Goldman's Verdict: No Contagion Yet

The Wall Street investment bank does not see a crisis in the credit markets, despite subprime woesas long as other banks' earnings don't tank

As the meltdown in the subprime mortgage market has gone from bad to worse to dire, all eyes turned to Goldman Sachs (GS), the leading Wall Street investment bank, on Mar. 13 to see whether the troubles were spreading into other segments of the credit markets. The verdict: The subprime troubles have been confined to that sector, at least so far.

Goldman, which surprised investors with the strength of its earnings for the first fiscal quarter of 2007, said the credit markets remained strong despite "significant weakness" in the subprime mortgage sector. "I can't predict the future," said David Viniar, Goldman's chief financial officer, during a conference call with investors. "But as I sit here today, I do not see any contagion in the credit markets."

Goldman said its mortgage business was strategically important, but relatively small. To the extent that it invests in mortgages, it tends to focus on prime mortgages and commercial mortgages. The mortgage business is part of Goldman's larger Fixed Income, Currency & Commodities unit. FICC reported record quarterly revenue of $4.6 billion, up 20% from the first fiscal quarter of 2006.

Performance Beat Expectations

Goldman's overall financial performance for the sector easily beat investor expectations. It reported earnings of $3.20 billion, or $6.67 a share, on revenue of $12.73 billion. Earnings were up 29% from $2.48 billion, or $5.08 a share, on revenues of $10.43 billion during the first quarter of 2006. Analysts at Merrill Lynch (MER) expected Goldman to earn $5.07 a share. The consensus estimate was even lower, at $4.97, according to Merrill. Goldman shares slipped $2.81, or about 1.38%, to $199.80 on Tuesday, as the overall stock market plummeted (see, 3/13/07, "Stocks Tumble on Mortgage Worries").

The quarter reflected strength in areas where Goldman committed its own capital, such as trading and private equity deals, according to Merrill Lynch analyst Guy Moszkowski. He said private equity results from Asia were particularly strong, and that trading was up nearly across the board.

During the conference call, analysts pressed Viniar for more information about Goldman's exposure to the subprime meltdown (see, 3/2/07, "Why Subprime Lenders Are in Trouble"). Moszkowski noted that Goldman's first fiscal quarter ended Feb. 23, "with the worst of the subprime meltdown arguably occurring since; but again, who's to say the firm didn't continue to benefit from the accelerating turmoil?"

Viniar refused to discuss details of the current ongoing second fiscal quarter, although he did say the firm saw no reason to alter its forecasts. He also noted that the subprime meltdown was orderly. While interest rates for some securities rose as the mortgage problems emerged, the rise was orderly and the market had plenty of liquidity, Viniar said. Some of the interest rates have subsequently come down, he said.

Problems May Taint Other Markets

Some analysts are concerned that the problems in the subprime market could spill over into other markets, or that they could signal the beginning of a trend in which similar problems in other markets emerge because of fundamental conditions (see, 3/1/07, "Lender Woes Go Beyond Subprime"). Subprime lender New Century's (NEW) shares were suspended by the NYSE on Tuesday, and lender Accredited Home (LEND) was searching for additional capital (see, 3/13/07, "Scary Times for Subprimes"). Shares of Countrywide Financial (CFC) fell 2.2% on Tuesday, and the Mortgage Bankers Assn. said delinquencies and foreclosures rose during the fourth quarter. Delinquencies on loans hit a record. "It could very well be that the problems are spreading," said Tom Foley, a financial services and brokerage analyst with Standard & Poor's, a unit of BusinessWeek parent McGraw-Hill (MHP).

Widening problems could mean several things. They could be the result of contagion, in which trouble in the subprime market actually causes trouble in other markets. The other scenario is that the subprime problem reflects parallel problems in other markets, which will weaken of their own accord. Lending standards have been lowered globally as credit market investors, searching for places to put huge amounts of cash, have accepted lower returns and higher rates of risk. Those standards fell the most in the subprime mortgage market.

Fear Itself May Unsettle Investors

Contagion could occur among big banks and hedge funds. Banks that bought securities that included bad debt could have trouble exercising their contractual right to sell them back to the originators. And hedge funds that took big losses in the subprime market could face margin calls to repay money they borrowed to make those bets. That could force them to cash out of healthier markets such as the prime mortgage market, in order to raise enough cash to meet their margin calls (see, 3/7/07, "The Mortgage Mess Spreads").

There's also a risk that fear itself will unsettle other markets. If investors in prime or commercial mortgage markets become so alarmed by the subprime market that liquidity becomes scarce, talk of contagion could become a self-fulfilling prophecy.

There's little to no sign that such contagion actually has occurred, although that could change as banks report their quarterly earnings. "We just don't know enough yet to say whether the problems in the subprime market are spreading," said Mike Englund, chief economist of researcher Action Economics. He said that discussions with economists who sit on bank interest rate committees suggest that the problems remain contained, at least for the moment.

The mere fact that delinquencies and foreclosures are rising and that some investors are losing money isn't proof of a crisis. Lenders knew from the start of the lending cycle that levels of bad debt in the subprime mortgage market eventually would rise. "The real question is whether lenders understood just how bad the problem would be, and whether they priced the debt properly," Englund said. The answer to that question will become clear as investment banks such as Lehman Brothers (LEH) and Bear Stearns (BSC), and commercial banks report their earnings during the coming weeks and months.

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