Summary
The Goldman Sachs Group (NYSE:GS) had a record results in terms of non-interest income in Q2 2020, up 66% sequentially and 44% year-over-year. Net earnings doubled sequentially from Q1 2020, again due to market volatility and the impact of the Fed’s strong market intervention.
The $13.3 billion in net revenues GS reported in Q2 2020 was up double digits sequentially and also year-over year, illustrating the volatility in earnings that we believe contributes to the low P/E ratio and also the discount to book value for the common shares.
GS is the smallest of the global investment banks but the most highly levered of the large US banking groups, with the ratio of LT debt to equity capital of nearly 200% vs 12% for the Peer Group 1 average.
The transactional business of GS continues to be both the source of outsized profits and losses, as illustrated by the settlement of the 1MDB scandal in Malaysia. The losses due to the 1MDB settlement essentially wiped out GS profits for the first half of 2020, caused a restatement event with the SEC, and the bank has still not completed the resolution of this matter.
Our overall assessment of the quantitative and qualitative factors behind the performance of GS remains negative. The BHC generates more risk than return to its investors, and therefore trades at or even below book value in the equity markets. The financial comparisons between GS and its asset peers among the largest BHCs is not flattering and suggests that GS has serious risk issues due to its business model.
Source: FFIEC
Although the majority of Sell Side analysts believe that the valuation for GS is below “fair value,” we disagree and instead believe that the heightened risk factors that accompany the bank’s business model tell the tale. Sad to say, like many names in the financial sector, GS is an issuer that deserves to trade at a discount to par.
Quantitative Factors
At $2.06 trillion in total assets as of June 30, 2020, The Goldman Sachs Group (NYSE:GS) is the fifth largest bank holding company (BHC) in the United States. Less than 20% of the consolidated assets of GS are attributable to the New York state bank subsidiary, Goldman Sachs Bank (USA). GS is the smallest of the global investment banks but the most highly levered of the large US banking groups, with the ratio of LT debt to equity capital of nearly 200% vs 12% for the peer group.
When comparing GS to other large US banks, the first factor that requires attention is the bank’s dependence upon non-interest fee income. As a result of the focus on trading and advisory income, GS is far less efficient in terms of asset returns than a typical large bank such as JPMorgan (NYSE:JPM). Even compared with all of Peer Group 1, GS underperforms. And with the added burden of credit reserve expenses due to COVID-19, the entire large bank group is suffering reduced profitability, as shown in the chart below.
Source: FFIEC
Non-interest income for GS as a percentage of average assets was 2.74% at the end of Q1 2020 vs just 1.12% for the 123 largest banks in the US that are members of Peer Group 1. The key point is that GS is very much an investment bank and only a relatively small commercial bank, with less liquidity and greater risk per dollar of revenue.
The top-level financials for GS are shown below using data published by the Federal Financial Institutions Examination Council (FFIEC) and EDGAR, In Q2 2020, GS’s results were helped significantly by the strong market intervention by the Federal Open Market Committee. The deposit growth seen in 2020 is largely due to the trillions of dollars in liquidity injected into the US banking system by the Federal Reserve.
The Goldman Sachs Group (RSSD:2380443)
Source: FFIEC, EDGAR
GS had a record results in terms of non-interest income in Q2 2020, up 66% sequentially and 44% year-over-year. Net earnings doubled sequentially from Q1 2020, again due to market volatility and the impact of the Fed’s strong open market operations. The enormous swing in earnings results illustrates one of the key reasons why we consigned GS to The IRA Bank Dead Pool last year, namely the huge variability of the bank’s results both positive and negative.
GS made some progress in terms of building its deposit base in 2020, but much of the increase was due to bond purchases by the Fed. Yet even as GS builds its Marcus retail banking platform, the loss profile of the loan portfolio displays above-peer losses typical for larger banks. The loss rate for GS is now more than two-times peer, as shown in the chart below.
Source: FFIEC
While the GS loan portfolio has grown, the bank’s loan pricing reflects an above-peer target coupon rate that is 150bp higher than its large bank peers. The 55bp of default in Q1 2020 maps to a “BBB-” default rate equivalent. This level of net credit loss is 2x the Peer Group 1 average and puts GS in the same neighborhood as JPM and above that of U.S. Bancorp (NYSE:USB).
Source: FFIEC
Notice how the pricing of GS loans dropped nearly a point in Q1 2020, suggesting that the bank is having difficulty sourcing assets. The competition among large banks for equally large assets is intense and likely to increase as 2020 comes to a close due the the Fed’s operations.
Just 40% of the GS bank unit’s assets are deployed in lending vs 25% in investing activities and the rest in “other” assets, according to the latest disclosure from the FDIC. New loans and leases were just 15% of the group’s total consolidated assets at the end of the second quarter, although the growth rate for new loans is well into double digits and more than 3x the average of 9% for the banks in Per Group 1.
The larger issue raised by the slow growth of the firm’s commercial banking business has to do with the overall GS cost of funds and the firm’s refusal to consider growth through acquisitions. While in terms of total assets GS ranks fifth among large US bank holding companies, in terms of deposits Goldman Sachs Bank (USA) with $200 billion in total assets ranks 14th between Charles Schwab Bank (NYSE:SCHW) and the US unit of HSBC Holdings (NYSE:USBC).
The chart below shows the relative cost of funds for selected large banks. Notice that GS has a higher cost of funds overall than Citigroup (NYSE:GS) but has a yield on earning assets that is significantly lower. Only about 1/3 of Citi’s assets are funded with core deposits, making the comparison even more striking. The fact that the cost of funds for GS is so high relative to subprime lenders such as Citi makes the point with respect to the long-term business model of Goldman Sachs.
Source: FFIEC
As a matter of sheer size of balance sheet, GS is simply not competitive with its larger bank peers. Viewed from the perspective of funding costs, GS is clearly not as efficient as are other BHC’s. Indeed, these larger depositories provide funding to GS and other securities dealers. The primary focus on the brokerage unit and on non-interest sources of income as part of the firm’s business model places GS at a distinct disadvantage compared with core deposit rich institutions like JPM and USB. Even Citi and CapitalOne Financial (NYSE:COF), which use brokered deposits to fund their consumer loan books, have cheaper funding costs than GS.
Source: Bloomberg (July 24, 2020)
The $13.3 billion in net revenues GS reported in Q2 2020 was up double digits sequentially and also year-over year, illustrating the volatility in earnings that we believe contributes to the low P/E ratio and also the discount to book value for the common shares. Even with the selloff in March, GS continues to trade at a significant discount to its peers.
JPM trading at 1.2x book value and USB flirting with 1.3x book, the fact of GS trading 20% below book value and the widest credit of the group in credit default swaps (CDS) speaks volumes as to how investors perceive the risk/reward ratio of this more than century old business.
Qualitative Factors
The qualitative analysis of GS starts with the conversion of an SEC-regulated investment banking firm into a Fed-supervised BHC a decade ago. This superficial change led to GS focusing time and management attention on organically growing the banking business, but only as a means of enhancing existing business lines in trading and investment banking. GS talks about “building the bank,” but the actual change in the business model falls short of the rhetoric.
The transactional business of GS continues to be both the source of outsized profits and losses, as illustrated by the settlement of the 1MDB scandal in Malaysia. On July 24, 2020, GS issued an announcement that it had reached an agreement in principle with the Government of Malaysia to resolve all the criminal and regulatory proceedings in Malaysia involving the firm relating to 1Malaysia Development Berhad (1MDB).
“Goldman Sachs has agreed to a $3.9 billion settlement with Malaysia as it begins to put behind it a kleptocracy scandal that changed the course of politics in the country,” reports The New York Times. While global banks face many different types of operational and reputation risks, the investment banking business of GS seems to generate these serious loss events with greater frequency and in larger size than other banks.
In the recent past, GS management has expressed a desire to move more business “in the bank’ to capture internal financing revenues, interest on loans that was heretofore paid away to larger depositories. This is a fine strategy, but the GS bank unit is still too small to really fund the operations of the entirety of GS as a firm. That is essentially the quandary that faces GS.
Management has made clear that the hurdle for considering “inorganic growth” is very high. This is, in simple terms, a way to say that GS will not consider significant acquisitions. We have written in the past of merger possibilities such as First Republic Bank (NYSE:FRC) with its strong asset management business.
Another possibility is KeyCorp (NYSE:KEY), a leader in commercial real estate lending and servicing, with over $100 billion in retail core deposits. The potential home run? Merge GS with U.S. Bancorp, the smallest money center with $400 billion in deposits, a significant lending, payments and trust business and the lowest cost of funds of the top ten banks. But GS management refuses to consider a transformational acquisition, apparently because it means the end of the banker/trader culture. As GS CEO David Solomon said in October 2019:
“I think one of the things this management team is trying to do is to think broadly both about our organic growth, but also potential opportunities over time for inorganic growth. I’ve said on this call and previous calls, the bar for us to do something inorganically, especially something significant inorganically is very, very high. At the same point, it’s the job of this management team to have a point of view and to be doing work and to be thinking about opportunities that can expand our franchise.”
With the bar set very, very high for a GS acquisition, this leaves only the existing GS strategy of organic growth in the bank and sticking to the existing securities and asset management businesses. This means battling just about every major financial institution for affluent retail customers with cash and investment AUM.
Acquiring and retaining high net worth customers for a private bank model is expensive and extremely difficult. This particular demographic of investor does not typically provide stable deposits or assets upon which to build a banking business. The acquisitions of United Capital and, more recently, the Folio RIA platform illustrate that GS remains focused on growing the asset management businesses.
In the world of capital markets, GS is the leading advisory firm but is engaged in a Darwinian struggle for survival with JPM and the other major universal banks of Europe and Asia. All of these universal banks have bigger balance sheets with bigger deposits than does GS. Many of the competitors of GS, including Morgan Stanley (NYSE:MS) and UBS Group (NYSE:USB) have chosen to emphasize asset management at least equally with transactional businesses. UBS trades significantly below book value, but MS which boasts two depositories that are twice the size of the GS bank unit trades, above book.
One way to measure the outsized enterprise risk of GS is to compare its total derivative footings with other large banks such as JPM and Citigroup, and Peer Group 1. At the end of Q3 2019, the derivatives positions of GS equaled more than 5,100% of average assets. The comparable levels for derivative dealers such as JPM and C, respectively, were 1,800% and 2,400%, respectively. The averages for USB and COF were at or below 100%, suggesting that GS has deliberately chosen to take outsized risks in derivatives, mostly interest rate contracts, in order to enhance earnings and returns, and implicitly make up for its relatively small banking business.
Source: FFIEC
Going down the list of categories of GS non-interest income, investment banking is highly competitive with zero visibility on future revenue. More, it is from the investment banking side that arise large operational risk events such as the 1MDB fraud and resulting fiasco in Malaysia, an event that cost GS billions in losses and incalculable damage to its reputation.
In the specific case of the 1MDB affair, the Goldman bankers apparently paid copious bribes to win an investment banking mandate that turned out to be a fraud. Now GS has paid a settlement and related expenses that are several time total fees earned from the fraud. The 1MDB settlement wiped out the excellent Q2 2020 results and, indeed, consumed the earnings for the first half of the entire year.
What is now called Global Market is the largest line item at GS and represents the firm’s trading and services activities, really the heart of the business. Trading in equities, along with fixed income, currencies and commodities (FICC), are the stock and trade of Goldman Sachs, but also illustrates why the firm won’t buy another bank.
The results in FICC are variable with the markets, but GS is a firm of the markets. In an expanded organization that encompassed a larger, retail depository, the GS FICC traders would no longer be the center of attention. Indeed, they would rightly be seen as a significant source of risk.
The Asset Management line at $2.1 billion in net revenues is about the same size as Investment Banking and the Lending and Investment lines on a run rate basis. Again, this business is incredibly competitive with shrinking margins that are visible among global asset managers.
With total assets under supervision of $2.1 trillion, GS Investment Management unit generated net revenue of $1.67 billion or less than 1% of AUM. This was down 18% YOY, again illustrating the volatility of financial results at GS for a line item that should be stable.
Consumer and Wealth Management is the smallest line item at GS at $1.3 billion in Q2 2020, down from the previous quarter but up by the same amount YOY.
The senior unsecured debt of GS is rated “A3” by Moody’s vs “A2” for larger peers such as JPM and Citi. Part of the logic of ratings is market share, which in turn informs the analysis of profitability and the stability of the enterprise. The uncertainty with respect to non-bank income, the significant op-risk and leverage, and the steady shrinkage in run-rate operating income over the past 5 years, supports a negative qualitative assessment.
Assessment: Funding, Business Model & Risk
Our overall assessment of the quantitative and qualitative factors behind the performance of GS remains negative. The BHC generates more risk than return to its investors, and therefore trades at or even below book value in the equity markets. The financial comparisons between GS and its asset peers among the largest BHCs is not flattering and suggests that GS has serious risk issues due to its business model.
The returns on the visible business are adequate but also extremely variable, this due to the highly competitive markets where the bank operates. But it is due to the hidden, operational and reputation risks that the bank’s market valuation suffers. In addition to the outsized risk characteristics of the GS investment banking business, there are three basic factors that inform our negative view:
Liquidity
GS is dependent upon the capital markets and other banks for liquidity. For example, the bank’s net time deposits > $250k are actually negative due to the fact that the bank maintains more deposits at other banks than it maintains for the bank’s customers. Unlike the asset peers of GS, which can essentially fund themselves internally, GS remains more of a brokerage firm than a bank.
The dependence on non-core funding at GS is over 80% of total funding, placing the BHC in the 97th percentile of Peer Group 1. To address this shortcoming, GS needs to grow the core deposit base of its subsidiary bank via acquisitions. Given the competitive landscape, it is unlikely that GS can achieve this level of deposit expansion via organic growth in the near-term.
Business Model
The financial results of GS are primarily determined by the performance of the Global Markets area, which accounted for over 50% of net revenue in Q2 2020. The degree of variability in such areas as trading equities and FICC due to idiosyncratic and market risk factors makes it impossible to estimate what the firm will achieve in terms of performance in future periods. Simply stated, there is no visibility on the single largest portion of the GS business and there is no real solution to change the opaque nature of the capital markets and investment banking business.
Risk/Return
The business model choices made by GS management evidence a tolerance for risk and an indifference to compliance norms such as know your customer that are disturbing. The 1MDB disaster is just the latest such example. As an investor with equity exposure to GS, you must be comfortable with the likelihood that new operational risk events will occur in the future.
Given the negative factors of liquidity and visibility, we believe that it will become increasingly difficult for GS to grow and deliver consistent profits given the competition from JPM and other larger global universal banks. We believe that an appropriate acquisition of a regional bank with substantial core deposits would greatly enhance the stability and risk-adjusted return on capital (RAROC) of GS. Such a change, however, implies less emphasis on trading equities and FICC, the traditional core revenue lines of the firm.
To us, the bottom line with GS is that CEO David Solomon et al must either 1) buy a bank of similar size deposit base or 2) be acquired by an even larger depository down the road. The former strategy path allows GS some considerable latitude in terms of the choice of merger partner. The latter path may occur at a less than optimal time when the firm is under stress. Just as the remnants of Bear, Stearns & Co & Lehman Brothers were absorbed by larger universal banks during periods of market contagion, the same fate potentially awaits GS unless they accept the fact that size (that is, liquidity) matters a decade after 2008.
The major obstacle to executing on an inorganic strategy is 1) the weak market valuation of GS equity and 2) the reluctance of GS management to be absorbed into a larger banking organization. The relatively flat, non-bank configuration of a broker dealer such as GS is at odds with the pyramidal management structure found in larger federally insured depositories. The level of risk appetite permitted in the GS investment bank would likely be tempered and, indeed, would decrease to align with that of its larger peers, resulting in a slow market share decline for GS.
So long as the management of GS remains unable or unwilling to change, we believe that GS is going to continue to trade at a significant discount to its asset peers among large US banks. At 0.85x book value and a 10.5 P/E ratio as of the date of this IRA Bank Profile, GS is hardly a compelling value. The three-month market beta of 1.5 illustrates the greater volatility in this issuer than the S&P 500.
In terms of credit, the elevated spreads in credit default swaps, for example, again suggests that the market sees GS as a higher risk counterparty. Although the majority of Sell Side analysts believe that the valuation for GS is below “fair value,” we disagree and instead believe that the heightened risk factors that accompany the bank’s business model tell the tale. Sad to say, like many names in the financial sector, GS is an issuer that deserves to trade at a discount to par.
The IRA Bank Profile is published by Whalen Global Advisors LLC and is provided for general informational purposes. By accepting this document, the recipient thereof acknowledges and agrees to the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The IRA Bank Profile. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The IRA Bank Profile are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The IRA Bank Profile represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The IRA Bank Profile is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The IRA Bank Profile is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The IRA Bank Profile. Interested parties are advised to contact Whalen Global Advisors LLC for more information.
Comments