure to AIG was immaterial. Prior to the bailout, Goldman had already wrung out of AIG $5.9 bn.

Why did Timothy Geithner, now Treasury Secretary but at the time President of the Federal Reserve Bank of New York, use taxpayer money to pay 100% of the value of these trades which even Goldman knew were clearly at risk of declining in value, given that Goldman bought from AIG insurance in the form of AIG swaps on these trades?

And why did the U.S. taxpayer have to pay back the collateral on the trades after AIG was downgraded, given that the U.S. government stepped in and backed AIG -- and that the government itself is a Triple-A rated entity?

The inspector general of TARP, Neil Barofsky, has said he is prepared to audit the decision to repay in full counterparties of AIG, the insurance group bailed out with $173bn of government aid.

The Government Accountability Office has already recommended the Treasury should demand “concessions” from AIG’s counterparties and executives “including seeking to renegotiate existing contracts.”

Also, executives at Goldman sold almost $700 million of stock following the collapse of Lehman Brothers last September, according to filings with the Securities and Exchange Commission.  Most of the sales occurred during the period in which the investment bank enjoyed the support of TARP money.

Problems Lurking on the Balance Sheet

Even after assets under management plunged 12% from the year-earlier period, Goldman still has $54 billion in truly dicey assets on its balance sheet that it gets to price based on its own internal models (called Level 3 assets) -- the worst of the worst in radioactive assets.

That $54 billion sum swamps both Goldman’s net worth on a hard asset basis of $51 billion, a measure called tangible common equity.

A look at Goldman’s footnotes shows that its Level 3 assets are still pretty bad, and that Goldman is working hard to hedge these bad bets. That’s a far cry from the first six months of last year, when Goldman recorded $781 million in paper gains from these assets, after they were offset by any losses in other assets.

And remember -- during this earnings reporting season, to avoid a run on bank deposits, the government allowed a bank run on the taxpayer, with massive capital injections of your money into the banks. All of the banks are showing better profits from your money, as they are made whole while you are not.

--FOXBusiness.com Senior Editor Joanna Ossinger contributed to this report.