Third quarter results were a grim affair for most of Wall Street. But head and shoulders above the fray was Goldman Sachs, who ran heavy on the line that they – the best bankers on the street – could spin profits even from the worst of times.
The figures said it all - a 79 per cent rise in net income despite the credit squall, with fixed income, currency and commodities generating record quarterly net revenues for the bank. It all hinged on a good bet. Said Goldman:
Significant losses on non-prime loans and securities were more than offset by gains on short mortgage positions.
Apparently Goldman anticipated the mortgage securities crash. And with that, Goldman could report trading revenues of $8.23bn, 70 per cent up on Q3 2006.
But it’s also becoming clear, through filings with the SEC, that Goldman marked far more of its assets as “level 3″ securities than any other US bank. Under Financial Accounting Standards Board Statement 157, level three assets are those which a valuation is reached using “unobservable inputs”. Because such assets cannot be valued accurately due to illiquidity, a price is instead reached based on assumptions about future pricing, derived from models. Not for nothing does Warren Buffet refer to level three accounting as “marking to myth.”
According to Fortune magazine, Goldman made a net gain of $2.94bn from level three booked derivatives. And $2.62bn of that gain was unrealized. The question now is, will it continue to be so?
Fortune speculates that there may have been “no way illiquid level 3 derivatives could be cashed out at the prices Goldman attached to them.”:
Indeed, if that level 3 derivatives gain does include the stupendously prescient bet against mortgages, it deepens the mystery over what type of institution is on the other side of that trade, effectively holding the losses. In other words, if hedge funds – which operate with thin capital and high leverage — are on the other side of a large part of this mortgage bet holding the losses, it may not be easy for Goldman collect all it is owed.
On which assumption, Goldman’s stellar performance may not be so heavenly. There is a timeframe before things might be brought back down to earth too; if asset prices for unattractive securities don’t return to earth by the end of Q4, it will be hard for banks to justifiably continue using level 3 as a fig-leaf.