There’s no doubt which firm stole the show in the most eagerly awaited and closely watched quarterly earnings season of recent times for investment banks. Goldman Sachs blew the market away with its third-quarter numbers. The firm, cast by its competitors as a highly leveraged hedge fund with a corporate finance arm attached, should have been most at risk in a quarter of sudden and alarming collapses in financial markets and constrained liquidity. But Goldman turned on a pin, producing not the worst results but by far the best. Its 32% return on common equity easily surpassed a still very respectable 21% for Lehman and 17% for Morgan Stanley.
Did it put a massive short on the mortgage market as a hail-Mary play to rescue its quarter? Goldman says it developed its bearish view over a period of time and went short across the entire capital structure of the mortgage market. In any event, it isn’t so much the numbers it posted as how it posted them that is the most impressive aspect of Goldman’s stunning performance.
There has been much comment since August on the difficulty of marking positions to market in many asset classes with prices gapping and bid-offer spreads widening in many types of securities. It has been a hot topic ever since BNP Paribas suspended redemptions on a couple of its funds on August 9, citing the effective disappearance of markets in many mortgage securities against which to calculate accurate net asset values. Amid such dislocations, it seems only reasonable to grant firms greater leeway in marking certain positions to fair values according to their models, even if Warren Buffett rather cruelly calls this marking to myth.
One of the most eye-catching aspects of Goldman’s third-quarter earnings was the way executives declared their fundamental disagreement with much of this commentary. Far from it being next to impossible for firms accurately to value their portfolios of mortgage and other securities, Goldman suggests that it is both eminently possible and entirely necessary. Marking to market, Goldman argues, is the lifeblood of the firm, something it does every day, requiring its traders to post marks using prices from the same or similar securities, having its 1,000 strong financial control group reconfirm these marks, requiring traders in some cases to sell positions in order to validate them, having marks reviewed by senior management, auditors and regulators and back-testing previous marks against actual trades.
If you’re in the securities business and you can’t mark your assets to market, then you can’t manage your risks, Goldman argues. It’s a powerful statement. Is it any more than brave talk?
Let’s take a look at its leveraged loan exposures. Goldman took a gross hit before fees of 5.7% on funded and committed leveraged loan positions of $42 billion at the end of the quarter. Morgan Stanley took a 3.4% write-down before fees on $31 billion of exposures and Lehman 4.26% on $27 billion of commitments.
It’s intriguing to see that the firm that reported the sharpest write-downs in the highlight troubled asset class is also the one that reported the strongest earnings overall. Since the quarter-end, Goldman has sold small pieces of those leveraged loan positions, typically at or slightly above where it marked them for reporting purposes.
Securities firms have the greatest opportunity to fudge valuations on so-called level-three assets. Level-one assets on the balance sheet are the most liquid, listed, actively traded; level two may include instruments such as OTC derivatives that are still actively traded but not listed on an exchange; level-three assets are the least liquid, including complex structured derivatives, private equity, real estate and, increasingly, portions of mortgage residuals and leveraged loans. It is against these assets that firms are allowed most licence to exercise judgment. Does Goldman have more of these than its peers?
No. The percentage of assets classed as level three at Goldman rose from 6% at the end of the second quarter to 7% at the end of the third quarter. Morgan Stanley’s level-three assets rose from 5% to 8% over the same period; Lehman’s are up from 8% to between 10% and 11%.
The lesson of Goldman’s results is that the harshest discipline in marking to market goes hand in hand with good risk management and smart position-taking. It’s for that, more than a smart bet on mortgages, that it deserves the market’s respect.