Update: Goldman Sachs + Citigroup; Interest Rates Higher Longer?

August 24, 2023 | Premium Service | Over the past several years, The Institutional Risk Analyst cataloged the credit and operational issues at Goldman Sachs (GS). We’ve noted that the ultra-high net worth customer base at GS was not the same crowd that were causing the alarming credit losses.

Say what you want about the madness of crowds, we think GS deserves to be trading closer to Citigroup (C) at 0.4x book than to JPMorgan (JPM) at 1.5x book value. We published the chart below back in June of 2023 (“Update: GS, MS, SCHW, RJF & SF”). Notice that Charles Schwab (SCHW) is crawling along the bottom of the chart in terms of net credit losses.

Source: FFIEC

Some of our readers think that SCHW is a good short trade, but we think it is merely expensive. While Schwab is an amusing situation, the retrenchment at GS is significant for several reasons. First, the retreat from an organic growth strategy is going to put pressure on the stock and on the BOD to fashion a new plan.

Since it is obvious that GS has no skill at commercial banking, as opposed to trading and doing deals, does retaining the bank charter model still make sense? Most of the GS business is regulated by FINRA and SEC rather than the bank regulators. Why is Goldman Sachs a bank? If we assume that GS will refuse the idea of a bank acquisition, will they give up the banking license?

The second issue faced by GS leadership is what to do with the business long term. Given the global shakeout in asset gatherers, the winners in the group include UBS AG (UBS), Morgan Stanley (MS) and SCHW. GS and Citi are the two also-rans among the asset gatherers group, the least well-positioned of the investment banks. Does it make sense to combine these two laggards and rationalize the institutional market share? There are few other partners on the dance floor for either firm. Some key metrics from both firms are shown below.

Source: FFIEC

These two firms are very dissimilar, but also have some notable similarities. Both have relatively high funding costs and finance a large portion of their businesses in the institutional money markets. Both lead with capital markets and both are globally focused in terms of market. And each have significant pieces like payments and consumer lending for Citi and investment banking at GS that the other partner lacks.

We continue to believe that combining Citi and GS may make sense in terms of consolidating two capital markets businesses and two small asset management businesses that are dwarfed by the other players. Citi has half a trillion in core deposits and a payments platform that is worth more than the rest of the business – all trading at less than half of book value. Call the bank Citibank, call the broker-dealer Goldman Sachs and think of a good name for the survivor.

Citi CEO Jane Fraser is in the process of restructuring Citi yet again, perhaps creating an opportunity for a real solution to a decades old problem. “Putting [Fraser] in closer contact with operating units gives her an opportunity to assess their business directly," Dick Bove told Bloomberg. "The fact that this needs to be done after 53 years of reshaping and restructuring is quite frankly very discouraging." We concur.

Meanwhile, going from the sublime to the ridiculous, Softbank portfolio company Better.com (BETR) has completed its merger with SPAC Aurora. When people ask why Softbank went ahead with Better.com listing, our supposition is that the Japanese fund is actively liquefying the entire Softbank portfolio. Given the losses realized to date, there is little downside in proceeding. Q2 earnings for BETR have yet to be released, of note.

“Better.com, the young mortgage fintech started by former Morgan Stanley (MS) employee Vishal Garg, completed its merger with “blank check” company Aurora Acquisition Corp. and expects the combined entity’s stock will begin trading on the NASDAQ Thursday,” Inside Mortgage Finance reports. “SoftBank and NaMa (formerly Novator Capital) are Better’s sponsors.”

Until there is an interest rate decrease by the Fed on the horizon, it will be hard to generate attention for the BET stock. The same could be said of a possible spinoff of NewRez by Rithm Capital (RITM). As we noted in our Housing Finance Outlook, we could be in an extended period of stable interest rates at levels 3-4 points above the average 3.6% MBS coupon today. This is a very difficult market for lenders and investors alike.

“Mortgage desks continue to face challenges pricing coupons that do not exist,” writes Adam Quinones. “Definitely getting lots of questions on hedging liquidity in the mortgage market. This tends to happen when the curve bear steepens in size. Traders are now trying to make prices on 7.0% coupons and they're basically flying blind. Slow migration up-the-stack so far but there's been a clear shift in pricing recipe weightings. The benchmark pricing coupon is actively moving from FNCL 5.5s to FNCL 6s and 6.5s.”

Speaking of RITM, there seems to be an auction developing for Sculptor Capital (SCU). A group of investors made a rival bid for the company at $12.25/share, this in an effort to break up the deal announced late last month for Rithm to acquire SCU at $11.15. The SCU transaction is important to RITM’s plan to transition from a focus on residential mortgages, but as noted above, we don’t think a spinoff of NewRes is possible in the current environment.

“The preliminary proxy filed by SCU on Monday details the competitive bidding process leading up to the RITM acquisition,” writes Eric Hagen at BTIG, “which included a number of offers above $11.15, but with more subjective terms, which leads us to believe the valuation alone might not be enough to break up the deal.” Another banker thinks that the Sculptor deal has been well received by the markets and has helped RITM's market value.

With the 10-year trading close to 4.25%, federal regulators need to prepare for some ugliness in bank earnings disclosure for Q3 results five weeks out. Members of the FOMC seem to be comfortable with another rate hike in September, but there is also a growing consensus that interest rates cannot go any higher without the risk of serious dislocation. With the average mortgage coupon around 3.6% now, a 6% SOFR rate is pretty daunting.

Federal Reserve Chairman Jerome Powell is expected to set future expectations this Friday “as policymakers enter what he’s called the most difficult stage of the inflation fight — calibrating how much more tightening is needed, with little certainty about how their actions have affected the economy so far,” writes Catarina Saraiva of Bloomberg. We'll see. Markets are declaring the inflation fight over, but we are not so sure.

The key problem in assessing future Fed policy is that neither Powell nor the other members of the FOMC have a good metric for gauging how a given interest rate change or increased bond sales would impact the markets. As a result, other than hiking short term rates up to 6%, we do not expect much deviation from the current script from Powell.

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