Tuesday, October 16, 2007

Goldman's "Blowout Quarter"

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Thanks to reader msb, for highlighting this specific article via Fortune. I was writing back in September how these investment banks are black boxes and how it is impossible to gauge what exactly is going on as they have so many levers to pull and push - how could we really tell how they are doing? I also opined that the regional banks, who are not nearly as opaque, would not be able to pull off some trickery, so when it came time for their confessionals (now), we'd see reality. I did not realize the depth of level 3 pricing which in layman's terms means stuff that is so illiquid (meaning there is no true market for it), that "computer models" from within the firm actually determine their price. So there is no conflict of interest there and no 'fudging' I am sure. Further, I did not realize that UNREALIZED gains could be counted in a quarter? So if I have paper gains in my stock account for quarter 2, I can count those against my losses? Hmmm, that doesn't really work too well in my Ameritrade account because the next day those gains could evaporate - but I guess it works for Wall Street. (I could go on a rant here about how almost every serious accounting restriction gets watered down by corporate America by the time it gets to and through SEC committee but I'll leave that for another day)

The Wall Street Journal also points out hedge funds are doing the exact same thing - so essentially they can say "well this is the value of our holdings" when in fact large portions of their holdings are NOT measurable until they are actually sold since the market is so illiquid. So in an environment like we are in now, they KNOW the prices would be far lower (ok they won't admit they know that) so instead they just keep it on their books and value it by a computer model from an era of cheap money, and say, everything is fine. This is exactly what is going on with the SIV bailout fund - the last thing Citibank wants to do is actually 'mark to market' what is sitting in their off balance sheet SIVs, because the true value is much lower.

So there you have it folks, our biggest money center banks, our biggest investment banks, and the hedge funds which some say now account for 70% of all daily trading are all playing the same game - when things are great we usher in and celebrate 'free markets' - when things go bad, we hide things off our books, we don't dare try to sell things that we know would probably be worth 40 cents on the dollar and instead say "well the computer is saying its worth 98 cents on the dollar", and then we take these unrealized gains against BOOKED losses, and say "it was a great quarter" - remember how the market was SO happy and ramping so HIGH into the news the investment banks were doing a lot better than we thought? And oh yeh just in case all those steps above are not enough, we get bailed out by the Fed.... all the while trying to buy time in the hopes things turn around and then we can actually sell these things to some sucker when this is 'all forgotten' in 6 months. What a system?! Why don't we just take a Magic 8 ball, and shake it, and whatever comes out will be the value of assets on our books - I mean that is pretty much what we are doing now.

This is too complex and not sexy enough to actually play on national news stories (non financial ones at least) - but this is the reality of our 'sturdy' financial system (which is leveraged as badly as most subprime borrowers). And yes in some ways I am simplifying it and 'sharp' investor banking folk and hedgies will argue that I have no clue how it really is out there (and no I don't, but even Uncle Ben doesn't know whats going on as he stated last night in his meeting, even these companies don't seem to know their OWN exposure as we sliced and diced all this 'risk' into tiny parcels and mixed and matched, who knows what 'is' or 'is not' anymore - so how can any ONE person truly know what the heck is going on out there)- but in its most naked form this is really what it is.

What gets me riled up is its all so opaque and everyone in the upper reaches of 'financial world' gets to play by a different set of rules. And we create billionaires out of hedge fund managers to play by this set of rules that no one else would be allowed to, and in return we all get our dollar devalued so they can continue their reindeer games... all the while getting political speeches with cheery eyed smiles and assurances it's all good. When all this is happening in the background. Blah.

Anyhow from the Goldman article
  • However, Goldman's blow out quarter benefited from large gains in hard-to-value financial instruments, and its trading results in the period were particularly volatile, according to data contained in a Goldman filing of quarterly financial results with the Securities and Exchange Commission.
  • Goldman's stock has gained 13% since its earnings came out, as investors have bought into the notion that the bank is a cut above its peers and is able to weather, and even profit from, tough market conditions.
  • But that view could get revised, now that it can be seen in the numbers that a large proportion of its third quarter profits were 'unrealized' - i.e. paper gains, and not hard cash payments from fully closed out trades - and came from financial instruments that Goldman values largely according to its own estimates.
  • "The opaqueness of Goldman's balance sheet makes us immediately question how they made money in the quarter," says Charles Peabody, analyst with Portales Partners.
  • The interesting data comes from disclosures in the filing about 'level 3' assets and liabilities, which are securities and derivatives that can't be valued according to observable prices in liquid public markets. Because of their illiquidity, Goldman has to attach values to them chiefly according to in-house models and estimates.
  • Investors typically prefer banks to make money from liquid assets and liabilities that trade regularly because they have greater confidence that they are valued on the balance sheet at their real worth. This is why level 3 gains have recently become a hot topic for the brokerages, and it is a subject Fortune has looked at closely.
  • And Goldman reaped huge gains within the level 3 pot in the third quarter. For example, it made a net gain of $2.94 billion from level 3 derivatives, financial instruments whose value is based on the value of underlying securities. And get this: $2.62 billion of that gain was unrealized. Was that amount unrealized because there's no way illiquid level 3 derivatives could be cashed out at the prices Goldman attached to them? (so almost all of the $3 billion in gains were unrealized - if in fact they were real, why not sell them into the open market at market prices? baloney)
  • "Common sense tells me that a lot of their losses were real and a lot of their gains were paper, and that's something we'd like to know more about," says Portales' Peabody. Indeed, if that level 3 derivatives gain does include the stupendously prescient bet against mortgages, it deepens the mystery over what type of institution is on the other side of that trade, effectively holding the losses. In other words, if hedge funds - which operate with thin capital and high leverage -- are on the other side of a large part of this mortgage bet holding the losses, it may not be easy for Goldman collect all it is owed.
  • Asked about the derivative gain, Goldman spokesman Lucas van Praag responded that the level 3 derivative gains "did not come from level three inputs," but from "observable" data taken from more liquid markets. Why not classify the derivatives in the theoretically more liquid level 2 and level 1 pools, then? "The rules preclude us from doing so," says van Praag. (damn rules, always getting in the way of a great profit - wait, not in this case - no rules can stop Goldman from profitting - after all they are the rule maker)
  • Okay, let's say Goldman does end up making cash gains from all its trading gains in the third quarter. How likely is it that the bank can do it again? Hintz isn't convinced, responding: "Goldman Sachs has increased financial leverage, added illiquid assets and has the highest percentage of level three assets in the industry. This might also explain why trading volatility would logically increase."
On to the Wall Street Journal article on hedge funds doing essentially the same thing....
  • New academic research suggests that some hedge-fund managers may cherry-pick flattering prices when valuing securities that don't actively trade in an effort to improve the performance of their funds.
  • Investors should take heed because this massaging can help make the difference between a winning or losing month, the research found. For hedge-fund managers, such statistics on the number of winning and losing months have grown increasingly significant as the number of hedge funds has exploded -- to more than 7,500 -- and managers vie to attract and retain investor capital.
  • How to price hard-to-value securities has become a hot-button topic on Wall Street in recent months as debt markets froze up. This made it difficult at times for banks, brokers and hedge funds to determine accurate prices for some debt securities that trade infrequently or have wide gaps between offers to buy and sell.
  • The academic research found a significant difference in the number of funds reporting a slight gain compared with a slight loss in any given month. That difference was most pronounced for funds that trade illiquid securities; it didn't show up in funds that primarily trade stocks or futures contracts, which have active markets and easily obtained prices. This suggests that some funds could be fudging results.
  • "Hedge-fund managers purposefully avoid reporting losses by marking up the value of their portfolios," according to the authors of the study, Nicolas P.B. Bollen, an associate finance professor at Vanderbilt University, and Veronika K. Pool, an assistant finance professor at Indiana University. If that is the case, the authors wrote, investors may "underestimate the potential for losses in the future and may overestimate the ability of hedge-fund managers."
  • Valuation of infrequently traded securities first sprang to public view as an issue this spring when two Bear Stearns Cos. hedge funds blew up. One of the funds initially reported a 6.5% loss for April. A few weeks later, investors learned that the fund was actually down about 20% for that month. The fund told investors that the change was because of downward revisions in the price estimates it received for hard-to-value securities.
  • Fund managers can have a lot of leeway in determining whether such securities have lost or gained money. As long as they remain consistent, they can, for example, choose whether to use the bid or offer price of a security, which can sometimes vary widely, or pick among different quotes offered by competing brokers. So if a hedge fund is looking at a possible loss for a month, a manager could pick the more optimistic prices for some securities to push the fund into positive territory while ignoring those that could exacerbate losses.
  • "This is perhaps no surprise: Distorting returns is more feasible when the opportunity for exerting managerial discretion is higher," the paper said.
Well that last sentence pretty much sums it up - I am a hedge fund manager, I get paid on results, so I can go buy illiquid stuff and then claim it's really tough to price it so I am going to choose X price (who programs the computer to value these securities? the hedge fund - bingo, no conflict of interest at all) - tada, my results look good, and I get paid! That works until my fund implodes. But I still made my money and I go off into the sunset with my payday.

If this all weren't so pathetic it would in some way be humorous. Anyhow - no regulation needed. Free markets solve all problems. Just keep that in mind - that is the mantra as we go through this "once in a lifetime" dislocation. And check back in about 2013 when we have the next "once in a lifetime" dislocation" as unchecked greed causes the next blowup, whatever it may be at that time.

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