Behind Goldman Sachs' Upgrade from J.P. Morgan (GS, JPM, MS, DB)

After weeks of downgrades following charges of civil fraud, Goldman Sachs Group Inc. (NYSE:GS) got some good news this morning. Analysts at fellow banker JP Morgan Chase & Co. (NYSE:JPM) raised Goldman’s rating from ‘Neutral’ to ‘Overweight’, and raised the price target on the stock to $175/share.

The upgrade comes as a result of Goldman’s internal method of estimating the value of its risk-weighted assets. The analysts believe that both Goldman and Morgan Stanley (NYSE:MS) base 25%-40% of the value of their risk-weighted assets on a “value at risk” model.

By taking more conservative approach than some European banks, Goldman has piled up enough Tier 1 capital to avoid having to make another injection of cash into its reserves. The JP Morgan analysts noted that European banks typically are more generous in computing the value of their risk-weighted assets, making those banks’ valuations more dangerous. At the same time that Goldman’s rating was upgraded, JP Morgan downgraded Deutsche Bank AG (NYSE:DB) from ‘Neutral’ to ‘Underweight’.

Another factor in the ratings changes stems from the proposed new financial regulations that are presumed to be coming from the US Congress. The JP Morgan analysts noted that the new rules on defining risk-weighted assets, not due until the end of 2011, are not likely to close the disparity between a bank’s internal estimate of its assets and an external estimate of those same assets. The over-valuation of mortgage-backed securities played a significant role in the demise of both Bear Stearns and Lehman Brothers.

The irony, of course, is that in the case of Goldman’s unrevealed short position on the sale of CDOs, the bank is being investigated for betting against its own investors, which had the effect of hedging the bank’s risk-weighted assets. On one hand, Goldman is vilified for its actions, and on the other it is praised.

Whether one blames or praises the bank depends on whether or not one views the Abacus and Hudson deals from the point of view of a regulator/investor or from the point of view of a financial rating group. This morning, the bank is getting praise, and its shares are up nearly 2%.

Paul Ausick