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Another stab at Goldman’s earnings

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2Q0910-Q-GS-cashflow

Accounting statements in accordance with the actual business are more and more becoming complex and bloated fixtures of financial institutions. At the end of third quarter 2008 Goldman Sachs listed six recent accounting developments on its consolidated financial statement 10-Q.

This changed dramatically for the most recent quarter and Goldman’s 17 accounting changes opened a new frontier for wild west style accounting. Though these days reading a financial statement and understanding it is almost impossible, tenacity can pay off and hopefully reveal some insight into the health of Wall Street’s former behemoths.

Under cash flow from operating activities there is a fixture called trading assets at fair value. There is nothing peculiar about this other than the fact that its value jumped beginning with the fourth quarter of 2008. Inquisitive minds might remember that a significant accounting change took place during this quarter.

The Financial Accounting Standards Board (FASB) introduced FAS 157-3 in October 2008. Staff Position 157-3 acknowledged the use of management estimates or assumptions in “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. In April 2009 this accounting rule was amended to FAS 157-4 to accept this kind of fair value estimates also to not orderly transactions with significantly decreased trading activity.

Goldman’s worst quarter ever was the third quarter ending August 29, 2008. This was the quarter before the accounting changes were implemented. During nine months ending August 2008 (GS fiscal year used to start in December before the firm changed its status to a bank holding company), cash flow item trading assets at fair value registered a meager inflow of $37.9 billion. A year earlier the company had even outflows of $92.7 billion on the same position.

From January to June 2009, in the first two quarters of the new bank holding company, inflows into this category of cash flow from operating activities had already taken off at $172.39 billion. A year earlier in the six months to May 2008 inflows came in at only $28.8 billion. The firm of course does not further specify trading assets at fair value and which assets create its cash flow. 

Since assets are designated fair value therefore not easily convertible to cash it is reasonable to assume that cash flow generated is associated with non-current assets. Associated cash flows are added back or subtracted from the income statement depending on inflows or outflows respectively. In that sense $172.39 billion of fair value inflows might have substantially contributed to positive earnings during the first two quarters of 2009.

I think is is fair to say that accounting change FAS 157-3 threw a lifeline to even our most venerable institutions on Wall Street. In the Huffington Post Nathan Lewis asked the question: Do We Need Goldman Sachs? Without FAS 157-3 this question would be redundant. Most likely GS would have already drowned in the stormy sea of mortgage backed securities and credit derivatives.

Could it be that recent celebrations on Wall Street are nothing but a smoke screen blowing hot air into the face of investors? In its August monthly report a congressional oversight panel (COP) evaluating troubled assets on the books of large and smaller BHCs came to the conclusion that a substantial portion of toxic assets from mortgage backed securities and real estate whole loans still remains on bank balance sheets.

Goldman Sachs and Bank of America are two examples of masterful deceit sanctioned by the appropriate agencies. I am beginning to think that former New York AG Spitzer is right and democratization of capital markets is no more.

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Written by Alfred

12. August 2009 at 4:53 pm

Goldman’s 10-Q reveals – balance sheet still bloated

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Goldman Sachs Group has tripled their growth forecast for the second half of this year. Inflation adjusted economic growth is supposed to jump to 3 percent annual rate. Yet even the mega bulls at GS do not think this growth spurt is sustainable, and anticipate a decline to 1.5 percent in late 2010.

Will the American consumer be able to return and then keep up with lavish spending habits? This is the 64 thousand dollar question. In the past US consumer spending powered both the US economy and the rest of the world. After the crisis there still exists a possibility of painful adjustments to household and corporate balance sheets mainly in debt fueled economies.

Indebtedness of US private households peaked at 132% of disposable income at the end of 2007. This ratio had fallen to 124% at the end of March, 2009, but is still too high. As a reaction US consumers are spending less and saving more in recent months. As people continue to struggle to repay their debt the savings rate is expected to gradually return to a range of 7% to 10%.

There are also those who disagree and are not convinced that higher savings will ipso facto result in lower output. Michael Darda, chief economist at brokerage firm MKM Partners, anticipates a strong recovery in stocks and the economy. Obviously an increased savings rate is only a temporary phenomenon according to Darda.

Even if Darda is right and we will return to old habits, can we be sure this is really what we want? A return to a debt fueled economy got us into trouble in the first place. These are rather conflicting interests between corporate and business protégés and basically everybody else.

The leader of the pack on Wall Street is investment firm turned bank-holding company, Goldman Sachs. Yesterday GS released its consolidated financial statement for the second quarter of 2009. On first impression we see a great quarter and a reoccurrence of the firm’s unmatched earning power. Taking a closer look reveals quite a different picture. The 10-Q statement for the second quarter tanked GS stock by 2.01% yesterday, down $8.65 since August 6, 2009.

GS 10-Q unaudited condensed consolidated financial statement makes certain estimates and assumptions. Most important are fair value measurements and accounting for goodwill and intangible assets. Actual results could be materially different from these estimates.

The firm’s assets and liabilities are generally separated into two categories, cash instruments and derivative contracts. In determining their fair value, hierarchy levels two and three are significant because of the use of judgment and estimate for price transparency. Government agency securities, certain mortgage products, and certain money market securities are considered to be level two, if not actively traded.

Cash instruments are considered to be level 3 if they are infrequently traded and lack price transparency. Such instruments include private equity and real estate fund investments, collateralized debt obligations (CDOs), less liquid mortgage whole loans and securitization products (backed by either commercial or residential real estate), and acquired portfolios of distressed loans.

Over the counter (OTC) traded derivatives contracts are always valued as level three, and therefore subject to least price transparency. In such cases the transaction price is often used as the best estimate of fair value. In addition the lowest level of input in any financial instrument determines its level within the value hierarchy.

In October 2008, the Financial Accounting Standards Board (FASB) issued FAS 157-3, approving the use of management estimates or assumptions to determine fair value in not active markets. In April 2009 this rule was amended to FAS 157-4 and applied fair value assumptions to not orderly transactions of assets and liabilities with significantly decreased activities.

These new FASB rules have tremendously helped financial firms to hide potential losses of mostly impaired mortgage backed securities under level two and three of fair value accounting. For Goldman Sachs trading assets at fair value increased to $355.2 billion in 2Q09 from $338.3 billion in 2Q08.

Composition of assets held at fair value has changed and Goldman has replaced risky collateralized debt obligations with safer US government agency debt during the most recent quarters. Though the firm has not at all shied away from derivative contracts and as of June 2009 held a net position of $90.0 billion at fair value.

Although compression efforts across the industry have helped to decrease the notional amount of derivative contracts outstanding, the firm’s gross fair value exposure was still a staggering $1.093 trillion. Purchased $3.19 trillion of credit derivatives were partially offset with $2.96 trillion in written contracts. Net of collateral only $90.0 billion contributed to trading assets at fair value.

Net purchased protection total derivative exposure was $227.02 billion as of June 2009, with $212.1 billion level 2 and $15.0 billion level 3. A $137.5 billion cash collateral helped to reduce the risks associated with these derivative contracts. At the end of the fist quarter 2007 cash collateral for derivative contracts at fair value was a meager $27.7 billion, representative of an easygoing and low risk culture on Wall Street at the time.

For the first time the financial statement provided some insight into the composition of the firms staggering exposure to derivative contracts. In the second quarter 2009 the firm held a gross exposure of written high risk credit derivatives with credit spreads of 501 to 1000 basis points or greater over Libor. $73.3 billion had a term exposure of 5 years or greater and a total of $526.9 billion a term exposure of zero to five years or greater.

These contracts were partially offset with purchased credit derivatives and their fair value was also greatly reduced. Nevertheless it poses a staggering exposure to potentially toxic assets in a harmful environment of severe credit contraction.

From trading assets held at fair value at the end of the second quarter $332.7 billion were still level 2 and $54.4 billion, with economic exposure of actually $50.3 billion, at level 3. In the first quarter of 2007 Goldman owned financial assets at fair value of $231.6 billion at level 2 and $47.6 billion at level 3. Fair value of level 2 and 3 assets as determined by FASB 157-3,4 are subject to the firm’s estimates and assumptions and not mark-to-market.

Probably the most contentious issue with the business of accounting in financial firms has been and still is the issue of securitization activities. Goldman Sachs securitizes commercial and residential mortgages and other financial assets. This has undoubtedly been the driving force of a debt fueled economy in the past, but will it remain so in the future? The latest data reveal securitization has virtually come to a standstill, and this shutdown of the consumer is behind rather tepid assertions of economic recovery.

During the three months ending June 2009 Goldman only sold $12.9 billion in securitized products, of which $12.4 billion were primarily safe government agency securitizations and only $496 million of other financial assets. In the first quarter 2007, $16.8 billion in residential mortgage securitizations and $14.8 billion in other securitizations, primarily collateral debt obligations, were transacted.

Total shareholder’ equity was $62.8 billion at the end of the quarter. As of June 2009 the firms equity was about fourteen times leveraged to hold total assets of $889.5 billion. During the first quarter of 2007 shareholder’ equity was still 25 times leveraged. This apparent reduction of leverage in the current quarter is not attributable to general deleveraging. Shareholder’ equity has benefitted greatly from increase in retained earnings and additional paid-in capital.

There were some positive developments as well during the most recent quarter. At the end of the first quarter of 2007 financial assets at fair value subtracted $36.9 billion from cash flows from operating activities. That has dramatically changed in the most recent quarter and trading assets at fair value attributed $172.3 billion to cash flow. This form of associated cash flow from the sale of non-current assets is added back onto the income statement and helps to improve the firm’s earnings.

Overall Goldman Sachs’ balance sheet has improved but is nowhere close to the optimism infused during its earnings report. Fair value accounting with level 2 and 3 still unreasonable high pose tremendous risk. Securitization activities, fuel to a consumer driven economy, ceased to exist. Yet financial firms and other Wall Street combat optimists are again celebrating.

The debate over reigning in the financial industry’s notorious ingenuity and lavish executive compensation is ongoing, all the while bankers are still celebrating. A conflict of interest in this mission impossible to control Wall Street is a done deal with no recourse to moderation. Public outrage is therefore understandable and some are even beginning to ask the question: Do We Need Goldman Sachs?

Formerly disgraced AG from New York and now resurrected from the dead Eliot Spitzer in a recent interview with finance blogger Henry Blodget declared an end to democratization of the market place. He had one advise for retail investors: Don’t play! (video)

Bloated and vague balance sheets of Goldman Sachs and others are testament to a culture on Wall Street hostile to a broad base of a public investment community. They want their game to be elitist and government and regulators have supported them in the past and will continue to do so also in the foreseeable future. Though we must fear that change is nothing but lip service.