Speculating that Goldman Sachs is losing its touch is like debating the purpose of the British Royal Family - it's an issue that crops up intermittently only to be suppressed by one big quarter or event and a concerted PR campaign.
This time, however, Goldman has lost one of its most sonorous cheerleaders. For the time being at least, Brad Hintz, a senior analyst at Bernstein Research who has advocated Goldman's stock for the past decade, has decided the firm won't be outperforming the market after all. Goldman Sachs is, "currently hobbled," says Hintz. Here's why.
As Goldman COO Gary Cohn pointed out last month, Goldman's fixed income business is suffering from low volatility, an inactive trading environment, and steady rates.
"If markets never move or don’t move, our clients really don’t need to transact,” said Cohn.
As the charts below (from Bernstein) show, sales and trading revenues and profitability at Goldman Sachs are fairly correlated to bond trading volumes.
Bond trading volumes:
Goldman Sachs' sales and trading revenues:
If the factors affecting Goldman's trading business were purely cyclical, the firm might be able to sit it out - but Bernstein makes the point that the issues are long term too. Goldman has been hit by both Basel III and the Volcker Rule.
Basel III means that banks have to hold more capital against their credit assets. This has had a negative effect on the return on equity across the fixed income business, with structured credit trading particularly affected. At the same time, the Volcker Rule prevents Goldman from engaging in the previously profitable business of trading on its own behalf (rather than simply making a market for customers).
To make matters worse, over-the-counter (OTC) derivatives have been moved to central clearing houses, thereby dramatically reducing the margins banks can make by trading in them.
Bernstein makes the point that unforeseen effects of the new regulations are also taking their toll on Goldman.
Hintz points out that fixed income assets like corporate bonds, non-agency MBS and structured notes are not liquid - dealers often need to hold inventory overnight to satisfy anticipated client demand. However, Basel III discourages banks from holding inventory in credit assets, because the increased capital requirements hurt their return on equity. This has led to widening bid-offer spreads and a decline in volume, says Hintz. At the same time, the Volcker Rule means that Goldman can't compensate for the increased cost of making markets in credit products by trading on its own book.
Similarly, moving OTC derivatives into central clearing houses was expected to increase overall OTC trading volumes - which could have benefited Goldman. But this hasn't happened, says Hintz. OTC trading has simply declined,
Yes, banks like UBS, RBS , Barclays, Morgan Stanley and Credit Suisse are pulling back from fixed income trading, but Hintz says they're not pulling back enough. "For banks which are heavily reliant on capital markets, the temptation to stay in the industry and wait for a cyclical recovery is considerable," says Hintz. But until more banks pull out or affect the pull-outs they've promised, those that remain committed - like Goldman and Deutsche will be squeezed.
Other banks have attempted to reduce their exposure to volatile sales and trading revenues. Goldman hasn't. That shows.
Goldman's M&A, equity capital markets (ECM) and debt capital markets (DCM) businesses are strong and in M&A and ECM at least, revenues are increasing. But Bernstein points out that Goldman's investment banking division (IBD) revenues and profits are dwarfed by the revenues and profits it generates in sales and trading. Even if IBD picks up, it won't offset the decline in trading.
Even after Goldman cut costs, Bernstein estimates that the return on equity (ROE) in Goldman's trading business is only 7%. Overall, Bernstein has reduced its ROE estimate for Goldman from 15% to 11%.
Goldman's sales and trading business generates 60% to 70% of the firm's revenues and uses more than 50% of the firm's capital.
Even if Goldman Sachs wanted to reduce its exposure to fixed income sales and trading (which it seemingly doesn't), Hintz says it couldn't. Goldman only has one other business (investing and lending) which operates at a similar capital intensity (and uses around 33% of the capital in firm). If Goldman shrunk the amount of capital it devotes to sales and trading, Hintz says it would either need to get approval from the Federal Reserve to return capital to shareholders or to make a large purchase not related to sales and trading.
Goldman Sachs says it's been gaining fixed income sales and trading market share. Hintz says this isn't so.
Ominously for Goldman's staff, the firm has been cutting compensation costs ferociously. But it hasn't made much difference. Thanks to increase regulation, other costs have risen to absorb the savings.
One day, Hintz says things will get better at Goldman. But that day won't be for at least two years. "We expect that after a number of years there will be a repricing across the industry, and Goldman, in its premier position as a long term market leader, will benefit immensely," says Hintz. "But this process could take years," he adds. Goldman Sachs declined to comment.