How Vulnerable is Goldman Sachs to Europe’s Toxicity?

by Michael Foster
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Europe’s sovereign debt crisis has taken its highest profile victim so far: Silvio Berlusconi, the flamboyant frontman whose seventeen-year tenure as prime minister was colored with scandal and controversy. How will the continued European saga affect American investment banks, many of which are deeply connected to European and specifically Italian activity? According to its most recent filing in September, Goldman Sachs (NYSE:GS) was only minimally exposed to the so-called PIIGS (Portugal, Ireland, Italy, Greece, and Spain) after a slow but steady de-investment into the troubled economies. At that point, the firm had gross investments of $2.32 billion in Italy (compared to $190 million in Portugal, $450 million in Spain, and only $8 million in Greece). In addition, Goldman Sachs is the creditor for approximately $750 million of private debt in these countries. Goldman competes with other U.S. banks in Europe like Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM) and Citi (NYSE:C).

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Goldman has minimal exposure to PIIGS

At first glance, this would suggest that the firm is only marginally invested in the troubled European economies and thus should not be terribly affected by Europe. However, the bank has also invested $31.1 billion in German, Britain, and the rest of Europe–with the PIIGS, the bank has over $35 billion exposed. While this is a small fraction of the firm’s $948 billion assets, the company is still heavily invested in bonds, currencies, and commodities, which make up nearly a third of the firm’s business.

The good news is that Goldman Sachs is much more heavily invested in American, Chinese, and Japanese markets. The bad news is that these have also underperformed. In Q3 2011, the firm lost $1.05 billion from their investment in the Industrial and Commercial Bank of China Limited (HKG: 1398). While this might be surprising considering China’s remarkable and consistent GDP growth, it is unsurprising considering that the EU is a bigger trading partner for the Chinese than the United States.

This points to Goldman Sachs’s indirect exposure to the Euro, which is great. Goldman Sach’s heavy activity in bonds and currencies means that threats to the Euro are also threats to the investment bank. With Berlusconi gone, there are high hopes on Mario Monti, an economic academic who has also worked as an advisor to Goldman Sachs in the recent past.

Monti has been called on to form a new Italian government in the hopes of inspiring confidence in the market. But Italian bond yields remain above 7 percent on headlines of political uncertainty, and it remains unclear how Monti is going to restructure Italian debt when his influence on the European Central Bank is minimal and public debt climbs to over 118 percent of GDP.

Euro’s fate is unclear

An unclear future for the Euro means an unclear future for anyone investing in the currency and bond markets of first-world countries, and this means an unclear future for Goldman Sachs. Despite its low exposure to the PIIGS, it is still exposed to Europe and Europe’s biggest trading partners. In Q2 2011, Goldman Sachs lost $393 million in its second loss ever, leading the firm to cut operating costs. Most recently, the bank announced the retirement of over a dozen partners–an unusual number that may suggest the company is quietly trying to cut operations from the top down.

The economic growth of Portugal, Italy, Irelan...

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Goldman Sachs is quick to abandon losing investments, as we saw with the company’s recent sell-off of its stake in the ICBC. (See Trefis note: Goldman Sachs’ Sells ICBC Stake to Raise Cash, Reduce Earnings Volatility.) We may see the firm moving away from any investment that may lose from European debt contagion before any contagion actually occurs. However, this may be easier said than done. Recently, LCH Clearnet required traders to set aside more capital against possible defaults if they want to trade in Italian bonds–meaning that it is now more expensive to trade in Italian debt, which should lower demand and make it harder for holders of Italian bonds, such as Goldman Sachs, to sell its stake.

The bank may react quickly to this setback or work around it by hedging against further rises in Italian bonds, which could yield higher profits. Also, Goldman Sachs has suffered a massive devaluation in the past year; since January, the stock has lost over 40% of its value, although the firm has grown by over $3.4 throughout 2011. Nonetheless, the bank needs to act fast in response to the European debt crisis before its stock price can start to recover. Until then, the company may find itself needing to scale down even further.

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This article was submitted as part of our Trefis Contributors program and may not reflect the views of Trefis analysts. Email us at contributors@trefis.com if you’re interested in participating.

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