Just when the bulls were starting to show some conviction the SEC files subprime fraud charges against Goldman and crushes the financial sector.
The SEC filed civil fraud charges against Goldman Sachs claiming Goldman sold mortgage investments without telling the buyers that another participant was betting on those same mortgages to decline. The announcement of the suit crushed the market and caused Goldman shares to fall -13%. After a day of charges and counter charges and reams of disclosures it appears this was crafted as a political ploy by the administration to get the financial regulation bill passed in coming weeks. I have proof.
First, the SEC case focuses on how Goldman sold the securities. According to the SEC, Goldman told investors that a third party, ACA Management LLC, had selected the pools of subprime mortgages it used to create the securities. The securities are known as "synthetic collateralized debt obligations." The SEC alleges that Goldman misled investors by failing to disclose that Paulson & Co, a major hedge fund not related to Hank Paulson, also played a role in selecting the mortgage pools and stood to profit from their decline in value. (The SEC account differs dramatically from the Goldman press release.)
The SEC claims "Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."
Two European banks that purchased the $1 billion CDO lost nearly all their investment. ABN Amro, a major Dutch bank, paid Goldman $909 million and IKB Deutsche Industriebank AG, a German commercial bank lost nearly all of the $150 million it invested. IKB lost a fortune through numerous CDO investments and was eventually sold to Dallas based Lone Star Funds.
In various documents ABN Amro and ACA Capital Management are referenced for the same role. According to the SEC complaint ABN Amro acted as an intermediary between ACA Capital and Goldman. ABN Amro was acquired by RBS in 2007 and RBS unwound the ABN/ACA position. ABN had purchased protection on its exposure to the deal from ACA Management affiliate ACA Financial Guaranty Corp in May 2007. Since ACA had done over 20 deals of this size they resold the packages they structured to other investors and at the same time selling them insurance on the packages through another entity. If anybody is complicit in this transaction it appears it was ACA and their many entities. At the end of 2007 ACA Capital defaulted on $69 billion of credit default swaps written on CDO and RMBS and is currently in receivership.
Goldman immediately fired back with a long list of reasons why it was not at fault. I am going to reprint the entire Goldman response.
"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:
1) 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.
2) 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.
3) 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.
4) 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."
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."
The SEC contends that Paulson & Co picked the mortgages to be included in the CDO. Goldman says that ACA picked the mortgages. According to the SEC complaint there was a long series of meetings and emails between Paulson and ACA over potential RMBS candidates. For instance in one series of emails Paulson suggested 123 RMBS candidates. ACA reviewed the list and determined it had previously purchased 62 in prior CDOs. ACA selected 55 that were acceptable and submitted a list of 21 replacement RMBS to Paulson for their review. After several meetings and various emails concerning new candidates ACA picked 90 RMBS for inclusion into the CDO from the candidates submitted by both parties. The key point here is that ACA submitted their own candidates at various points in the process. It should also be noted that they already owned 62 of the initial candidates on Paulson's list. That means they accepted the qualifications of those candidates on other CDOs that did not include Paulson's review.
It is NOT material that Paulson selected mortgage instruments for the list that they thought would decline in value. ACA could have chosen or declined on any of the mortgages on the list. They, in their role as an experienced asset manager, could have picked all, any or none or even walked away from the deal. Instead they picked 90 mortgage securities (tranches from other mortgage securities) and constructed the CDO they wanted for their investment. The point here is that ACA was in complete charge of their destiny and they even insured their own selections with another ACA company.
Goldman is not without liability in this case. At one point in the process the point person for Goldman, Fabrice Tourre, was asked by ACA what investment position Paulson would own in the final CDO and Tourre tried to duck the issue but eventually said Paulson was expected to be an equity investor in the bottom 10% of the CDO, the equity portion of the CDO. This is the part of the deal that could come back and bite Goldman. It is definitely going to bite Tourre since he is the one that misled ACA. However, Goldman is going to plead that it made no difference at the time since ACA had already committed to the deal and had selected the RMBS components.
Link to SEC Complaint
Here is the proof this is politically motivated. None of the participants in the transaction are complaining. Everybody lost money except for Paulson & Co so anyone could be a complainant. If there was a failure to disclose anything then ABN Amro and IKB should be at the front of the line but they are not complaining.
Secondly, in 99.9% of SEC actions the various parties are given a chance to settle by paying a fine and disgorging profits before the case goes public. ONLY when an entity decides against accepting the settlement does the case get filed and made public. Goldman was not offered a settlement but I doubt they would have taken it. Goldman specifically mentions "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."
The SEC does not come up with their data on their own. When on a witch-hunt they subpoena every possible document related to any and every transaction in hopes of finding an I that was not dotted or a T not crossed. They have an army of clerks and lawyers that would have expended tens of thousands of hours wading through the semi truck sized loads of documents. If at the end of the task they have nothing to show for their effort they write up "potential complaints" citing every gray area they found. They then tell the company they are going to "explore" these remaining areas and file charges unless the company would rather pay a fine while admitting no wrong doing. It is criminal blackmail and anyone else would go to jail if they tried it.
The worst part is that should the company agree to pay their blood money and make them go away they have to agree not to EVER discuss the complaint, NEVER deny it in any way and NEVER to disparage the SEC in any way. They have to pay the money and forever be quiet. Once everything is signed and paid the SEC then holds a big press conference saying that the company was being investigated for "insert various potential crimes here" but while neither admitting or denying any wrongdoing (wink, wink) they have agreed to pay a fine of a gazillion dollars. How many times have you heard this comment in the news?
Basically the SEC gets to smear them in the press, imply their guilt because they paid a fine and that justifies the thousands of man-hours they spent investigating them. The company cannot respond in any way.
The SEC knows if they look hard enough at anyone they can find some mistakes. It is like the IRS auditing your taxes. I don't care who you had prepare your taxes an intensive audit of your returns for the last seven years WILL find errors. They are not malicious and 99% of the time those things are like a failure to include that 1099 for $11.48 cents from a bank account you don't use but never closed. Maybe a receipt for a car rental was entered twice by mistake or something similar. The point is if the IRS looks hard enough they will find errors. The SEC always looks hard enough until they find an error to justify their effort and force the company to pay for their expenses.
I had a securities lawyer tell me once that when a company gets an inquiry from the SEC they should immediately plead guilty to the smallest event they can think of and ask the SEC if they can pay the fine now. The longer the SEC investigates the larger the fine regardless of what they find.
The announcement on Friday of the civil suit on Goldman was absolutely politically motivated. With the vote on the financial regulatory bill due over the next couple weeks the administration needed some dirt on a big bank to sway the votes by lawmakers. Need proof? Literally within minutes of the SEC announcement there were several lawmakers making informed statements to the press on why this shows the need for including derivatives regulation in the reform bill. Why would representatives and senators have detailed knowledge of a SEC case before it was filed? There are confidentiality provisions within the SEC. They can't be spreading the details of a case before it is filed. Otherwise the SEC could ruin anyone by leaking information even when there was no due process. Within minutes President Obama told reporters that he would veto any reform package that does not regulate derivatives.
The conspiracy theorist in me completely believes that the SEC was asked what dirt they had on the big banks and Goldman was biggest. I heard two people claim that Goldman thought this investigation had been put to bed a couple months ago. The SEC inquiry was instituted in July 2009 so it was almost a year ago. Instead it was kept under wraps until the perfect opportunity for a blockbuster release just ahead of the reform bill vote. Also, announcing on a Friday morning allows all the news people run with the ball all weekend before the first round of counter claims can be released on Monday. You can imagine what the weekend newspaper headlines are going to say.
Obviously if Goldman is found not guilty or the case is thrown out of court the reform bill will already be history and there will be no SEC apology for smearing Goldman in the press. The damage will be done as part of the administration's attack on the evil big banks. The fact they went for a civil charge instead of a criminal charge also says they don't have enough evidence to get a conviction.
Another reason for releasing the Goldman announcement on Friday was a competing announcement by the SEC Inspector General that the SEC knew about the Allen Stanford ponzi scheme as far back as 1997. This scathing report by the SEC's own Inspector General was almost completely ignored after the Goldman news broke. In fact the IG found that the SEC enforcement official who repeatedly helped quash investigations of Stanford later represented him against the SEC on three separate occasions.
The IG also found that complex cases that could not be concluded quickly were routinely ignored in favor of high profile cases that could be quickly settled. Senior SEC officials felt they were being judged by the number of cases they could complete rather than the importance of the cases. It was not until the SEC was severely criticized for a failure to act on information regarding Bernie Madoff that Stanford's case was elevated to an enforcement status.
Is it any surprise that the Goldman announcement was made on the same day as the IG announcement severely criticizing the SEC on Stanford's $7 billion ponzi scheme? I am sure it was just a coincidence. (wink)
Ironically Goldman Sachs was the largest corporate contributor to President Obama's election campaign. Goldman contributed $994,794 to Obama's campaign. That was more than Microsoft, Google, Citigroup, JP Morgan, Time Warner, UBS, IBM and Morgan Stanley all of which contributed more than $500K each. It still did not keep Goldman from becoming road kill in the financial reform process. Only the University of California contributed more at $1,591,395.
Don't get me wrong. I believe the $600 trillion derivatives market should be regulated. I just object to the obviously politically motivated method being used to advance that regulation.
The attack on Goldman knocked $23.57 (-12.8%) off their stock price and pushed it back to close at $160. They lost $12 billion in market capitalization and several analysts believe their maximum exposure to this suit would be in the $750 million range. They are paying the price for being recognized as the strongest financial institution. I will be going long Goldman in the Option Writer newsletter this weekend. I don't have any special bias towards Goldman but I think they climbed to the top of the financial heap because they are smart and well managed. I seriously doubt they committed financial suicide in this transaction for a trivial $15 million fee.
Goldman Sachs Chart
The Goldman news killed market sentiment but consumer sentiment was already tanking. The Consumer Sentiment number for April was released on Friday at 69.5 and a sharp drop from the prior reading of 73.6. The decline under 70 is the lowest level since November and obviously suggests the consumer is not convinced the economy is getting better.
The biggest decline came in the expectations component, which fell to 62.3 from 67.9. The present conditions component fell from 82.4 to 80.7. These declines came after the rise in jobs that should have lifted sentiment. Several analysts including myself believe the lowered sentiment came because of the passage of the healthcare bill. The news is full of stories about all the new taxes everyone will have to pay, the jobs that are going to be cut and the thousands of people who are going to be losing their existing healthcare because of the higher prices to employers. I believe this is weighing on sentiment.
Gasoline prices are also nearing $3 per gallon and home prices are starting to tick lower as we near the end of the tax credit period. The Fed Beige Book this week showed that wage pressures were nonexistent and the lack of wage growth is always a depressing factor. It is obviously more long term than those other factors but since this survey took place just before tax return day there was sure to be money problems.
Consumer Sentiment Chart
The economic calendar for next week is very short and devoid of any major reports. The PPI and home sales are the only reports of interest and that interest will be minor. The big events next week will still be the earnings reports with the heaviest week in the quarterly cycle. Looming on the economic calendar is the 800-pound gorilla with the FOMC meeting the following week. That is a major stumbling block for the market over the coming weeks.
I could have tripled the size of my earnings calendar this week given the number of companies reporting. The key reports are in green with IBM, Apple, AMZN, EBAY and MSFT the ones that most readers will be following. The Goldman earnings on Tuesday should prove to be exciting since they will probably have a lot to say about the SEC case and they are expected to produce blowout earnings.
IBM and Microsoft are probably the most important for the health of the tech sector. Apple will be closely watched but I think the other two are more important. After Intel's strong earnings we should expect the same thing from Microsoft. Microsoft has a much lower cost of product and yet they populate over 90% of the retail PCs sold. Strong guidance from Microsoft could go a long way towards limiting the amount of correction we get over the summer.
IBM is more of a services company today and they should be a read on the health of global businesses. I suspect their services order backlog has grown by several billion and they will say positive things about the global rebound. How positive is the key.
American Express will be important as will Capital One on Thursday for a continued look at the health of the U.S. consumer. HAL on Monday and SLB on Friday will tell us if the oilfield services business is picking up with the higher price of oil or is it still lagging.
Overall 123 S&P companies will report next week.
What we don't need next week is another earnings report like we got from Google on Thursday. The Google report was lacking in form and substance and the stock was punished appropriately. Google's results fell short of expectations but that was not the worst part. Google announced that CEO Eric Schmidt would no longer participate in the conference calls. Schmidt has been a cheerleader for Google and of course the rumor mill flew into high gear after the news broke about his disappearance. As Stifel Nicolaus said, "Schmidt's disappearance is troubling." BGC Financial said "Schmidt's absence is significant, it adds another layer of speculation and puts another log on the fire for the bear case."
It is clear from the metrics that the current revenue model for advertising is slowing and analysts are becoming concerned that Google can't continue to post good numbers. Everyone has been waiting for Google to come up with a new revenue stream but none have materialized. However, new costs continue to appear as Google tries to be all things to all people. Generating electricity, converting entire towns to WiFi, and sponsoring a race to the moon. These cost money but there are no revenue streams to support them.
Analysts were racing each other to cut price targets and investors were racing each other to sell the stock. GOOG closed down -$45 at $550 on Friday.
There was little to talk about in the markets on Friday expect for the SEC "made for TV" press conference. Stocks other than Goldman and Deutsche Bank were trading lower as a result of the market drop not specifically because of negative stock news.
Deutsche Bank (DB) lost almost 10% because they were also a big player in the CDO market. Other financials that had CDO dealings were down roughly 5%. The graphic below shows the top five players in the CDO market and their percentages for 2006 and 2007. Obviously Bank America could come under increased scrutiny since Merrill is now part of BAC.
U.S. CDO Market Share
The obvious ramifications of a high profile case against a CDO vendor suggests a successful prosecution could lead to similar charges against other banks. This is likely to keep the pressure on the banking sector for some time even though only the top ten or so banks ever sold a CDO. Guilty by association. If Goldman is able to blunt the SEC case by presenting additional facts with their earnings on Tuesday then the pressure could ease.
With Goldman and Deutsche Bank under such severe pressure we saw a major drop in commodities. Goldman and DB are major commodity players and traders were quick to make the association that the banks could decide to lighten the ship during the storm. Crude prices fell -$2.27 to $83.24 but had the added pressure of futures expiration next Tuesday. Gold dropped $23 to close at $1,135.
With Google leading the Nasdaq lower, the major banks pushing the other indexes lower and energy and commodity stocks crashing, it was an ugly day. Add in the fact that this all happened on an option expiration Friday and it should be no shock that volume soared to a whopping 13.7 billion shares. That was the highest volume day in 2010 and I would bet it is in the top two for 2009. Needless to say it was almost a 90% down day with over 12 billion shares of down volume. In theory a day that lopsided is generally a reversal day if it comes at the end of a big decline. Coming the day after the markets set new highs would also be a reversal day EXCEPT that it was event related.
I don't think we can apply any generalities to the event other than it was overdone. Both Goldman and Google sold off way more than the situation warranted. This suggests if the smoke clears by Monday we could see a rebound. Remember we still have major earnings ahead from companies like IBM, APPL, MSFT and AMZN. Traders will still want to trade these events. The news on Friday was against two stocks and the combined drop triggered every trailing stop in existence as we can see by the volume.
The Dow crashed all the way back to - - - 11,000. Despite the "crash" it still posted a gain for the week and closed over 11,000. I know it seems bad on the surface but it was NOT that bad. Only six Dow components lost over a buck and three of them were banks.
The trend is still intact. It was bruised from the face plant back to 11,000 but it is still intact. We could easily drop another 100 points to 10900 and it would still be intact. This suggests that even with a little remaining volatility on Monday from option expiration and from those away from the market on Friday there is still room for another gain next week.
While I personally believe that the markets will experience weakness before next weekend I think we will see a dead cat bounce early in the week.
This paragraph is where I eat my words. Pardon me while I chew and swallow. I thought S&P 1200 would be more of a challenge for the market. Instead the post Intel earnings spike blew past 1200 like a cab driver through a yellow light. Tuesday closed at 1210. However, on Thursday we saw some post traumatic shock settle in and the S&P only gained one point to 1211 despite continued good earnings news. I believe it was poised to fall on Friday regardless of what the news would have been.
The decline took it back to 1186 before the rebound began but it was not able to stray far from prior support at 1190 before the close. At this point I would be very surprised to see another high over 1211. I think the damage is done and even though we may see a dead cat bounce next week most traders got a bloody nose and they are going to be a little gun shy about buying the top again.
I could summarize the Nasdaq performance in one word for Friday: GOOGLE. When a major Nasdaq component drops $45 in one session the Nasdaq is going to have a very bad day. Other major decliners were ISRG -27, BIDU -16, PCLN -10 and CME -9. ISRG beat the street on earnings but they typically exhibit extreme volatility around earnings. The stock had rallied from $350 to $393 through Thursday so a little decline on Friday was to be expected. Those other three big declines were probably from knee jerk reactions to the market rather than any specific news.
I would not get too excited about the Nasdaq decline but I would worry about Google giving it a negative bias for next week. With a lot of big name tech stocks reporting there will probably be enough spin to keep it positive through Wednesday but then I would start to worry. Initial support would be 2460 followed by 2400.
The Russell only dropped -1.3% on Friday and closed at 715. The small cap index was relatively untouched by the big cap news but once the market sentiment changes after earnings I would be cautious about small cap longs. Critical support to watch is 700.
In summary, I believe there will be a snap back rally early in the week. We could see further volatility on Monday as a result of the extreme dislocations on an expiration Friday. Once that passes and the market shifts back into earnings mode we should see some gains.
However, we should be at further risk for news. There is probably going to be a war of words in the news as the various factions square off over the Goldman event and each tries to justify their position in 15-second sound bites. The SEC, lawmakers and the President have a far larger podium from which to launch lightning bolts from on high than the embattled Goldman officials. Beware the lightning strikes.
Hopefully by Tuesday the verbal sparring will be over and the process will be left for the courts. Earnings from IBM on Monday afternoon should help the market forget the battle. AMZN, AXP and MSFT on Thursday should mark the end of the Q1 earnings cycle. Many companies are left to report but they should all say the same things. We will know by Friday morning how the earnings story ends.
Friday is when the worry over the FOMC meeting begins. The two-day meeting starting on Tuesday is going to cause all sorts of angst over the potential rewording of the extended period sentence in the statement. Regardless of how many times Bernanke says quit worrying about the statement most traders will worry. Worry over a potential statement change could hold the markets back. Quite a few analysts including myself are projecting a trend change around the FOMC meeting. We may not go down but we may quit going relentlessly up. Sentiment has been damaged and without some new event to recharge it we could be in for a period of consolidation.