The Goldman heyday

What are we to make of Goldman’s Q1 results…? Making $3 b in as many months is indeed recession defying but how much of it is its own making in contrast to the near absence of competition – Citigroup, UBS, Lehmann and its ilk? The Economist says - To the survivor the spoils - and I can’t agree more.

Monday, after market close, Goldman Sachs Group, Inc. reported 1Q09 earnings of $1.66 billion or $3.39 a share, up from $1.51 billion, or $3.23 a share a year earlier. The results were way ahead of consensus estimates of a profit of $1.64 per share.

Higher-than-expected profit was mainly due to strong trading revenue. Of the first quarter net revenues of $9.4 billion, $6.6 billion (34% higher than its previous record) was the contribution from the company’s fixed-income, currency and commodities (FICC) group. High volatility (benefiting the Treasury markets and the Dollar), wide spreads in fixed income and reduced competition in the markets were the main reasons for strong earnings.

However, the areas outside fixed income and currency businesses showed weakness during the quarter. Investment banking revenues were down 30% year-over-year, due to the low activity in the capital markets. Asset management revenues also declined 28% to $949 million.

Again as the Economist says this windfall will likely dwindle soon. The firm may be scooping up market share at quite a clip. But the bigger picture is still far from pretty. Goldman and other survivors will benefit from the coming wave of debt issuance by federal, state and local governments. But dealer spreads are sure to shrink as markets normalise and those that have retreated return to the fray. This is likely to be offset only partially by a pick-up in businesses tied more closely to economic growth, such as advising on mergers and acquisitions.

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"Outrageous"

Sometimes you get to read funny combination of headline news. Today I had one such - on Wall Street bonuses and another on PE firms unlikely to invest now.

Even as the whole world reels under recession triggered by Wall Street excesses, they have no qualms in collectively showering upon themselves billion $ bonuses as usual. Barack Obama felt it’s “outrageous”. Indeed.

Another is not so retchy, yet funny. Now that valuations are at their near lowest, PE firms are unlikely to invest. May be they are waiting for hyper valuations to return so that they can stir in right earnest burning bigger holes in their investors’ pockets!

What they teach only at B-schools ?

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Bailout bill passed; now comes the hardest part

Yes. Getting the $700 billion mother of all bailout up and running.

From what it seems like Hank Paulson and his crack team (filled with ex-investment bankers, attorneys and accountants) has its priorities cut out. It will have to decide which assets to go after first, and who to buy them from. Congress has given Treasury wide discretion to decide what assets to target. Although most of the funding is likely to go toward buying up mortgage-backed securities and whole home loans still held on the books of the lenders who originated them, Treasury can also buy up construction loans, home equity loans, or even credit-card debt or car loans if it decides that is necessary.

Does that mean Treasury is likely to start out buying from banks, in an effort to shake the credit markets back into shape – biggest banks first, in that order? If so, whether to go after widely held MBS or exotic one-of-the-kind stuff…? Whoever Treasury buys from initially, the biggest issue is one of pricing the assets since market for these securities has dried up, making it hard to figure out what any of them are worth amid fears that the underlying mortgages have gone sour faster than expected. If they price it too low, banks won’t attend the auctions. If they price it too high, the government will be taking too much load. The task will be somewhat simpler when Treasury buys assets from firms that have already marked down the value of their assets to current fire-sale prices. Anyways, the initial success of the plan should have a multiplier effect in helping bolster other banks, even if they don't take part in the auctions. By purchasing assets similar to those that other institutions hold, Treasury would essentially establish a new market price, which the nonparticipating banks could use to improve their balance sheets. That might also reassure other investors enough that they start buying as well.

The irony is, Paulson will not be able to find asset managers to run this that don't already have distressed assets on their own books; there's no one else to do it. Hiring people to fix the very problem they helped create will be an issue. For that matter even Hank Paulson is an ex-Goldman Sachs alumnus – a part of the problem in a way. Conflict of interest or not, success of the program could hoist Hank Paulson a big hero, may be win him a candidature for next Presidency. Failure would mean a return to economic dark ages - not just for America, if the downward drift of global markets (post passage of the bailout bill) is anything to go by!

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Parsing the crisis

T.T.Rammohan squeals in Business Standard

On risk management and quality of leveraged assets

“The top investment banks have vanished as a class [not] because they were highly leveraged: In financial institutions, leverage or the ratio of debt to total assets, can be misleading as a measure of financial risk. The management of asset risks is equally important. A financial institution can be highly leveraged but if its assets are of high quality or are highly diversified, the institution is not exposed to high risk….

Investment banks may have had a leverage of more than 20:1 but some high-profile banks in Europe today have even higher leverage. What counts is leverage after adjusting for the risks of various assets. The European banks in question would not be allowed to operate if their leverage was not in conformity with regulatory norms. ….The trouble with the investment banks was not so much leverage as poor asset quality and heavy dependence on short-term funds.”

On short selling

“Short-sellers were right on Lehman, so short-selling should not be banned: Yes, short-sellers were right in sensing that Lehman had more problems than it had disclosed. But, in times of crises, it makes sense to ban short-selling because a fall in share prices sets off a vicious spiral that pushes an institution quickly into bankruptcy. A fall in the value of equity causes leverage to rise, which causes the debt rating to fall. This, in turn, prompts demands for higher collateral, which forces distress sale of assets, which erodes equity value. Before you could say ‘Hank Paulson’, the firm is gone. In financial crises, as in times of war, the normal rules of information must stand suspended and this applies to price discovery [enabled] by short-sellers.”

Splendid. Wonder how well K.V.Kamath’s defense goes down with people!

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Get your act together, IT vendors...!

Readers of this blogstream should be wary of my screams for innovation in India’s IT vending space.

Now here is an analysis that explains why overwhelming focus on one sector – Financial Services – is extremely vulnerable. With the Wall Street turmoil, some of India’s big IT outsourcing vendors face a frosty weather.

I shall repeat. Go beyond BPO, ADM and easily replicable services. Differentiate. Make meaningful dents in diverse high-end fields like system integration, data center management, remote architecture support, process automation coupled with product innovations that stun the markets with their utilities and features.

And…And…And… Focus on domestic market. You’ll be in far better control. See Bharti has awarded its $1 billion IT infrastructure maintenance contract to IBM, not to any of our famed vendors ;-)

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Killing I-banks is stifling innovation in structured finance

In a watershed moment, Goldman Sachs and Morgan Stanley last night abandoned their status as independent investment banks (and morphed into larger Universal Banks) in a move marking the end of an era on Wall Street. While the change appears to be a technicality, it means that both banks have equal and permanent rights to access emergency funds from the US central bank, the Federal Reserve – their only lifeline to stay alive. They will also be far more tightly regulated.

Well, in a way the Fed has ruled, though in this late hour of credit crisis, enough is enough. Suddenly I hear all Wall Street honchos, analysts and even erstwhile CEOs of these investment banks publicly admitting that it is the way to go. The era of independent investment banks had to end – as it has, now.

I look back a bit. Is it so simple? Isn’t it a bit ironic that the time-tested business models of the independent I-banks have suddenly become unviable? Were they inherently weak or has it been the lack of prudence that did them in? Or is it the lack of oversight and the unfettered, excessive leverage in ratios of 33:1 to blame?

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Specialists are specialists. They will have to stay that way. Can someone bring cardiology, a specialized domain under general practitioners because a few recent heart surgeries performed by cardiologists have failed?

I have a feeling they are prescribing the wrong medicine for the illness. What do they want, United Socialist States of America?

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The USSR brand of socialism failed because it was founded on anarchist theory – everybody’s property became nobody’s responsibility. Amercian free market economy is based on greed that is just human instinct like lust, envy or anger. They implore one to beat competition and excel. They are creative spurs, not unsystematic or anarchist self-serving socialist wet blankets.

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Get local. A Tata Steel ranked 65th in the global steel industry could acquire a Corus (ranked 5th) because of the liquidity provided by those enabling models. Now it’s going to be a slog all the way for the ambitious. This is like turning off the tap on growth when all that was needed was enforcing stricter compliance by a bunch of alert regulators. There is a strong case for these I-Banks to remain independent for the global economic engine to keep purring. The leverage that provided liquidity to help the poor afford homes is not entirely a bad idea. The level of social benefits that it entailed is not to be easily forgotten. The fault lay in promotion of fallacies like the house prices will always rise. Blame it on running poor credit checks on borrowers and allowing reckless leverage models. At best, are they not simple process lacunae? More importantly, haven't they been emitting strong enough signals for the Fed and SEC to reign them in, which they chose not to? Isn't it something that can happen even now, under Universal Banking? You agree?

I-banking as a division of another commercial bank will sure lose focus, its innovative drive and finesse. It can never be as nimble if it is burdened with the yoke of reserve requirements and Credit-Deposit ratios. It will lead to sub-optimal performance and deals won't get done in the same pace, at least. It will certainly fail to attract the best brains that can thrive only in a liberal, innovative ecosystem that spurs creativity and ingenuity. Can we make do with Levi Strauss type archaic regimes devoid of dynamic innovative spirit? Can we honestly say we never need structured finance innovations (imagine the convenience of a `sale and lease back’ and other factoring mechanisms) with changing times and dynamic business needs? That would be pure tactlessness wearing the masks of precautionary excesses. Just not up.

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Doctors failed to diagnose own symptoms

A.V.Rajawade makes some intuitive statements on the Wall Street fiasco. The best I quote

“…With total assets of $640 billion, [Lehmann Brothers] would be the largest ever bankruptcy filing in history. Those who charged millions of dollars as fees for advice on restructuring or selling others’ businesses could not manage to save their own…”

I concur. I have been way too immersed in the I-Banking sector to refute that. I know their mediocre and credentialist ways. In the PE world, mediocrity just rules the roost.

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Dreamworks - high on ideas, low on fuel

The much hyped deal between Steven Spielberg’s Dreamworks and ADAG’s Reliance Big Entertainment now rests at the mercy of JP Morgan Chase.

Although Reliance is poised to invest $500 million in the venture for a 50% ownership stake, that deal hinges on the group getting a firm guarantee from lead bank JPMorgan Chase to raise up to $700 million in debt financing to satisfy the business plan to make four to six movies a year. JPMorgan, which will not underwrite the entire portion of the loan as DreamWorks had hoped, will now attempt to syndicate it -- and that could take months.

Did you say months? That soon? Given the turbulence in the wall street, Spielberg will not have many options that are not already underwater.

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