Juicy Derivatives Margins Make Goldman a $164 Stock
Goldman Sachs (NYSE:GS), JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) are the largest players in the US over-the-counter (OTC) derivatives market. Recently the Commodities Futures Trading Commission (CFTC) announced that it will need at least another year more to draft the regulations aimed at standardizing practices in this highly lucrative market. [1] The CFTC was earlier expected to draft these regulations by mid-July.
We have a $164 price estimate for Goldman Sachs, which is at a premium of about 20% to market price.
The OTC market, the criticism and the delay
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OTC contracts are primarily sold by financial institutions to corporations so that they can hedge their risks. [2] It is estimated that almost 95% of the Fortune 1000 companies use derivatives to hedge against risks. The OTC derivatives market reportedly trades contracts worth $300 trillion in notional value each year.
However the derivatives market has received a lot of criticism in the past for being largely unregulated and opaque to outsiders. The CFTC took it upon itself to introduce more transparency into the market by modelling a derivatives exchanges – a move that could limit the flexibility of the contacts that banks offer to their clients.
Not much is known about banks’ derivatives business
Banks generally do not reveal their revenues from trading derivatives. However in 2010, the Wall Street Journal reported that Goldman Sachs had declared to the Federal Crisis Inquiry Commission that 25 – 35% of its revenues in previous years had come from trading derivatives with most of the sales concentrated in the fixed income trading segment of the bank. [3]
More transparency in the derivatives business would reduce some of the barriers to entry and invite competition to the market, thus reducing margins in this business. [4]
The delays in regulation would help the bank postpone the expected declines in its derivatives trading businesses.
Banks are lobbying against regulation
Goldman Sachs spent $1.3 billion in Q1 2011 on issues that included the overhaul in financial regulation. [5] Its lobbying efforts were also directed at the CFTC according to its disclosures. Dealbook cites an estimate that the top five banks had hired more than 130 registered lobbyists in 2010 to defend their case against excessive regulation. [2] Critics of the CFTC efforts also highlight the fact that unless the regulations are implemented at a global level, local restrictions will only shift derivatives trading activity to countries with lax standards. [1]
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Notes:- Derivatives Watchdog Should Streamline Quest for 51 Rules: View, Bloomberg [↩] [↩]
- Banks Lobby Against Ban on Derivatives Trading, Dealbook [↩] [↩]
- At Goldman, Derivatives Were 25% to 35% of ’09 Revenue, The Wall Street Journal [↩]
- Wall Street Stealth Lobby Defends $35 Billion Derivatives Haul, Bloomberg [↩]
- Goldman Sachs spent $1.3 million on lobbying in 1Q, AP – Yahoo Finance [↩]