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Goldman Sees `Bottom' as Besieged Wall Street Can't Yet Concur By Christine Harper and Bradley Keoun Sept. 24 (Bloomberg) -- Goldman Sachs Group Inc., the world's biggest and most profitable securities firm, has good news for its competitors: The worst credit-market shakeout since 1998 is abating. After winning its third-quarter bet against all forms of money devalued by the subprime mortgage collapse, while almost everyone else on Wall Street did the opposite, Goldman is signaling a turnabout. ``We are a lot closer to the bottom than where we were at the end of last quarter,'' Chief Financial Officer David Viniar said in an interview assessing the third-highest earnings in Goldman's history and the industry's only increase last quarter. ``There are going to be opportunities in the mortgage business,'' he said, and ``there are certainly going to be opportunities to buy distressed assets.'' The emergence of a bullish sensibility is resonating if only because so many of the New York-based firm's strategies have been on target. It was Goldman that foresaw this decade's bull market in fixed income and built a team of traders that generated a record $14.3 billion of revenue last year. Goldman shares are up 5.3 percent so far in 2007, the only equity among the five biggest U.S. securities firms to advance. Morgan Stanley fell 4.7 percent, while Merrill Lynch & Co. and Lehman Brothers Holdings Inc. dropped almost 20 percent, and Bear Stearns Cos. slumped 28 percent. Goldman trades at almost nine times earnings, more than Morgan Stanley, Merrill and Lehman. Only Bear Stearns trades at a higher multiple after profit plunged 61 percent in the third quarter. Goldman's Patience Goldman stuck with private-equity investing while Morgan Stanley and JPMorgan Chase & Co. exited the business, and it now reaps about $400 million a year managing the second-largest fund for leveraged buyouts, based on the typical 2 percent annual fee. Goldman also was quicker to respond to demand for alternatives to stocks, bonds and money markets by building the world's No. 2 hedge fund manager by assets after New York-based JPMorgan. ``They've been more right than wrong in how they've positioned their own book of business,'' said Mark Batty, a financial-services analyst at PNC Wealth Management in Philadelphia, which oversees $77 billion and holds shares of Goldman, Morgan Stanley and Merrill. ``So you give them the benefit of the doubt, in terms of their outlook, versus the other firms.'' At least six sell-side analysts raised estimates for Goldman's full-year earnings after last week's third-quarter report. The average profit estimate of 13 analysts in a Bloomberg survey now is $10.7 billion, compared with net income of $9.54 billion in 2006. Misreading the Signs Goldman's rivals misread the credit markets heading into the quarter that ended Aug. 31. They didn't anticipate that investors, spooked by rising defaults on subprime mortgages, would shun everything from leveraged-buyout debt to investment- grade bonds. The risk premium on bonds rated BB more than doubled to 3.53 percentage points in the three-month period, according to a Merrill index. Not since Russia's debt default of 1998 and the collapse of hedge fund Long-Term Capital Management LP would Wall Street face such a bear market in credit. In the flight to quality, Treasury bonds rallied by the most in five years. Morgan Stanley, the second-largest U.S. securities firm by market value after Goldman, was optimistic in June when CFO David Sidwell told analysts that ``the current market plays to our strengths'' and that ``concerns early in the quarter about whether issues in the subprime market were going to spread dissipated.'' Unhedged Loans By the end of August, Morgan Stanley's credit-trading revenue had dropped by more than $1 billion from the second quarter, and the New York-based firm's losses in fixed income were exacerbated by a decision not to hedge its financing commitments to LBOs. ``They're going to think a lot harder about the bets that they take on from here until the end of the year,'' said Helena Ocampo, an analyst at Sentinal Asset Management in Montpelier, Vermont, which manages $4.4 billion and holds shares of Goldman, Morgan Stanley and Merrill. Morgan Stanley isn't sure yet that now is the time to put capital at risk again, a reticence that may become an opportunity cost. ``We believe it will take at least a quarter or two for the credit markets to return to a more normal extension of credit and provision of liquidity,'' incoming CFO Colm Kelleher said on Morgan Stanley's earnings conference call Sept. 19. Deutsche Bank AG Chief Executive Officer Josef Ackermann said the same day that Germany's biggest bank will scale back hiring after making ``mistakes'' before the credit boom ground to a halt during the past two months. `Challenging Markets' New York-based Merrill, which reports earnings in October, said on Sept. 14 that ``credit market conditions have continued to remain challenging in the third quarter.'' Goldman hinted at its position on June 14, when Viniar said the firm expected ``more pain'' from the collapse of the subprime mortgage market. Less than two weeks later, Chief Executive Officer Lloyd Blankfein offered more clues. ``We certainly are organizing ourselves like the market is undervaluing risk, and so we are in a high state of nervousness,'' Blankfein said at a June 27 conference in New York organized by the Wall Street Journal. ``The biggest risk we face, and there are a lot of things that contribute to this risk, would be a very big crisis in the credit markets.'' New York-based Bear Stearns and Lehman Brothers, the two securities firms most reliant on mortgages, didn't share Blankfein's concerns. Doomed Quarter ``Mortgages are obviously at a low point in this recent period here,'' Lehman's then-CFO, Chris O'Meara, said on June 12. ``And I think as we look forward, without giving specific guidance, I would think that we would be in for better performance.'' Bear Stearns CFO Samuel Molinaro told analysts and investors on a June 14 conference call that he anticipated trading ``to be a little bit challenging'' in the third quarter. It would turn out that the firm's earnings were already doomed. Two Bear Stearns hedge funds that invested in mortgage securities melted down days later, resulting in $200 million of losses and related expenses. Bear Stearns last week reported its lowest quarterly net income in five years after a further $700 million loss for writing down mortgage holdings and loans for LBOs. Lehman's third-quarter profit fell 3 percent, its first decline since 2002. Trading Prowess ``Goldman had themselves set up correctly for what the market did, and their trading prowess really showed through,'' said Ryan Lentell, an analyst at Chicago-based Morningstar Inc. who gives Goldman three stars out of a possible high of five. ``They were short mortgages this quarter, which was the right way to be.'' June wasn't the first time Blankfein, 53, has called a credit crunch. As a senior Goldman partner in early 1998, he raised concerns about excessive leverage in the U.S. financial system, according to Roger Lowenstein's 2000 book about Long- Term Capital, ``When Genius Failed.'' He told Peter Fisher, then head of open market operations at the Federal Reserve Bank of New York, that investors weren't distinguishing between the risks of different securities. ``Blankfein thought the next big problem would be a credit problem, not a problem specific to any one market,'' Lowenstein wrote. Later that year, Russia would default and the New York Fed would have to orchestrate a $4 billion bailout for Long-Term Capital to stabilize the financial system. Goldman, then run by current New Jersey Governor Jon Corzine, was one of 14 banks that participated in the rescue by putting up $300 million of its own capital. Calling the Bottom Today, at least two of Goldman's rivals also are ready to call the bottom, even after timing it wrong in June. Lehman's O'Meara said on Sept. 18 that ``we feel that the worst of this credit correction is behind us.'' Bear Stearns's Molinaro, who on Aug. 3 said the fixed-income market was ``about as bad as I have seen it'' in 22 years on Wall Street, declared last week that ``the worst is definitely behind us.'' To be sure, Goldman doesn't always get it right. The firm lost at least $350 million in 1994 after betting on an increase in Treasury bond prices and a decline in the British pound, according to Lisa Endlich's 1999 book ``Goldman Sachs: The Culture of Success.'' When the Fed and the U.K. central bank raised interest rates, both trades went haywire. ``Nobody is a super-trader,'' said Bruce Foerster, a former Lehman executive who now runs South Beach Capital Markets, an investment-advisory firm in Miami. ``Goldman was rocked by the 1994 trading losses. Everybody makes mistakes. Sometimes you're on the right side of the bet, sometimes not.'' To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net ; Bradley Keoun in New York at bkeoun@bloomberg.net . Last Updated: September 23, 2007 19:29 EDT