Awful Reaction to Goldman Sachs (GS)

As always it's never the news, but the reaction to the news which is what matters. Goldman Sachs (GS) had "ok" earnings - poor for them, but great compared to anything their peers have put out - but the stock is down double digits in premarket. To make money at all in this environment is a victory but the market is in fear mode - not logic mode.

• Goldman Sachs Group Inc (NYSE:GS - News) said third-quarter earnings plunged 70 percent as one of the market's worst slumps ever sapped revenue in almost every business while fueling investment and credit losses.
• The largest U.S. investment bank reported net income of $845 million, or $1.81 a share, for the quarter ended August 29, down from $2.85 billion, or $6.13 a share, a year earlier. Net revenue fell by half to $6.04 billion from $12.3 billion. The earnings beat analysts' sharply reduced expectations of $1.75 a share, but revenue fell short of the consensus forecast of $6.3 billion, according to Reuters Estimates.

• As expected, Goldman Sachs' investment banking revenue dropped 40 percent amid a dearth of deal activity. Fixed-income trading revenue plummeted by two-thirds, reflecting weak credit and mortgage trading results, while equities trading revenue fell by half.

• The quarter also included $1.1 billion of losses on financing for junk rated companies, residential mortgages and commercial mortgages. "This was a challenging quarter as we saw a marked decrease in client activity and declining asset valuations," Lloyd Blankfein, Goldman's chief executive, said in a statement.

• Moreover, Goldman, the most aggressive investment bank in betting its own money, recorded a net loss of $453 million from principal investments. (this is why we sold the stock - we were worried about this - Goldman usually always makes money from their own trading as they have a lot of "advantages" of information) Asset management revenue fell 6 percent, reflecting lower fees, falling market prices and a $7 billion net outflow of assets. (scary to see net outflows out of even Goldman)

• "This is a heroic effort," said Mike Holland, chairman of investment firm Holland & Co in New York. "I think we have probably not seen a more challenging environment than the one that we are going through right now."

Even more concerning is the jump in credit default swaps which a week ago no one even considered as an afterthought for a firm like Goldman.

• The cost of insuring the debt of Goldman Sachs (GS) and Morgan Stanley (MS) against default rose on Tuesday after the bankruptcy of Lehman Brothers (LEH) fanned worries about the health of other investment banks. Five-year credit default swaps on Goldman jumped by 165 basis points to about 500 basis points, while Morgan Stanley 5-year CDS jumped by 275 basis points to 750 basis points, according to data from Phoenix Partners Group.

In basic English credit swaps are basically "insurance" if you will against the equity - as there is more fear about the stock the insurance rates go up. Now, people are speculating that shorts are driving up the price for default swaps to "create" an atmosphere of fear, which in turn drives down the stock price (which they can short), which drives up the value 0f default swaps and its a feedback loop. Could be - but with the SEC asleep at the wheel we'll never know. Or if we do it will be 10 years from now. The speculation now is that the 2 remaining independent investment banks will now need to attach themselves to a commercial bank so they have a ready source of funds. Their old model relied on them raising funds from borrowing in the open market but with the fears out there - the push is now to have a ready source of funds from deposits - basically what Merrill Lynch (MER) gets with Bank of America (BAC). The initial reads are that Goldman Sachs will buy a bank, and Morgan Stanley will need to be acquired by a bank. We are running out of banks that could acquire investment banks - maybe a Wells Fargo (WFC) or a foreign bank. But this all goes back to the basic model of financials - unlike widget companies these are companies that rely on the faith and trust of investors and customers. Since they are levered, if every client came and asked for their money at once, they would not have it - that is the basic business model. Which works 99.9% of the time. But this is the other 0.1% of the time.

Now the scary thing is when we last saw Morgan Stanley (MS) earnings they were very poor and outside of gains made from selling off one of their units overseas would of gone from very poor to horrible. So that worries me for tomorrow, when they report.

We owned both Morgan and Goldman but thankfully sold both - the stock performance is frightening and in this market the shorts see a lot of red meat - what can be a $40 stock price today can be $10 in just a few days. Markets are about emotions - fear and greed. We are in fear mode and prices have nothing to do with fundamentals in some cases so it's best to just step aside and let the fear play out.

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