Goldman Sachs recently reported first-quarter earnings that exceeded Wall Street's estimates by a significant margin. (See "Our take on US banking results".) Though people may view Goldman as a poster child of the financial services industry, it is a poster child because of its differentiated nature. Therefore, the company's first quarter should not be extrapolated to the overall financial services industry.
The main contributor to Goldman's quarterly outperformance was the company's fixed income, currencies, and commodities (FICC) business. In fact, every other major business line was lower both year-on-year and sequentially. This implies that the tail winds that helped Goldman may also help companies with these types of trading operations and that the majority of banks with no trading operations will see no additional wind in their sails.
We caution investors that we believe this trading tail wind will be short-lived and may not affect all players equally. The reasons behind the outsized FICC revenues were largely increased fixed-income trading spreads and market share gains. Fear in the market led to traders requiring higher profit margins to trade. Eventually, the fear will come out of the market and spreads will tighten. Trading is also a competitive business and traders can smell where money is to be made like sharks smell blood in the water. The influx of additional players and more capital facilitation may reduce spreads even before fear comes out of the market.
If Goldman gained market share, you must wonder who lost it. We believe that Goldman gained share by employing its balance sheet when competitors were distracted by recent acquisitions or reducing their allocation of capital to their trading businesses to reduce risk. Goldman did not scale back on risk, as can be seen from its average daily value at risk (VaR) increase of 22% from the previous quarter and 53% from the previous year to $240 million. That said, while reducing the capital allocated to trading can be prudent because trading can be a double-edged sword, Goldman demonstrated this quarter that sometimes the rewards outweigh the risks. Larger spreads may lift all trading boats, but changes in market share are a zero-sum game.
One point that must not be overlooked when comparing Goldman to the banking industry is its balance sheet exposure. Of the assets on Goldman's balance sheet, we're most concerned about its $8.5 billion of commercial real estate related loans and securities, $2.3 billion of leveraged loans, and its $18.2 billion of corporate and real estate investments. We note, however, that these exposures have been brought down from $10.9 billion, $8 billion, and $20.6 billion at the end of the fourth quarter of 2008, respectively, and are becoming much more manageably sized compared with its equity base. Additionally, many of these investments have been marked down significantly over the preceding year and the company has a reasonable ability to hedge much of its remaining security-related exposures. For the first quarter, write-downs and investment losses were relatively under control. Again, it may be difficult to extrapolate these results to other banks--more retail- and commercial-orientated banks have loans on their books that are in the earlier stages of their loss-generating process and are more difficult to hedge.
We see multiple companies whose results could mimic some of Goldman's good fortune. Banks with material investment banking operations as a percentage of revenues that we believe could report outsized trading revenues include: Morgan Stanley, Citigroup, JP Morgan, Bank of America, Barclays, and First Horizon. We find it interesting that CME Group did not show a material increase in volume for its interest rate, currency, and commodity futures for the first quarter, even though it was Goldman's FICC business that outperformed. If the dissonance in the numbers is due to Goldman's over-the-counter transactions, then interdealer brokers, such as GFI Group and BGC Partners, would appear to be logical beneficiaries. If fixed income was the largest contributor to FICC revenues, then electronic bond trade facilitator MarketAxess, which has some matched principal trading operations, might report a surprisingly good quarter.
