Saturday, April 17, 2010

The Government's Civil Suit Against Goldman Sachs

The weekend edition of the Wall Street Journal contained several articles pertaining to the SEC's recently-announced fraud suit against Goldman Sachs in the matter of mortgage-backed securities allegedly designed to the specifications of hedge fund manager John Paulson, so the latter could bet on the securities' expected declines in value.

According to the articles in the Journal, Paulson, seeking ways to short the housing bubble, approached Goldman in late 2006 with a list of mortgage portfolios to securitize, against which he could bet using CDOs. Goldman recruited ACA Management to construct Abacus, the security Paulson desired, without informing the company that the security's designer, Paulson, expected it to lose value. Goldman then sold the securities to customers, apparently in 2007, allowing Paulson to buy credit-default swaps from Goldman on the Abacus securities.

If this is all true, there appear to be two aspects to the dealings which cause consternation.

The first is Goldman's accepting an underwriting assignment from Paulson to design and sell securities intended to lose their value. The second is Goldman's implementing this plan without informing the firm they tasked to construct the security, or the customers to whom it sold the instruments.

The Journal article contends that at least one other investment bank, Bear Stearns, declined to do Paulson's bidding in this matter.

Most observers would probably characterize Goldman as being cynical and perhaps unethical in its dealings in the Abacus/Paulson matter. But fraud? I don't think so.

In a prior post concerning regulation, I wrote that one is naive to think any sort of regulatory "reform" will ever curb ruthless practices among trading and underwriting businesses in the pursuit of profits. Mind you, I don't mean illegal. Simply sharp, brazen activities which may leave counterparties with heavy losses, or bankrupt.

That's the way it is in capital markets. It's just business.

It's tempting to believe Goldman is somehow guilty of something for having sold securities which John Paulson believed would plummet in value. However, I can't recall any underwriters of securities ever guaranteeing that the value of the securities in question would rise.

The sophisticated institutional investors whom Goldman approached should all have done their own due diligence on the Abacus securities, as well as assured themselves that buying mortgage-backed securities in 2007 was astute.

Evidently, they didn't do this.

Is this Goldman's fault? No.

Granted, there are those institutions which will buy from Goldman because of the firm's reputation. I think it's a mistake, but, there you are. Some institutions do foolish things.

Was Goldman doing anything wrong in retaining ACA Management to create a security, Abacus, according to Paulson's criteria, while not telling ACA of this connection, and that Paulson expected Abacus to fall in value?

Technically, it would seem not. Unless Goldman's staff, when selling Abacus, gave assurances of the quality and prospects for the securities, it's unclear that Goldman defrauded anyone. I would be surprised if documents exist at Goldman Sachs indicating that senior executives knew of and shared Paulson's beliefs that the value of Abacus securities was highly probable to fall precipitously.

More astutely, it would seem that Goldman, having a ringside seat at the capital markets, used its knowledge of Paulson's plans and beliefs to do its own shorting of mortgage assets in its own proprietary trading.

Again, sharp practices, but, frankly, part of the benefits of deal flow accruing to a highly-ranked investment bank.

In capital markets, securities change hand due to differing outlooks and expectations. For every buyer, there must be a seller.

Could one not theoretically hold any investment bank liable for selling securities which, subsequently, declined in value?

Should every investment bank client verify that the seller of a security is retaining some for itself before buying any of the instrument? Probably so.

But investment banks, narrowly defined, aren't in the business of holding assets. Merely underwriting.

This brings up another point about Goldman, in particular. As I opined to someone last week, the Goldman Sachs of Lloyd Blankfein is an entirely different firm than that of John Whitehead.

Whitehead was scrupulous about keeping Goldman from competing against its underwriting and trading clients through excessive proprietary trading. That is no longer true.

To the contrary, Goldman runs a large asset management unit, as well as proprietary trading operations.

Frankly, it is naive for any institution to deal with Goldman on faith, alone, in any business dealing. Because of the various, substantial conflicts of interest among Goldman's businesses, between the firm and some of its clients, who are often counterparties of proprietary trades by the firm, any firm purchasing securities from Goldman, whether as trades or through underwriting, should be independently certain of the value and prospects for the instruments.

On a related note, some years ago, a wealthy young friend, recently retired from Intel, sought high-end wealth management services. Without going into too much detail, I assisted her in contacting the appropriate Goldman Sachs Asset Management personnel. Their subsequent treatment of my friend, and cavalier, arrogant manner, surprised me at the time. Since then, it's become routine for Goldman. Anyone who expects Goldman to be looking out for them as a customer is a fool.

If Goldman had, internally, cooked up the Paulson idea, underwritten the securities themselves, and sold them to clients, then it may well have been guilty of fraud.

But Goldman, perhaps very carefully, avoided that. They only sold securities constructed by ACA.

I would guess that, ultimately, Goldman will depend upon the classification of Abacus buyers as "sophisticated investors." It will note that it never assured them of the securities' quality. Only the terms, composition and price of the instruments.

As to informing Abacus of Paulson's beliefs, what of it? Perhaps Goldman did not share Paulson's views of the underlying mortgages. Even if they did, what of it?

Like the broader market for mortgage-backed securities, which, we have regrettably learned, was full of naive, gullible institutions which trusted sellers too much, and failed to do their own research, Abacus' buyers appear to have had similar failings.

Goldman will doubtless have a public relations nightmare from this. And the affair may affect pending legislation in Washington to change regulation of the financial sector.

I do think this will severely damage Goldman. Remember, Bankers Trust never fully recovered from their dervatives trading scandal in the 1990s. They eventually had to be bought by Deutsche Bank to avoid collapsing.

Customers have a way of leaving vendors who are shown to be callously inconsiderate of their needs, taking advantage of them at every opportunity. Selling securities which Goldman suspected were designed to lose value will, I think, bring lasting damage to their firm- finally..

But in a market which expects sophisticated investors to be responsible for their own valuations and transactions, capable of doing their own research, it's hard to see how Goldman can be guilty of fraud in the Abacus case.

Unethical and expeditious, short-term minded business? Yes. Fraud? Hardly.

Friday, April 16, 2010

Teflon Cramer On CNBC This Afternoon

I just witnessed a great example of how coddled and protected CNBC's rock star ex-hedge fund manager Jim Cramer has become.

While conducting a multiple-person discussion of today's government suit against Goldman Sachs regarding some of its CDO dealings during the financial crisis, co-anchor Erin Burnett attempted to moderate an exchange between Cramer and a guest analyst.

(Author's Note: The guest's name was Sylvain Raynes.)

Almost from the beginning, Cramer began posturing and making statements with an air of complete certainty. The analyst called Cramer into question, and Cramer immediately attacked the guy.

Here's the video of it.


As the exchange became heated, Raynes referred to Cramer- and others- as having some being 'PR for'Goldman, to which Cramer reacted explosively.

As the analyst tried to respond to an assertion of Cramer's, Cramer kept interrupting and talking over him, claiming that Raynes implied Cramer was paid by Goldman. But that's not what Raynes said.

And it would make quite a bit of sense for Cramer to function as an unpaid Goldman PR guy, because that way, he maintains his sources. One might conclude the same for David Faber.

One thing that's been true of CNBC in recent years is that the anchors, reporters and 'contributors' rarely, if ever, accuse any large, important entity or person of doing anything bad or criminal. After all, their business is financial entertainment. They want to attract sources, like, this morning, BofA's Brian Moynihan.

You can't get those people to talk to you if they believe you might speak truthfully, but negatively, about them, too.

Finally getting a few sentences out free of Cramer's bluster, Raynes noted the forum, how in-depth explanations were not really possible, and then coyly said he'd 'keep it shallow out of deference to Mr. Cramer,' or words to that effect.

Burnett suddenly decided personal attacks were now out of order, admonishing the analyst for daring to insult Cramer on the air.

Within the minute, Burnett went to a break, reprimanding the analyst and forthrightly telling viewers that all the participants, except for Raynes, would be back. Then, after they'd cut the analyst's feed, she chided him for his on-air comments to Cramer.

Funny how, when Cramer was lambasting the guy, Burnett was silent. As soon as Cramer was on the receiving end, they banished the offending guest.

Yet, CNBC staffers must have found and vetted the guy beforehand. These so-called guests aren't accidental. The program staffs have to recruit people to come on-air on short notice with relevant expertise. It's not like Raynes snuck onto the program unnoticed or unknown.

I guess it goes to show how heavy-handed CNBC's on-air staff will behave in order to protect their own. Free exchanges of comments aren't really free. If a CNBC sacred cow is in danger, the plug is pulled before any interloper could do damage to a franchise player like Cramer.

Flashes In The Pan: Inconsistent Total Returns

Lest you be overly-impressed by the recent year's returns of some equities, take a longer term perspective.
For example, here is a price chart of the remaining four large 'real' US commercial banks (excludes Goldman and Morgan Stanley), and the S&P500 Index, for the past 12 months.
Looks impressive, doesn't it? BankAmerica up nearly 100%, Wells up over 50%, and Chase even with the index. Even Citi is positive.
Trouble is, my proprietary equity performance research found that one- or two-year outperformances of the S&P are actually pretty common.
Given that the index hit bottom last March, then rocketed upward over the next 8 months, the past 12 months are going to look good for a number of firms.
Looking back five years, those same four banks, and the S&P, look quite different, don't they?
The index has been flat. Only one bank, Chase, has been positive. The other three banks were not, two having appalling losses in shareholder wealth.
Chase, of course, looks better simply because, as usual, it was late to the CDO and mortgage party, and, though anemic in absolute terms, managed to avoid the crippling losses of its more agile competitors.
I chose a handful of large commercial banks, but you can probably construct similar charts in other sectors right now.
Being fooled by 1-year performances can lead to unpleasant surprises for the longer term. Much of the current hoopla over the recent gains in the equities of many firms amounts to little more than backward-looking timing plays. Buying into a firm's equity now, on the strength of just the last year, is the epitome of rather naive momentum investing.
Whether all of these firms can actually maintain fundamental performances and total return outperformance for the next few years is an entirely different matter. Last year's March low in equities provides a handy comparison for so many equities this quarter.
Investor beware.

The Need For A Simple Glass-Steagal Replacement Now

My friend, colleague and periodic business partner B sent me an email the other day including this passage,

"Yesterday, Morgan Stanley was reported to be bulking up its trading staff (adding about 350 people). Its major competition in trading is seen as JP Morgan Chase and Goldman. Today, the Journal headlined, “Property Loss Pounds Morgan Stanley Bank Says Battered $8.8 Billion Real-Estate Fund Stands to Lose Nearly Two-Thirds of Its Value”. "

B's point is that Morgan Stanley could, quite easily and quickly, now that it's a commercial bank, become a major systemic liability and source of risk- again.

When I had lunch with B on Tuesday, he remarked approvingly on the Volcker Rule. Like me, he sees it as a necessary step to segregate federally-, that is, taxpayer-insured banking activities from any financial activities in the areas of underwriting, proprietary trading or investment in non-Treasury assets.

B noted that, having narrowly escaped destruction under John Mack's questionable leadership, Morgan Stanley is far from chastened. Instead, it's hiring literally hundreds of traders and re-entering the proprietary trading arena. Meanwhile, the Wall Street Journal hails Morgan Stanley's leftover troubles with the headline announcing the sizable losses in its real estate investment funds.

Do you, as a taxpayer, really want a gang that lost so much money in real estate investing to be jumping back into proprietary trading in such a major way?

Forget the complex, mistake-riddled omnibus financial regulation bill discredited Senator Chris Dodd is trying to ram through Congress.

What we need, right now, is a simple, clear reenactment of Glass Steagal, as currently articulated by the Volcker Rule.

If this doesn't happen, there's no reason to doubt a repeat of Morgan Stanley's catastrophic, nearly-lethal risky behavior of earlier this decade. After all, it's not their money they are betting- it's yours. You just don't get the upside if they win. Only the downside, when they eventually lose it all.

Thursday, April 15, 2010

Jamie Dimon As Heir To JP Morgan?

This morning's Wall Street Journal's Money & Investing section featured heavy doses of Chase bank CEO Jamie Dimon.

I didn't know whether to laugh or become sick to my stomach at the graphic, on an internal page of the section, depicting Dimon 'high fiving' the legendary American financier from the turn of the last century.

To compare Dimon, essentially a large-corporate bureaucratic hack, Sandy Weill's one-time bag man, to a truly titanic figure from America's past, is ludicrous.

Yes, thanks to the merger of many mediocre commercial banks, Dimon heads a firm which contains, as part of its name, that of Morgan's commercial bank element. Mind you, that part was added in an almost-trivial merger, so moribund had the once-proud JP Morgan (commercial) & Co. become.

The front page of the section presented Dimon as newly-anointed chief economist of the financial sector. Do tell.

I guess it slipped my mind that Dimon had been trained and practiced as a generally-acknowledged economic seer. His forecast is that maybe we've turned a corner on the recession. He sure hopes so.

Wow, is that impressive.

Actually, I had the occasion to talk recently with someone who has met Dimon and many of his colleagues. This person's overall take on Dimon is that he's intelligent and detail-focused. However, unlike the original J Pierpont Morgan, "vision" is not a quality she said she would attribute to Dimon. Her description of the Chase CEO was pretty much what you'd expect of a guy who cut his teeth in business carrying water for the rag merchant of the old Wall Street, Sandy Weill. Weill's greatest and, arguably, only real financial success was merging a succession of old wire houses, via back-office consolidations, into the precursor of the now-failed Shearson Lehman.

Vision wasn't exactly Sandy's strong suit, either. Once he got hold of IDS and Primerica, then went after Citigroup, things got out of hand.

What elements of that tale would have served as the font of Dimon's newly-found strategic and visioning skills? Nothing.

No, Jamie is generally credited with being an obsessive detail guy. Cost-cutting and operational in the extreme. Just like his old mentor and long-time boss.

The woman also didn't disagree with my, and my fellow, former-Chase colleagues, that the main reason Dimon is viewed so positively now is that the Chase he found when he became CEO was so late to mimic the excesses of Merrill Lynch, Morgan Stanley and Citigroup that Dimon didn't have time to get the bank into as much trouble. Typically late to any really good, profitable party, Chase was luckily absent from the scene when the mortgage sector meltdown struck. It wasn't wisdom, but ineptitude and lack of speed that saved Chase and Dimon two years ago.

The most interesting Chase- and Dimon-related piece, however, was the back page article. It noted the potential decrease in the high loan loss reserves of recent quarters at the bank. However, noting potential changes in capital requirements for derivatives, and Chase's rather high capital levels, the piece cautioned that producing prior peak levels of returns on capital will be a challenge for Chase going forward.

This dovetails with something I wrote some months ago regarding capital allocation in banking. Often, businesses don't wish to accept the internal allocation which completely spreads regulatory capital bank-wide. I've seen this myself during my days at Chase.

The situation becomes one of regulatory capital levels exceeding the needs of the business, depressing returns on that capital. This would be a natural and expected consequence of the hand-wringing over capital adequacy, and the continuing witch hunt for guilty bankers, in the wake of the 2007-08 financial sector meltdown.

Let's just say that today's Chase is hardly, by any measure, your grandfather's integrated JP Morgan & Co. And it's CEO is similarly not a modern-day J. Pierpont Morgan, either.

Larry Summers On Extended Job Benefits

Curiously, according to Tuesday's lead staff editorial in the Wall Street Journal, no less an economic authority than Larry Summers has the Concise Encyclopedia of Economics, that government assistance programs contribute to long-term unemployment.

Specifically, the quoted passage is,

"The second way government assistance programs contribute to long-term unemployment is by providing an incentive, and the means, not to work. Each unemployed person has a 'reservation wage'- the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase (the) reservation wage, causing an unemployed person to remain unemployed longer."

One wonders how Summers would therefore view the fourth Congressional extension of unemployment benefits, passed in the past week.

Meanwhile, the US economy has reached at least one record. Among unemployed workers, 44.1% have been so longer than 26 weeks.


So, Congress just extended benefits for another 20 weeks. Nearly half the unemployed have been so for half a year. They'll get nearly another half year of benefits.

And the stated unemployment rate is 9.7%.

Paying the unemployed extended benefits is, one is to believe, apparently intended to help lower the unemployment rate?

But Mr. Summers' contended that doing so only increases their 'reservation wage.'

Doesn't sound like that will help reduce unemployment from the supply side, does it?

Once again, forget market economics, market-clearing forces and the forces of supply and demand for anything, including labor.

Let's just borrow a few tens of billions more from the Chinese and let our unemployed rest a bit longer.

Wednesday, April 14, 2010

Elizabeth Warren's Misguided Mission

TARP oversight panel head and perennial scold Elizabeth Warren was granted more time than she's worth, again, on CNBC this morning.

Becky Quick fawned over Warren to a point that became sickening. I won't go into the Supreme Court nominee episode, but it nearly made me physically sick.

What Warren ranted about this time was how only 1 in 10 foreclosed mortgages have been rescued by the Treasury's various programs. She breathlessly intoned that too many families with foreclosure looming were not being saved by the government.

This, she solemnly warned, would lead to further housing price declines, and, thus, even more foreclosures. These must be avoided! Housing prices must be propped up articificially!

It's clear that Ms. Warren, a lawyer by profession, has absolutely no notion of how markets actually work.

That is, by allowing foreclosures to occur, inflated housing prices are brought down to, well, market-clearing levels.

Why we discriminate and confer special privileges on those who bought unaffordable housing, rather than, say, those with money who are waiting for those houses to fall in price to a level they can afford, went unexplained by Ms. Warren.

It's simply enough for you to believe that Warren feels that existing owners are special.

If you wonder why moral hazard has vanished from our financial lexicon, and nobody seems to seriously expect consequences from their bad financial decisions anymore, you don't need to look any further than Warren's views on mortgage foreclosures.

Yet another chilling example of naive, misguided government at work interfering with markets and scaring off or simply forbidding private investment to play it's normal, market-correcting role in the economy.

Palm's Demise

Yesterday's Wall Street Journal provided some recent news on the fortunes of once high-flying Palm, Inc.

Back in the day, over ten years ago, PalmPilots were a major step forward in electronic organizers. I had, and still have, an ancient, non-communicating Sharp Wizard, in which I store contact information and notionally keep a schedule.

PalmPilots added a local communicating capability which made them a coveted toy among young professionals. I think it's fair to say they were the first widely-used PDA.

How things have changed. The Journal article noted that the RIM Blackberry and Apple iPhone swamped the PalmPilot.

Though Palm eventually brought out its own integrated PDA/cell phones, they became also-rans, having great difficulty being accepted by the major cell networks, ATT and Verizon.

The nearby price chart of Palm and the S&P500 Index illustrates how the firm's fortunes stalled, then plunged, in recent years. It's now down about 50% in value from five years ago.

According to the Journal piece, common equity holders have little chance to realize any gains, since private equity group Elevation got very sweet terms for a $460MM investment in the company that gave it a 1/3 interest.

While the article cites one analyst as valuing Palm at $600-700MM based on research and marketing 'assets' from spending, the company's nearly $600MM of cash might be more indicative.

Palm seems to be a prime example of Schumpeterian dynamics. Once a category leader, it failed to anticipate or deliver on the next big thing in its space, the integration of PDA and cell phone. As a distant third in the race, it just isn't really worth much anymore.

When is the last time you even saw someone with a Palm Pilot?

I suppose some entity might eventually bid some fraction of the alleged value of the firm, as the cash is spent. But it's not even clear what the patents or brand are worth anymore.

It's a lesson in the way markets are supposed to work. Rather than expect some government intervention to save every job and company in sight, Palm illustrates how ailing or failing companies become low-priced fodder for some other entrepreneur, thus clearing the market of old assets and recycling them, if possible.

For an unfortunate example of intervention, read the next post.

Tuesday, April 13, 2010

Massachusetts' Command Healthcare Economy

Friday's Wall Street Journal editorial concerning Massachusetts' demands that health insurers sell policies at a loss ought to give investors a lot of pause about risk in this economy.

It may seem like ancient history now to recall the federal takeovers of Citigroup, AIG and GM. Or the bailouts of Morgan Stanley and Goldman Sachs, as the two investment banks ran for cover to register as commercial banks in order to take Fed injections of funds.

But it is a fact that the federal and state governments are intruding into the private sector to a greater extent than any time except for Nixon's wage and price controls and FDR's massive attempts at socialization of the economy.

Having been refused premium increases to cover losses, three non-profit health insurers in Massachusetts- Blue Cross Blue Shield, Tufts and Fallon Community Health- stopped selling new policies.

In retaliation, the state has demanded that these companies never the less sell loss-making policies in the state.

With actions like this, doesn't it make you just reflexively avoid the health care insurance sector for equity investment? This perfectly illustrates how meddling with private sector companies can so easily chill investor interest in a sector, or businesses in a particular state.

Confidence in capital markets and their operation free of excessive, arbitrary interference from government, is a fragile thing.

Monday, April 12, 2010

Volcker On The VAT

Taxes are surely an important element of business.

It's well-known that the famed Bush tax cuts of 2001 expire at the end of this year. We have already seen new tax increases passed into law as part of the recent health care bill. For example, for the first time ever, investment income is now subject to FICA taxes.

It's a conceptual step of significance, since it breaks the original link between wages and social security contributions and payments.

Now, the current administration is widely signaling a move that makes the FICA-taxing of investment income look like a baby step.

I'm referring, of course, to the VAT tax.

Personally, I have great respect for Paul Volcker's opinions on monetary policy and, to some extent, his basic ideas of financial sector regulation. However, I don't recall his being Treasury Secretary. Nor his particular expertise on fiscal matters, such as tax policy.

In fact, Volcker has been a lifelong Democrat. And he consorts with the most explicitly socialist American administration in history.

Thus, it's disappointing, but not surprising, that Volcker announced last week that new taxes will be necessary and, what the heck, a VAT isn't as "toxic" anymore as it used to be.


Volcker essentially admitted a VAT is toxic. But, according to Paul, if taxes are needed....because we can't possibly cut spending......well, maybe the time has finally come to succumb to the silent theft of the VAT.

Want to really put any US economic recovery on hold? Make a big push to raise prices on everything by 20%. Because tax incidence always moves to the consumer.

Too bad Volcker didn't stick to monetary affairs and declare himself unqualified on this matter.