Goldman Sachs: Oversold or Value Trap?
The plot thickens. Investors have even more to chew on regarding Goldman Sachs (NYSE: GS) as possible criminal charges hit the rumor mill, and the Oracle of Omaha expresses his unabashed support. Shares fell about -20% after the Securities and Exchange originally filed a complaint against the banking behemoth. A subsequent rebound proved premature as shares fell sharply again on Friday. So at current prices, are shares trying to find a bottom before an eventual rebound, or are they ignoring more bad news to come?
Before answering that question, let’s try to anticipate how events will play out in coming months. First, Goldman will need to deal with the SEC. Pundits have gone back and forth over whether the government has a strong case. The latest read seems to tilt in favor of the SEC, as investors increasingly suspect that the case is even stronger than has been let on (since the government need not show the depth of its finding when bringing preliminary charges). Analysts also think the SEC would not have brought the case up if it did not believe it to be airtight. SEC morale hinges on successful outcomes, and the agency’s lawyers have a bias against bringing cases that they might lose.
While it may appear that the SEC case could drag on for some time, Goldman would likely look to settle as soon as it concludes that the government’s case is indeed strong. A fine in the $500 million to $1 billion range is not inconceivable, which would likely only represent around 1% of the company’s market capitalization.
The greater threat to Goldman is legislation coming out of Congress, as well as new banking rules proposed by the Obama administration. When Senator Dodd (D-CT) was originally drafting his bill to overhaul the banking industry, he sought to make sure that major banks would not have to exit any key lines of business. But Senator Blanche Lincoln (D-AK) introduced a bill that would prohibit Federal “bailouts of swap entities,” that would effectively force banks such as Goldman Sachs to exit the highly lucrative derivatives business if it wanted access to the Federal Reserve’s , any advances from the government when it serves as a lender of last resort in a crisis, and the backing from any FDIC-insured businesses. Those provisions would likely be too a high a cost to pay, and Goldman and its peers would likely seek to shed their derivatives businesses.
But the debate continues. FDIC Chair Sheila Bair thinks that forcing banks out of the derivatives business is a bad idea, as it would crimp liquidity in a market that only works when many players are involved. And it would invite even less-regulated entities into the derivatives market. A combination of banking-friendly Republicans and liquidity-concerned Democrats could hold enough sway to prevent Senator Lincoln’s efforts. For Goldman’s shareholders, this may prove to be a key factor in the future direction of the stock, as the firm has the highest exposure to derivatives of any of the big banks.
The “Volcker rule,” which the Obama administration has started to support, would also force Goldman to sharply downsize another lucrative division: proprietary trading. Prop trading has increasingly become a component of bank profits, but also creates a much higher degree of risk as those proprietary trades might turn sour. The Volcker Rule seeks to diminish that risk by making sure that commercial banks, the heart of our economy, can not be laid low by risky trading. Goldman currently derives $3 to $4 billion in revenue from prop trading, typically tying up $8 to $10 billion to support those trades.
Goldman also has nearly $25 to $30 billion tied up in hedge fund sponsorships and other investments. It’s unclear how much of that would need to be shut down or sold off. (Goldman would still be able to retain proprietary trading activities in areas that support its role as a market maker and lender). The Volcker Rule has received increasing support from Democrats and strong resistance from Republicans. Its passage appears probable, but far from certain.
Looking at the changing regulatory landscape, investors need not be too concerned. If Washington forces Goldman and its peers to exit certain lines of business, then the capital committed to those divisions will simply be reallocated elsewhere. Revenues and profits may shrink a bit, but not enough to justify the stock price swoon. A fairly hefty stock buyback would likely be the result of the freed-up capital.
Of additional concern to investors: the possibility of criminal charges. Rumors abound that Goldman may eventually be charged with fraud in its mortgage dealings. When Goldman notes that it lost money on the deal, it misses the point. The outcome of a transaction is far less important than how it was structured and how that information was disseminated. Although we are not privy to all the facts, it does appear that Goldman did not maintain its fiduciary responsibility to represent the best interests of its clients.
Then again, a criminal charge may be hard to pursue, because we are talking about very sophisticated buyers and sellers. Accredited investors are expected to conduct their own due diligence on investments, regardless of whether a broker assures a client that it is a good deal. On that score, Goldman is looking at ways of beefing up disclosures and tightening the rules on what kinds of investors can buy into its complex deals.
It is also too early to handicap the growing pile of shareholder lawsuits that have been filed against Goldman. Unless the SEC takes very aggressive action against Goldman, and the firm also loses criminal complaints against it, these civil lawsuits probably won’t gain traction.
What sayeth the sage?
Warren Buffett sure seems to think this is much ado about nothing. Not only does he think the issues have been overblown and misunderstood, but he thinks Goldman is a clear bargain at current levels. Then again, he’s a major shareholder and is unlikely to talk down his portfolio. But the “world’s greatest investor” also has his own reputation to consider, and would be unlikely to stand by Goldman so publicly if he believed the company was damaged goods.
But is that precisely what Goldman has become? It’s been a long-held belief that you want to do business with Goldman because its staff has always had an insider’s view of the market. Goldman greatly benefited from its leading role, but clients also profited by riding shotgun. As we now know, Goldman clients don’t always come out ahead, which could be troublesome for future dealings.
During the next few quarters, we’ll hear a lot more about whether clients are staying put or taking their business elsewhere. In the meantime, it would be foolhardy to bottom-fish these shares. This may all blow over, and Washington’s reforms may lack any real bite, but the news headlines in the weeks to come are bound to remain dire.