Subprime Separates The Weak From The Strong (GS, BSC)

By Dean Lundell | October 12, 2007 AAA

In the motion picture "Wall Street" the villainous character Gordon Gekko gave the now infamous "greed is good" speech. It's a simple philosophy for finding success, but in reality success often comes down to the more subtle philosophy of risk management.

This was in evidence when you examine the latest results for investment banks Goldman Sachs (NYSE:GS) and Bear Stearns (NYSE:BSC). Both companies are "greedy"; they're supposed to be. The difference came in how they managed their risk and how this played out as the subprime meltdown began to roil. In this article we'll examine how Goldman Sachs managed to come out ahead, while rival Bear Stearns wilted under pressure. (For a one-stop-shop on the subprime meltdown, check out our Subprime Mortgages Feature.)

Goldman Sachs Crushes Expectations
Goldman Sachs thrashed consensus earnings estimates for its third quarter, earning $6.13 per share against consensus estimates of $4.35 per share.

In its Q3, the firm had revenue of $12.33 billion and earnings of $2.85 billion. Looking into specific results by category, the company's Investment Banking segment chimed in with $2.15 billion. The Advisory portion went up a whopping 64%. Fixed-Income, Currency and Commodities contributed an impressive $4.89 billion, indicating Goldman Sachs was on the right side of the CDO fiasco. Core results at GS would have been even better if the firm had not written down its LBO commitments to the tune of $1.48 billion.

On the other side of the ledger, operating expenses were about 55% higher, rising to $8.08 billion, while compensation and benefits rose 68% to $5.92 billion and non-compensation related expenses edged up 27% to $2.16 billion. (To get started on your own analysis, check out Understanding The Income Statement.)

Also of note, the firm has bought back about 11.2 million shares at an average of $219.35 per share and has remaining authorization of its board of directors to buy back another 23 million.

A Bear of a Quarter
Bear Stearns has a new dubious distinction, a new low in return on equity, coming in at 5.3% for the last quarter. The previous lowest quarter in the last seventeen years was 8.5% for the firm's third quarter in 1994. Bear Stearns' earnings per share for its third quarter of $1.16 were literally half the consensus estimate of $2.33 and down 62% from the same period a year ago. Net income for the quarter was $171.3 million, down about 61% the same period just one year prior.

It wasn't all bad at Bear Stearns for the quarter. The bright spots included a rise of 53% in net revenue to $719 million from Institutional Equities, driven primarily by structured equity products and international trading. The firm saw a 30% bump in the firm's Global Clearing to $322 million, and even Private Client's net revenue edged up about 15% to $148 million. The board of directors saw fit to increase the share repurchase authorization to $2.5 billion from $2 billion which included $1 billion for corporate share buyback. Bear Stearns has already bought back approximately $1.3 billion.

One of the major sore-spots was the Fixed-Income division. Its revenue was down roughly 88% to $118 million from $945 million in same period a year ago. Market conditions were much to blame as not only did volume decrease but asset values declined as well. The firm's Asset Management segment had to eat $186 million in losses related to the BSAM High Grade hedge funds and the unit actually had a negative $38 million net result. (For more on Bear Stearns' hedge fund problems, check out Dissecting The Bear Sterns Hedge Fund Collapse.)

It's clear from the most recent results that risk management is the key to success. Bear Stearns failed to manage its risk, its hedge funds and its results suffered. Meanwhile Morgan Stanley planned ahead and so it came out ahead. As Sun Tzu (one of Gordon Gekko's favorite men to quote) advises in "The Art of War", we must choose our battles wisely.

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