Early in 2008 I named Morgan Stanley the "The Riskiest Bank on the Street" (see historical links at the bottom of this article). Well, now its time to update my opinion. Who deserves the title "The Riskiest Bank on the Street" now? Well, let's see what the market says...
As defined by Wikipedia: Cost of Captial - Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital.
This means that one should not simply glance at accounting earnings and declare all is clear on the western front. Whatever return your company generates has to exceed the cost of investing in said company. Well, of the bulge bracket, who has the highest cost of capital? Who has the highest bar? Who does the Street see as the Riskiest Bank on the Street?
Well it seems as if the company that had the highest cost of capital apparently had enough risk to actually implode. Is there a pattern here? If so, I must be the only one that recognizes it because the current number one spot (the graphed number one spot already collapsed) traded over $130 per share last week.
For those that don't believe in Cost of Capital in measuring risk, I bring you to another metric. As defined by Wikipedia: Leverage (or gearing due to its analogy with a gearbox) is borrowing money to supplement existing funds for investment in such a way that the potential positive or negative outcome is magnified and/or enhanced.[1] It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity. Deleveraging is the action of reducing borrowings.[1]
Financial leverage
Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets (ROA) is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor that otherwise would have been unavailable but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid.
Margin buying is a common way of utilizing the concept of leverage in investing. An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage. This debt to equity ratio's influence on the value of a firm is described in the Modigliani-Miller theorem. As is true of operating leverage, the degree of financial leverage measures the effect of a change in one variable on another variable. Degree of financial leverage (DFL) may be defined as the percentage change in earnings (earnings per share) that occurs as a result of a percentage change in earnings before interest and taxes.
Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb - 17 pagesGoldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages
Derivatives
Derivatives allow leverage without borrowing explicitly, though the "effect" of borrowing is implicit in the cost of the derivative.
- Buying a futures contract magnifies your exposure with little money down.
- Options do the same. The purchase of a call option on a security gives the buyer the right to purchase the underlying security at a given price in the future. If the price of the underlying security rises, the value of the call option will rise at a rate much greater than the value of the underlying security. However if the rate of the call option falls or does not rise, the call option may be worthless, involving a much greater loss than if the same money had been invested in the underlying instrument. Generally speaking, a put option allows the holder (owner), the investor, to achieve inverted-leverage and/or inverted enhancement--- sometimes called inverse enhancement and/or inverse leverage.
- Structured products that exist as either closed-ended funds, or public companies, or income trusts are responding to the public's demand for yield by leveraging. That's a good idea. Let's refer to Goldman Sachs as a Structured Product!
Risk and overleverage
Employing leverage amplifies the potential gain from an investment or project, but also increases the potential loss. Interest and principal payments (usually certain ex-ante) may be higher than the investment returns (which are uncertain ex-ante).
This increased risk may still lead to the optimal outcome for the entity or person making the investment. In fact, precisely managing risk utilizing strategies including leverage and security purchases, is the subject of a discipline known as financial engineering.
There are economic periods when optimism incites to a widespread and excessive use of leverage, what is called overleverage. One of its forms, associated to the subprime crisis, was the practice of financing homes with no or little down payment, playing on the hope that the price of the assets (the property in this case) will rise. Another form involved the five largest U.S. investment banks, which borrowed funds to invest in mortgage-backed securities, increasing their leverage between 2003-2007 (see diagram). During September 2008, the five largest firms either went bankrupt (Lehman Brothers), were bought out by other banks (Merrill Lynch and Bear Stearns) or changed to commercial bank holding companies, subjecting themselves to leverage restrictions (Morgan Stanley and Goldman Sachs).
Well, on the topic of leverage, who do you think is the most leveraged bank? Notice that these leverage ratios below are unadjusted. That means that they will go up significantly if I took the time to extract the accounting shenanigan trash that is used to give the impression of lower leverage (this adjustment is explictly done in the 131 page Goldman Sachs Professional Stress Test).
Notice that although Goldman Sachs is the leveraged risk winner as of now, but they would have probably been beaten by Merrill Lynch. Hey, where is Merrill Lynch by the way? You know, it can get pretty painful for guys to play hide the "leveraged" sausage. If you know what I mean...
Okay, for you real stubborn guys and gals who don't think the cost of capital or leverage are legitmate determinants of risk, let's take a look at other popular risk metrics. Surely they will vindicate the riskiest bank on the Street, right? Below, please find the Goldman Sachs VaR and Risk Adjusted Return on Risk Adjusted Capital Chart.
Now, as we can plainly see, Goldman Sachs has steadily trended down in its RARORAC and steadily trended higher in VaR. In other words, risk has steadily increased as risk adjusted return has steadily decreased.
For those who feel I am simply blogging in sanscrit, let's pull up the Wikipedia definitions for VaR and RARORAC:
Value at Risk (VaR):
In financial mathematics and financial risk management, Value at Risk (VaR) is a widely used measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.[1]
For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will fall in value by more than $1 million over a one day period, assuming markets are normal and there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day in 20. A loss which exceeds the VaR threshold is termed a "VaR break."[2]
The 10% Value at Risk of a normally distributed portfolioVaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well.[3]
Risk adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust in the late 1970s. Note, however, that more and more Risk Adjusted Return on Risk Adjusted Capital (RARORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel II.
...
Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst case scenario, that is it is a buffer against heavy shocks. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.
RAROC system allocates capital for 2 basic reasons:
- Risk management
- Performance evaluation
For risk management purposes, the main goal of allocating capital to individual business units is to determine the bank's optimal capital structure -- that is economic capital allocation is closely correlated with individual business risk. As a performance evaluation tool, it allows banks to assign capital to business units based on the economic value added of each unit.
Now that we're all up to speed, let's take this one step farther. Below you may find the One-Day Trading VaR of GS with a 95% confidence level.
Here we find proof that Goldman Sachs has indeed usurped Morgan Stanley for the title of "Riskiest Bank on the Street".
Hey, notice how Goldman Sachs has trended DOWNWARD regularly and steadily over the one year period. As a matter of fact, the only company that had a lower risk adjusted capital return was Lehman. So let's compare what is happening now... Oh yeah, we can't because Lehman has already collapsed. What does that portend for Goldman who appears to operate quite similarly?
I know many of you new readers are wondering, "Who the hell is this guy?". Well, this guy is someone who has been pretty good at ferreting out weak companies on the verge of collapse:
There is the call of the fall of REITs and commercial real estate in 2007 - "GGP has finally filed Bankruptcy, Proving My Analysis to be On Point Over the Course of 18 Months". I also called Bear Stearns (Is this the Breaking of the Bear? [Sunday, 27 January 2008]), Lehman Brothers CRE implosion connection (Is Lehman really a lemming in disguise? [Thursday, 21 February 2008]), Countrywide and Washington Mutual (Yeah, Countrywide is pretty bad, but it ain't the only one at the subprime party... Comparing Countrywide with its peer), nearly all of the failed or failing regional banks of significant size (As I see it, these 32 banks and thrifts are in deep doo-doo!), MBIA (A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton) and Ambac (Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion Market Cap and Follow up to the Ambac Analysis), among others - well in advance.
More Goldman Sach's Research:
Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb - 17 pagesGoldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages
Free research and opinion
- Reggie Middleton on Goldman Sachs' fourth quarter, 2008 results
- Goldman and Morgan losses in the news, about 11 months late
- Blog vs. Broker, whom do you trust!
- Monkey business on Goldman Superheroes
- Reggie Middleton asks, "Do you guys know who you're messin' with?"
- Reggie Middleton on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis
- Reggie Middleton on Goldman Sachs Q3 2008
- As Reality hits, the Masters of the Universe are starting to look like regular bank employees
Premium Stuff!
- Goldman Sachs - strategic investment and public offering 2008-09-26 02:29:15 895.36 Kb
- Goldman Sachs Report June 21, 2008 2008-10-20 16:48:01 361.18 Kb
- Goldman Sachs' Bank Holding Company Fundamental Valuation and Forensic Analysis - Professional 2008-12-18 10:12:37 267.49 Kb
- Goldman Sachs' Bank Holding Company Fundamental Valuation and Forensic Analysis - Retail 2008-10-20 15:45:05 348.99 Kb
- GS ABS Inventory 2008-02-25 06:48:56 1.22 Mb
Historical context for the "Riskiest Bank on the Street" moniker.
Banks, Brokers, & Bullsh1+ part 1
Wednesday, 19 December 2007 | Reggie Middleton
A thorough forensic analysis of Goldman Sachs, Bear Stearns, Citigroup, Morgan Stanley, and Lehman Brothers has uncovered... Last week, Morgan Stanley called Citibank the "short play of...
The Riskiest Bank on the Street
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
Key highlights of my research on the "Riskiest Investment Bank on the Street": The Riskiest Bank on Wall Street - Morgan Stanley has US$74 billion of Level 3 assets, over 200% of its eq
Monday, 11 February 2008
A closer look at the exposure of the other brokers
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
...- Who has the most of their assets tied up in illiquid Level 3 as a proportion to tangible equity? You guessed it, The Riskiest Bank on the Street. Now, they do have a decent amount of liquidity the ...
Sunday, 16 March 2008
19. On the insolvencies of non-bank financial institutions
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
...Bullsh1+ part 1 Banks, Brokers, & Bullsh1+ part 2 Money Panic Bear Fight The Breaking of the Bear The Riskiest Bank on the Street Here comes the CRE Bust (Quip on Lehman Brothers)...
Tuesday, 18 March 2008
20. Quick Morgan Stanley update from my lab
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
This is a refresher to the The Riskiest Bank on the Street piece that I posted a few months ago on Morgan Stanley. Let me get straight to the salient points. High exposure to lev
Thursday, 20 March 2008
21. Early morning scan of events
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
For those that haven't noticed, I've begun sharing my early morning news and data routine with the blog. Here goes Monday moring EST. Is the Fed running out of ammo? Reserve
Monday, 31 March 2008
22. Reggie Middleton on the Street's Riskiest Bank - Update
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
This is the update to my forensic deep dive analysis of Morgan Stanley. It is still, in my opinion, the "riskiest bank on the street". A few things to make note of as you browse through my opinion a
Sunday, 06 April 2008
23. Banks, Brokers & Bullsh1t 3.0: Shenanigans at Morgan and Lehman
(Archived/Reggie Middleton's Boom Bust Blog/MyBlog)
I've been promising to give an illustration of the shenanigans being played by the commercial and investment bank's for some time now, but I've been quite busy working on my entrepeneurial pursuits
Wednesday, 16 April 2008
24. I warned you about the risk of those I Banks
...ive counterparty and credit risk to imperfect hedges to dead and depreciating assets held off balance sheet: The Riskiest Bank on the Street Is this the Breaking of the Bear? Banks, Broke...
Wednesday, 21 May 2008
