Saturday, October 11, 2008

Is Goldman's 10Q tarnished?

Let's look at some of their assets:

Level 3

$18 billion in mortgages
$11 billion in bank and bridge loans
$7 billion in corporate debt
$17 billion in private equity and real estate
$13 billion in derivatives

Level 2

$131 billion of cash instruments
$208 billion of derivatives

Goldman also has a net $21 billion in exposure in off-balance sheet VIE's. Goldman has also purchased 12 million shares of stock this year at about $188, and then raised capital two weeks ago, selling stock at $115. Goldman is now at $88.80. Those investors that bought stock from Goldman are now substantially under water, as was Goldman when they purchased stock 100 points higher. Did things change so materially for Goldman, or was their stock buyback just a trade that couldn't be put in Level 3? Every quarter, Goldman marks down it's Level 3 cash assets, and every quarter Goldman marks up it's Level 3 derivative assets.

Goldman assures us that they employ the best independent estimates of Level 3 values. But has there been any Level 3 values that have been written up? Why do we only see losses in Level 3 assets? Is it because Level 3 values are based on purchase price and hope?

Where is the disclosure? Their commercial real estate loans are broken down in three categories by Geographic Region. America, Asia, and the Rest of the World, except the North and South Pole. Does that tell us anything?

Now FASB is changing rule 157. Here's a good link on fair value accounting.

The new FASB rules will require more than a footnote on the input, and in their illustrative example on how to apply FASB 157 on Level 3 assets, they gave an implied discount rate of 22% for a CDO. Here's the example:

The standards-setter offered the following example: A corporation, called entity A, invested in a BBB-rated tranche of a collateralized debt obligation on Jan. 1. Until June 30, the company was able to determine fair value using quoted prices in active markets for the CDO or quoted prices in active markets for similar CDOs.

But since then, the markets for CDOs have become increasingly inactive. And on Sept. 30, the measurement date, the company determined that the market for its CDO was in fact inactive because there were few observable transactions and the prices for those transactions weren’t current and varied significantly.

“Consequently, while entity A appropriately considers those observable inputs, ultimately, entity A’s CDO security will be classified within Level Three of the fair value hierarchy because significant adjustments are required to determine fair value at the measurement date,” FASB wrote in its staff position.

So entity A determines that an income approach will be representative of fair value. The implied rate of return as of the last date on which the market was active was 15% and the company thinks the market rates of return have increased since then. In addition, it determines that credit spreads have widened by 100 basis points and liquidity risk premiums have increased by about 400 basis points. Based on those factors, entity A calculates that an appropriate rate of return is 20%.

The company also takes into consideration the indicative quotes for the CDO, which imply a rate of return of 25%, and concludes that 22% is the point in the range that is most representative of the fair value of the CDO in the circumstances.

The comment period for FASB’s proposed staff position ends on Thursday. The staff position will be effective upon issuance, which is expected at the board’s meeting Friday, Oct. 10, including for prior periods, such as the third quarter of this year, for which financial statements haven’t been issued.

A 22% rate would materially knock down the asset value of many Level 3 assets.

And if their value is materially overstated, then the equity capital of these firms is also materially overstated, and then their leverage ratios are also materially understated.

So what happened Friday night?

On Friday night, America’s chief accounting body, the Financial Accounting Standards Board, revealed that it would suspend the mark-to-market rules to take account of extreme market conditions. Institutions will be able to use their own estimates of an asset’s worth instead. The move follows pressure from the US Securities and Exchange Commission.

Treasury Secretary Paulson, the former chairman of Goldman Sachs, said at the IMF meeting that they would pump money into the banks:

``We're going to do it as soon as we can do it and do it properly and do it effectively and right,'' Paulson said. ``Trust me, we are not wasting time; people are working around the clock to deal with this.''

Goldman and the other Investment banks say the same thing, with their Level 3 valuations. "Trust Me."

Is it any wonder investors are selling these Investment Banks?

Maybe that's why the Times Online, in the above article also had this to report:

US Treasury secretary Hank Paulson gave a clear indication late on Friday that he would stand behind Morgan Stanley and Goldman Sachs to prevent another collapse on the scale of Lehman Brothers.

Because with Goldman, the Government's secrets lie.

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