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Tuesday, April 20, 2010

Phil Flynn: Goldman Gets Rolled

Oil prices are beginning to shake off the fall-out from the Goldman Sachs fraud allegations yet at the same time, the market is worried about the longer term ramifications of these charges. Set aside the fact of Goldman’s guilt or innocence at this point, it's the larger issue of confidence in the overall market place that raises the largest concern. The timing of these charges that we now know was voted at the SEC along party lines makes one worry about the political influence over the market place. If The SEC is being controlled by the government to push financial reform it could be more dangerous to the economy than Goldman’s alleged fraud.

The Wall Street Journal Editorial page that I wanted to quote yesterday until my computer crashed stated, “The Securities and Exchange Commission's complaint against Goldman Sachs is playing in the media as the Rosetta Stone that finally exposes the Wall Street perfidy and double dealing behind the financial crisis." Our reaction is different: Is that all there is? After 18 months of investigation, the best the government can come up with is an allegation that Goldman misled some of the world's most sophisticated investors about a single 2007 "synthetic" collateralized debt obligation (CDO)? Far from being the smoking gun of the financial crisis, this case looks more like a water pistol. The Journal said, “Let's deconstruct the supposed fraud, in which Goldman worked with hedge fund investor John Paulson, who wanted to bet on a decline in the subprime mortgage market. The SEC alleges that Goldman let Paulson & Co. dictate the mortgage backed securities on which investors would speculate via the CDO, and then withheld from investors Paulson's role on the other side of the transaction.

The SEC also alleges that Goldman deceived ACA Management a unit of the largest investor on the other side of the deal and the firm officially selecting which mortgage backed securities everybody would bet on into believing that Mr. Paulson was actually investing in an "equity" tranche on ACA's side of the deal. Regarding the second point, the offering documents for the 2007 CDO made no claim that we can find that Mr. Paulson's firm was betting alongside ACA. The documents go so far as to state that an equity tranche was not offered by Goldman, as ACA must have known since it helped put the deal together and presumably read the documents. The SEC complaint itself states that ACA had the final word on which assets would be referenced in the CDO. And in some cases, ACA kicked out of the pool various assets suggested by the Paulson firm.

More fundamentally, the investment at issue did not hold mortgages, or even mortgage backed securities. This is why it is called a "synthetic" CDO, which means it is a financial instrument that lets investors bet on the future value of certain mortgage backed securities without actually owning them. Yet much of the SEC complaint is written as if the offering included actual pools of mortgages, rather than a collection of bets against them. Why would the SEC not offer a clearer description? Perhaps the SEC's enforcement division doesn't understand the difference between a cash CDO—which contains slices of mortgage backed securities and a synthetic CDO containing bets against these securities.

More likely, the SEC knows the distinction but muddied up the complaint language to confuse journalists and the public about what investors clearly would have known: That by definition such a CDO transaction is a bet for and against securities backed by subprime mortgages. The existence of a short bet wasn't Goldman's dark secret. It was the very premise of the transaction.” The Journal also points out that, “By the way, Goldman was also one of the losers here. Although the firm received a $15 million fee for putting the deal together, Goldman says it ended up losing $90 million on the transaction itself, because it ultimately decided to bet alongside ACA and IKB. In other words, the SEC is suing Goldman for deceiving long-side investors in a transaction in which Goldman also took the long side. So Goldman conspired to defraud . . . itself?

The Journal asks, "Did Goldman have an obligation to tell everyone that Mr. Paulson was the one shorting subprime?" Goldman insists it is, "normal business practice" for a market maker like it not to disclose the parties to a transaction, and one question is why it would have made any difference. Mr. Paulson has since become famous for this mortgage gamble, from which he made $1 billion. But at the time of the trade he was just another hedge fund trader, and no long side investor would have felt this was like betting against Warren Buffett.

“Not that there are any innocent widows and orphans in this story. Goldman is being portrayed as Mr. Potter in "It's a Wonderful Life," exploiting the good people of Bedford Falls. But a more appropriate movie analogy is, "Alien vs. Predator," with Goldman serving as the referee. Mr. Paulson bet against German bank IKB and America's ACA, neither of which fell off a turnip truck at the corner of Wall and Broad Streets."

Some would argue that the global economy suffered when the housing bubble burst yet at the same time are these financial instruments to blame or is the government, the great enablers, and their policies that allowed the housing bubble to develop? The IBD points out that the financial reform bill fails to address some of the root causes of the financial crisis like, “The 1977 Community Reinvestment Act (CRA) was used as a bludgeon to force private banks to lend to unworthy bowers. Politicized (Government Sponsored Entities) Fannie Mae and Freddie Mac that became the chief funding mechanism for this corrupt housing policy and its bad loans."

For crude oil the Goldman news was bearish but as the markets asses the facts of the case it is unlikely that this case will lead to many others. The White House is already trying to distance themselves from the Goldman charges because any implication that the White House had a say in the timing of these allegations may indeed be fraudulent in itself and an abuse of power. The White House cannot be seen as having a major regulatory authority being used to further its own political agenda. This is not Venezuela for heaven’s sakes. It isn’t, is it?

The volcano pressured oil with an estimated demand destruction of roughly 2 million barrels of oil a day, some due to canceled flights and also decreased economic activity. The bulls' confidence has been shaken and oil needs to continue its rebound. The removal of economic optimism could mean the focus on over supply and sluggish demand may weigh. We still feel the best way to play the market right now is to take advantage of these very wide trading ranges.

You can reach Phil at and watch him every day on the Fox Business Network!

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