Goldman earnings fall on trading slump and charges

Goldman Sachs could turn out to be a mere mortal after all.

The investment bank said on Tuesday that quarterly earnings tumbled 82 percent, steeper than analysts had forecast. A trading and underwriting slump tempered profits and raised questions about whether the firm is losing its ability to outsmart the competition.

We've grown accustomed to Goldman bucking the trends in (investment banking), but this quarter it seems like maybe they're more susceptible to broader industry issues, said Walter Todd, portfolio manager with Greenwood Capital Associates. Maybe Superman is turning into Clark Kent.

Profit at the bank, long famed for lavish pay and political influence, slumped to $453 million, hurt by $550 million for settling the fraud suit brought by the U.S. Securities and Exchange Commission and $600 million to compensate its City of London bankers for a special 2009 UK bonus tax.

Even after stripping out those costs, Goldman's return on equity, a measure of the bank's ability to squeeze profits out of shareholders' money, was just 9.5 percent. Over the prior four quarters, the average was close to 25 percent.

Despite a lower profit, Goldman shares were up 2.2 percent after opening lower as value investors saw clearer skies ahead for the bank and seized on opportunities to buy the stock cheaply. Goldman is trading at 1.2 times book value, compared with well above two times book value before the financial crisis.

You are getting value investors dipping in on light trading volumes, said Matt McCormick, a portfolio manager with Bahl & Gaynor.

If Goldman continues to generate a return on equity of around 10 percent, it should be trading closer to book value by one rule of thumb for valuation, but the firm's cost of capital is a key element of that analysis.

Goldman Chief Financial Officer David Viniar, on a conference call with reporters, said client activity fell in the quarter. He blamed worry about global growth rather than concern about the SEC suit.

Hopefully things will pick up and we hope that (return on equity) over the cycle will be higher than this, Viniar said.

Goldman's chief rival, Morgan Stanley , is due to report quarterly earnings on Wednesday. Morgan Stanley shares were up 1.8 percent on Tuesday.

Goldman's weak numbers were expected by analysts after rivals including Bank of America Corp and Citigroup Inc also saw their investment banking results get pummeled.

The bad is in the (Goldman) stock, said Anton Schutz, president of Mendon Capital Advisors. I think it is pretty well built in. The whole group has gotten punished pretty hard and I'm not sure how bad the sins really are.

REFORMING WALL STREET

Viniar underscored the significance of a financial reform package approved by the U.S. Congress but said it was far too early to assess the impact of the new rules.

The legislation targets lucrative trading in risky over-the-counter derivatives and aims to force banks to end trading for their own profits. It will also limit how much large financial firms can invest in hedge funds and private equity funds.

The new financial regulatory legislation represents the most sweeping change for the financial industry in decades, Viniar said.

Uneasiness over financial reform was just one factor that rattled markets and weighed on trading and underwriting profits in the second quarter. In a quarter marked by increased currency volatility, higher risk premiums for corporate bonds and plummeting stocks, client activity diminished and Goldman scaled back risk.

Most of our risk is driven by client activity, and there was just so much less in activity in the quarter, Viniar said.

By one measure, the bank took less trading risk during the period. Its value-at-risk, or the maximum possible losses on 95 percent of the trading days during the quarter, fell to $136 million from $245 million in the same quarter of 2009. The second-quarter 2010 figure was the lowest in three years.

THE NUMBERS GAME

Goldman's revenue fell a greater-than-expected 36 percent to $8.84 billion, reflecting weakness in fixed income trading as well as investment banking.

Equity trading revenue tumbled 62 percent to $1.2 billion as extreme volatility hampered the market.

Goldman's numbers were not good, said Peter Kenny, a managing director at Knight Equity Markets in New Jersey. ... Their business is down, and it's down in virtually every segment -- not just trading but product sales, innovation in terms of product offerings. The business is down, demand is down, volumes are down.

Even though Goldman's quarter missed expectations and the company dealt with the SEC charges, its investment banking franchise still was strong compared with its rivals.

The bank reclaimed the top spot for mergers and acquisitions advice in the first half of 2010, advising on nearly $190 billion of transactions, although Goldman slipped to a fourth-place ranking when the second quarter is taken on its own.

SEC SETTLEMENT

Viniar said there was no evidence that clients fled from the company in the second quarter as it faced the SEC charges.

As best we can tell, for the most part, our clients stayed quite supportive of Goldman Sachs, he said. Our market shares did not suffer.

I can't tell you there weren't some calls that we would have gotten that we didn't get, he added. We don't know about those.

Some customers with large public profiles have been more cautious in working with the company recently, and analysts speculated that a prolonged legal battle with the SEC would have been damaging to Goldman's brand.

Goldman last missed analysts' forecasts in January 2009, when it reported a deeper-than-expected loss following the financial crisis. It was also the smallest profit the bank has reported since the financial crisis.

The SEC civil fraud suit stemmed from Goldman's marketing and packaging of the Abacus collateralized debt obligation. The bank agreed to settle the case last Thursday.

As Goldman's earnings swung lower, so did its set-aside for compensation. The firm slashed its compensation and benefits expense by 42 percent to $3.8 billion.

Analysts pointed to non-compensation expenses, which rose 44 percent, as a driver behind Goldman missing estimates. The increase included the SEC settlement and related litigation costs, plus higher professional fees and brokerage, clearing, exchange and distribution fees.

(Reporting by Steve Eder; Additional reporting by Dan Wilchins and Chuck Mikolajczak; Editing by John Wallace and Steve Orlofsky)