Minyan Peter, former bank treasurer at a very large national bank, was writing this morning about the financial sector in general and Goldman Sachs in particular in a post called Immunity. Let’s take a look.


As I watch in the premarket, Goldman Sachs (GS) is trading up following their earnings beat this morning.

That the company beat comes as no surprise, but I would be very careful extrapolating GS’s success to the broader market, particularly other financial services firms, and particularly regional banks. Goldman’s business is fundamentally different from other firms. Further, from my perspective there is no firm better prepared and equipped to benefit from the pain of others than GS. And in a business where your franchise is your reputation, it certainly came into this crisis well prepared.

But this morning’s earnings, while better than expectation, are down 34% from its record fourth quarter of 2007 results, while the stock is down not quite 25% from its December peak. So to me, a lot of GS’s relative success is already priced into the stock.

For the stock to trade this morning as if it is coming off of an oversold decline, like many of the other brokerage firms and banks (which truly were oversold), seems a little silly. Further, given that what is ahead looks more like a marathon than the 50 yard dash, I would be careful to assume that even the best can and will remain perfect forever.

Don’t get me wrong it is a great firm, and compared to the ugly, it looks cute. But great firms should always outperform. The question in my mind, is whether great is now being translated as immune.

My thoughts will come in a second but let’s first consider a post by Bennet Sedacca, called shrinkage.


So, does size matter? Some say yes, some say no. I say yes.

Why? because as investment banks and regional banks shrink their leverage and their balance sheets just as credit costs rise and prices of what the are selling sink, what happens?

Margins shrink. I would liken it to having a margin account and you are forced to sell at the bottom. Granted you are less levered. But the real problem is that you can’t participate on the upside.

So anyone expecting bank and investment bank earnings to recover anytime soon had better reconsider. It’s nearly impossible with less leverage.

Rush To Reduce Leverage

Across the board, financial companies are attempting to shrink leverage. On June 9th, MarketWatch announced Lehman sells assets, cuts leverage.

Lehman Brothers said on Monday that it sold $130 billion of assets in recent months, reducing leverage, but analysts and others said questions remain about the brokerage firm’s illiquid holdings and how it has valued some of those exposures.

Asset sales reduced the firm’s exposure to mortgages and real estate investments by 15% to 20%. Exposure to loans made to finance leveraged buy-outs and other acquisitions dropped by more than a third, Lehman also reported.

The sales also cut Lehman’s leverage to less than 25 times from more than 30 times at the end of February. That will decline even more as fresh capital comes in from Monday’s sale of new shares and preferred stock.

Lehman Chief Financial Officer Erin Callan said on Monday that she couldn’t assure analysts that level III assets fell during the firm’s fiscal second quarter.

“The tension is that Lehman does not want to fully disclose its positions and yet investors appropriately question whether the charges are sufficient,” said Egan-Jones Ratings, a rating agency that’s paid by investors rather than issuers.
Hedge fund manager David Einhorn, who’s shorting, or betting against Lehman shares, said the firm’s results and efforts to raise new capital suggest that it still has losses on its balance sheet that it hasn’t recognized.

“Lehman is raising $6 billion that they said they didn’t need to replace losses that they said they didn’t have,” Einhorn, founder and president of Greenlight Capital, said in a statement that was emailed to MarketWatch.

Unimpressed By Lehman’s Efforts

For starters the reduction in leverage from 30-1 to 25-1 is hardly impressive.

I also get the distinct impression Lehman is hiding something in level 3 assets marked to fantasy. What else can one possibly assume when the CFO said she couldn’t assure analysts that level III assets fell during the firm’s fiscal second quarter?

Lehman reduced exposure to mortgages and real estate investments by 15% to 20%. Although this is a step in the right direction, it’s a baby step. Wake me up when that hits 80%.

Lehman does not like being compared to Bear Stearns. Fair enough. Lehman has more commercial exposure than the Bear and the fallout from a commercial real estate bust has really just started. Lehman is going to need to raise capital, again, and again, and again.

So is Citigroup (C), Merrill Lynch (MER), Morgan Stanley (MS), Bank of America(BAC) , Wachovia (WB), and Washington Mutual (WM).

The mess in pay option ARMs is starting to accelerate and it will hit Wavchovia and Washington Mutual hard. Investors should be wondering if those companies will even survive.

Goldman Warns On Banks

Reuters is reporting Goldman Warning On Banks.

Goldman Sachs warned that banks may need to raise an additional $65 billion, stoking worries about further fallout from the mortgage crisis. Goldman said the global credit crisis will not peak until 2009 and lowered its price targets for 14 banking companies. It also cut 2008 earnings-per-share forecasts for 11 banks [including Bank of America, Wachovia, and Washington Mutual].

If Goldman Sachs is correct, the credit crisis will last until sometime in 2009. However, I think Goldman is optimistic about both the timeframe and amount.

Another $65 billion (if that’s all it is) would mean the worst is over in terms of writedowns. I think the worst is ahead based on commercial real estate, pay option ARMs, credit card writeoffs, and corporate loan defaults that have just begun to rise. All of those are going to soar along with unemployment numbers as the consumer led recession picks up steam.

The Worst Is Ahead Of Lehman and the financial sector in general. Some 300 or so bank failures are coming and that process has not even started. And that is just one of the Things That Have Not Yet Happened but will.

Ideas that financials are cheap and bank earnings will begin to recover are fatally flawed. Right now we cannot even say for sure (other than Goldman), who the survivors will even be. The financial sector hit a secular peak in earnings that will not be approached for a decade or longer.

Mike “Mish” Shedlock
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