Two days ago NY Times reported that Goldman Sachs (GS) shareholders lost $21 Billion since the SEC filed a civil suit against the investment bank. The main allegation against GS is that it withheld material information about complex mortgage securities that it was selling to investors. This perhaps led to a loss of $1 Billion to the investors while GS and John Paulson ended up making money—around $1 Billion.
Some people raised the question whether the market overreacted to this event. Even if GS settles this with SEC, agreeing to pay the fine and compensate its customers for the losses, the reduction in the GS expected cash flow is not expected to be as high as $21 Billion. Then why is market value of GS stock dropped down precariously in the last few days? Are the players in the market irrational or they turned extremely risk averse overnight? In this post, I try to list a few reasons for why GS stock fell down so much. These reasons are ex post and therefore strictly descriptive. Further, I don’t make any claim to the completeness of this list.
1. Fines and compensation: As mentioned earlier, this is expected because there is a significantly large probability that GS will be found guilty. The market has to take this probability into account while discounting the expected cash flows and valuing the stock.
2. Loss of customer trust: There is a growing consensus in the media and among bloggers that GS benefited at the cost of its clients. Their main business line is investment banking. However, increasingly it is acting as a market maker, transacting at arm’s length. GS’s edge in the trading business will last for some time. However, it is a technology driven business where the money is made by the firm with the fasted computers and mean trading algorithms. Already the competition in program trading business is putting pressure on profit margins and therefore it may not continue to be the long-term money making operation for GS. The traditional investment banking business is no longer an important revenue source for GS. However, its name was very strong among its clients and people generally think that the GS bankers are smarter than their peers from other Wall Street firms. This law suit presents evidence to its clients that transacting with GS is like playing with fire. Consequently, many firms may just decide to take their business elsewhere. Note that even if GS comes out of this fraud allegations clean, the clients may still be reluctant to do business with GS. The loss in the expected cash flows from this reluctance is priced by the market.
Loyal customers also steady the cash flows of the firm. Going forward, the customer loyalty might not be easily available to GS which will result in increased cash flow risk. This increased risk will also push the stock price down.
3. Possibility of more lawsuits: If Abacus deal was the only GS deal with MBS then there would be little concern about more lawsuits. But, this is not true. GS was one of the biggest players in the CDO market underwriting CDOs worth more than $6 Billion between 2005 and 2008. Therefore, there is a good chance that similar fraud charges will be brought against GS in other CDO deals. The market is considering this loss of expected cash flow as well and valuing the stock lower.
4. Reduced political influence: Many people have pointed out the connection between GS and the US politicians including President Obama. GS was one of the few banks that emerged stronger from the current financial crisis. It influenced the political system to a great extent to get itself all sorts of beneficial arrangements. When the market perceives that GS is in a very strong position because of the close political ties, it values GS stock more due to the reduced risk. In other words, the market can see that with increased leverage, GS can take highly risky bets wherethe upside belongs to GS but the downside belongs to the American public. However, with the recent lawsuit, the chance that this will happen in future as well has reduced. If GS still goes ahead and carries out business as usual, then its risk has gone up because now it assumes the downside risk as well. This will reduce its share price. Of course, if GS doesn’t want to increase its risk, then it has to forego the higher expected cash flow. In either case, the stock price will be lower. That’s what has happened in the last 2 weeks.