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If you missed our weekend discussion about the many questions raised by the SEC litigation against Goldman Sachs & Co., be sure to see itnow:

Questions Surrounding the SEC’s Litigation vs Goldman

Goldman Sachs & A Cumberland Strategy Change
April 18, 2010

John Mauldin quickly added text about Goldman Sachs to his weekly letter. He wrote:

“Goldman Sachs is all over the news after being charged with fraud. The way I see it, this is essentially a charge that there was not full disclosure. And it appears to me that that is true. It also is true that Goldman will argue (or I think they will) that only very sophisticated investors who signed very lengthy offering documents were involved, and they should have known better. They were also reaching for yield.

“Last week I read a very interesting report from propublic.org about a hedge fund called Magnetar, which basically did the same trade as in the Goldman deal. And they did those deals with nine banks. You can read the whole article at http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going.

“Let me quote a few paragraphs.

‘From what we’ve learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn’t cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

‘Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses the banks didn’t disclose to CDO investors the role Magnetar played.

‘Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.’

Goldman and at least 8 other banks are going to have serious litigation costs, if they don’t actually have to eat the losses of the investors in these synthetic CDOs. Understand, these were not securitizations of actual mortgages. They were securitizations of derivatives that acted like these mortgages, and the worst tranches of them to boot. On top of their loan losses, there could be tens of billions of losses to investors in the CDOs they sold. This will play out over years.”

A Cumberland Strategy Change

In Cumberland’s view, the GS news is big and is not a one-off event. Since the announcement of the SEC suit, we have been polling everyone we talk to about GS. They are universally despised. The alleged wrongdoings have intensified an already large anger. GS arrogance has created a perception problem, and now GS has a reality problem. It could quickly become a criminal action. One lawyer said “just wait until we hear from Andrew Cuomo.”

Welcome to the modern post-crisis era. In the case of GS, we have an actual allegation of fraud. This is different than the Lehman repo 105 disclosures, although we expect fraud allegations to come there, too. In Lehman we have a failed firm. In GS we have an existing stock and a company that is the largest capital-market player on the US scene.

We expect that there are a lot more charges coming and they will impact GS and many other firms. And we will soon see state attorneys general piling on. The plaintiff law firms are already preparing class-action suits. Germany and the U.K. are launching their own investigations. These types of allegations are not going to be confined to SEC vs. GOLDMAN SACHS & CO. and FABRICE TOURRE. The allegations will not be limited to a single security series known as Abacus 2007.

At Cumberland we have raised some cash. We exited the capital-market ETF quickly. We expect this news will be the catalyst for some market correction. It is long overdue.

The GS news doesn’t impact other sectors and will be confined to the financials. Thus we remain overweight in the tech sector and in the industrial companies.

GS will be used by politicians to justify elements in the financial reform legislation. Will anyone ask how the proposed legislation would have prevented this alleged fraud? Also, the fact that the SEC is bringing these charges under existing law suggests that the law is in place and that enforcement is the real issue, not new legislation. And what would lead us to expect that the supervisors who didn’t prevent this alleged fraud in 2007 will be able to do so next time? They are and will be the same people.

Anyway, GS has added to the volatility in the market. There is more to come. and a little cash on the sidelines awaits some buying opportunities at lower prices.

We thank John Mauldin for saving us some writing time. His website link to the letter is: http://www.frontlinethoughts.com/gateway.asp?ref=reprint.

The continued witch hunt and scapegoating at just the symptoms of the credit bubble and not the disease comes in the context of a market that was very overbought and was due for any excuse to take a rest. To quantify, the RSI in the S&P 500 went 6 weeks straight above 65 for the first time since 1986. With that said, the open ended nature of future lawsuits and the greater possibility of tighter scrutiny of our banking system will have an impact on the financials and their future earnings power. As important for the global economy and its markets is the correction going on in China in response to further steps to crack down on their property bubble. The Shanghai index fell 4.8% after banks were told to halt loans for 3rd home buyers (investors) in cities with large price gains and to tighten the criteria for sales to non residents. Commodities are also down in response. Greek bond yields are breaking out to the highest since 1998.

“I think they were wrong and I think I was wrong to take” their advice.”

-President Bill Clinton, April 18, 2010 on on ABC’s “This Week.”

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In Bailout Nation, I held Bill Clinton, and his two Treasury Secretaries, Robert Rubin and Larry Summers, responsible for signing the ruinous Commodity Futures Modernization Act that exempt Derivatives from all regulation and oversight. The CFMA was passed as part of a larger bill by unanimous consent, and that Clinton signed on December 21, 2000.

Bill Clinton now joins Alan Greenspan in admitting his contribution to the credit crisis.

The former president admits his error: He said his Treasury Secretaries — Robert Rubin and Lawrence Summers — were wrong in the advice they gave him about regulating derivatives. And, he was wrong to follow their advice.

Bloomberg has the details:

“Their argument was that derivatives didn’t need transparency because they were “expensive and sophisticated and only a handful of people will buy them and they don’t need any extra protection,” Clinton said. “The flaw in that argument was that first of all, sometimes people with a lot of money make stupid decisions and make it without transparency.”

“Even if less than 1 percent of the total investment community is involved in derivative exchanges, so much money was involved that if they went bad, they could affect 100 percent of the investments,” Clinton said.”

Clinton doesn’t only throw Rubin and Summers under the bus — he also blames his successor, George W. Bush:

“Clinton also said the Bush administration contributed to the financial crisis with lax regulation.

“I think what happened was the SEC and the whole regulatory apparatus after I left office was just let go,” Clinton said. If Clinton’s head of the Securities and Exchange Commission, Arthur Levitt, had remained in that job, “an enormous percentage of what we’ve been through in the last eight or nine years would not have happened,” Clinton said. “I feel very strongly about it. I think it’s important to have vigorous oversight.”

He certainly has a point about the SEC — the Bush appointees for SEC chairman ranged from bad to worse.

Other actors who have yet to come clean include Harvey Pitt, Hank Paulson, Phil Gramm and George W. Bush. I am not holding my breath waiting for any of their mea culpas . . .

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Previously:
Who is to Blame, 1-25 (June 29th, 2009)
http://www.ritholtz.com/blog/2009/06/who-is-to-blame-1-25/

Source:
Clinton Says Rubin, Summers Advice on Derivatives Was ‘Wrong’
Joshua Zumbrun
Bloomberg, April 19
http://www.bloomberg.com/apps/news?pid=20601087&sid=aVN001cNkLMA

Busy weekend for the boys:

Charts courtesy of The Chart Store

51 WAYS TO COPE WITH STRESS

1. Get up 15 minutes earlier.
2. Prepare for the morning the night before.
3. Watch a sunrise.
4. Watch a sunset.
5. Avoid tight fitting clothes.
6. Set priorities in your life.
7. Avoid negative people.
8. Tell someone to have a good day in pig latin.
9. Throw a paper airplane.
10. Clean out one closet.
11. Take a walk.
12. Try yoga.
13. Get enough sleep.
14. Freely praise others.
15. Get to work early.
16. Clean your car.
17. Strive for excellence not perfection.
18. Be cheerful and optimistic.
19. Smile-it’s contagious.
20. Look at a work of art.
21. Go watch the monkeys at the zoo.
22. Teach a child to fly a kite.
23. Look at problems as challenges.
24. Be prepared for rain.
25. Tickle a baby.
26. Pet a friendly dog/cat.
27. Look for the silver lining.
28. Always have a plan “B.”
29. Quite trying to fix other people.
30. Talk less and listen more.
31. Watch a movie and eat popcorn.
32. Plant a tree.
33. Feed the birds.
34. Don’t know all the answers.
35. Don’t rely on your memory-make a list.
36. Read a poem.
37. Stop a bad habit.
38. Buy flowers.
39. Do it today.
40. Stand up and stretch.
41. Take a different route to work.
42. Go on a picnic.
43. Be a tourist in your own town.
44. Keep a journal.
45. Believe in you.
46. Visualize yourself winning.
47. Dance a jig.
48. Watch a ballet.
49. Listen to a symphony.
50. Go to a comedy club.
51. Relax and take each day as it comes…you have the rest of your life.

Via NorthWestern University

William Black, a professor at the University of Missouri at Kansas City, talks with Bloomberg’s Lori Rothman about the impact of a U.S. Securities and Exchange lawsuit against Goldman Sachs Group Inc. on legislation overhauling the financial regulatory system. Goldman Sachs created and sold CDOs tied to subprime mortgages in early 2007, as the U.S. housing market faltered, without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and bet against them, the SEC said in a statement today.

Source: Bloomberg

Hat tip Howard G

Here’s a little “inside baseball” stuff.

Sam Antar, the former CFO of Crazy Eddies who now specializes in training investigators how to uncover White Collar Fraud, noted the significance of a Friday SEC Complaint:

“The SEC filed the lawsuit on Friday without giving Goldman the heads up.

When a company receives a surprise subpoena or a lawsuit on a Friday, it is known as the “kiss of death” from the SEC. (I received my first SEC subpoena on a Friday afternoon, back in the day). It is meant to ruin your weekend plans (yes, the SEC can get personal in its own way), since your lawyers usually don’t work weekends.

Goldman compounded its problem by putting out a misleading press release contesting the SEC’s charges. That press release can be the basis for later 10b-5 violations, if the SEC wins its case against Goldman.

Goldman should not engage in a public debate on this issue, if they want to avoid being baited by the SEC.

Fascinating stuff . . .

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UPDATE: April 19, 2010 6:21am

The WSJ is reporting that GS was blindsided by lawsuit

Late last year, the NYT detailed Goldman’s role in the collapse of various GS constructed CDOs (Banks Bundled Bad Debt, Bet against It and Won). The article looked a numerous CDOs, including the Abacus 2007 that was the subject of the SEC complaint.

If you missed it during the last minute holiday shopping, I suggest you take a close look now.

Excerpt:

“Mr. Egol and Fabrice Tourre, a French trader at Goldman, were aggressive from the start in trying to make the assets in Abacus deals look better than they were, according to notes taken by a Wall Street investor during a phone call with Mr. Tourre and another Goldman employee in May 2005.

On the call, the two traders noted that they were trying to persuade analysts at Moody’s Investors Service, a credit rating agency, to assign a higher rating to one part of an Abacus C.D.O. but were having trouble, according to the investor’s notes, which were provided by a colleague who asked for anonymity because he was not authorized to release them. Goldman declined to discuss the selection of the assets in the C.D.O.’s, but a spokesman said investors could have rejected the C.D.O. if they did not like the assets.

Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.

“Egol and Fabrice were way ahead of their time,” said one of the former Goldman workers. “They saw the writing on the wall in this market as early as 2005.” By creating the Abacus C.D.O.’s, they helped protect Goldman against losses that others would suffer.

As early as the summer of 2006, Goldman’s sales desk began marketing short bets using the ABX index to hedge funds like Paulson & Company, Magnetar and Soros Fund Management, which invests for the billionaire George Soros. John Paulson, the founder of Paulson & Company, also would later take some of the shorts from the Abacus deals, helping him profit when mortgage bonds collapsed. He declined to comment.”

To me, there is a line that separates what is acceptable behavior on Wall Street and what is not. Shorting stocks, betting against housing and mortgages is one thing. I have no issue with a directional bet, up or down.

Creating synthetic products that are designed to implode, sandbagging clients to invest in them, and then betting against them — that is highly problematic.

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click for larger graphic

Graphic courtesy of NYT

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Source:
Banks Bundled Bad Debt, Bet against It and Won
GRETCHEN MORGENSON and LOUISE STORY
NYT, December 23, 2009
http://www.nytimes.com/2009/12/24/business/24trading.html

by Dylan Ratigan
Host of MSNBC’s “The Dylan Ratigan Show” weeknights at 4PM ET

The following includes questions and commentary for Goldman Sachs as the company defends itself against charges of fraud:

Dear Lucas,

Since I haven’t been able to get you or anyone from Goldman Sachs to appear on my show in months, perhaps we can just try corresponding in writing. Thank you for your press release. I have submitted my follow-up questions in bold:

Press release:
Goldman Sachs Makes Further Comments on SEC Complaint
April 16, 2010

The Goldman Sachs Group, Inc. (NYSE: GS) said today: We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact. We want to emphasize the following four critical points which were missing from the SEC’s complaint.
– Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.

But what about the other “transactions”… You know, the one where you may have potentially shorted this exact transaction with AIG for a lot more than $90 million? You remember AIG, right? It’s where the taxpayers paid you 100 cents on the dollar for a company that you helped blow up.

– Extensive Disclosure Was Provided. IKB, a large German Bank and sophisticated CDO market participant and ACA Capital Management, the two investors, were provided extensive information about the underlying mortgage securities. The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world. These investors also understood that a synthetic CDO transaction necessarily included both a long and short side.

There must be a big difference between “extensive disclosure” and “complete disclosure,” because if you provided “complete disclosure,” you probably would have mentioned to your customers that the entire product was funded and selected by someone who was betting on it to fail. You know, kind of like you did for your coworkers at Goldman Sachs, but forgot to do for your customers!

– ACA, the Largest Investor, Selected The Portfolio. The portfolio of mortgage backed securities in this investment was selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions. ACA had the largest exposure to the transaction, investing $951 million. It had an obligation and every incentive to select appropriate securities.

Not to mention their incentive to be Goldman and Paulson’s unwitting patsy…

– Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC’s complaint accuses the firm of fraud because it didn’t disclose to one party of the transaction who was on the other side of that transaction. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor.

True, but Goldman also never represented to ACA that Paulson was planning on shorting the same product that Paulson & Co. created in the first place!

Background: In 2006, Paulson & Co. indicated its interest in positioning itself for a decline in housing prices. The firm structured a synthetic CDO through which Paulson benefited from a decline in the value of the underlying securities. Those on the other side of the transaction, IKB and ACA Capital Management, the portfolio selection agent, would benefit from an increase in the value of the securities. ACA had a long established track record as a CDO manager, having 26 separate transactions before the transaction. Goldman Sachs retained a significant residual long risk position in the transaction.
IKB, ACA and Paulson all provided their input regarding the composition of the underlying securities. ACA ultimately and independently approved the selection of 90 Residential Mortgage Backed Securities, which it stood behind as the portfolio selection agent and the largest investor in the transaction.

The offering documents for the transaction included every underlying mortgage security. The offering documents for each of these RMBS in turn disclosed the various categories of information required by the SEC, including detailed information concerning the mortgages held by the trust that issued the RMBS.

Any investor losses result from the overall negative performance of the entire sector, not because of which particular securities ended in the reference portfolio or how they were selected.

The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs’s substantial long position in the transaction lost money for the firm.

No, it was created as a way for Paulson & Co. (and maybe you), to short your customers… you know, the same customers that you apparently forgot to mention that little fact to…

The Goldman Sachs Group, Inc. is a leading global investment banking, securities and investment management firm that provides a wide range of financial services to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals. Founded in 1869, the firm is headquartered in New York and maintains offices in London, Frankfurt, Tokyo, Hong Kong and other major financial centers around the world.

And you’re welcome for that. Sincerely, the U.S. taxpayers.

Media Contact:
Lucas van Praag
Tel: 212-902-5400
Investor Contact:
Dane Holmes
Tel: 212-902-0300

Thanks Lucas, hope we can chat again soon. Maybe next time about exactly how a then-28-year-old Goldman Sachs junior executive did this with no apparent supervision?

Dylan

Follow Dylan Ratigan on Twitter: www.twitter.com/DylanRatigan