Financial markets are facing extreme selling today after Goldman Sachs (GS) was charged with fraud by the SEC for marketing debt products which were essentially designed to fail. According to the accusation, John Paulson assisted Goldman in creating Collateralized Debt Obligations (CDO) which allowed investors to capture positive cash flow by essentially “insuring” mortgage securities. Paulson who took the other side of the trade ended up getting paid huge sums when the mortgage market eventually fell apart.
The SEC charge brings up an interesting philosophical debate. How much liability should Goldman (or for that matter Paulson) have for creating investment products that buyers were clamoring to own – even if it was clear that the end result would be major losses for clients of Goldman.
Keep in mind the years leading up to 2007. Real estate prices continued to climb and optimism reigned supreme. Middle class, lower class, and even upper class consumers were all but assured that the way to build permanent, sustainable wealth was to own real estate – a LOT of real estate. Since land has a fixed supply (how many times did we hear the wisecrack “they’re not making any MORE of it”?) investors expected the price of homes, land, condos and office properties to continue to rise ad-infinitum.
Leverage was strongly encouraged because when prices do nothing but rise, leverage works in the buyers favor. So Wall Street was all-too-happy to create opportunities for non-creditworthy buyers to get in the home of their dreams. It all made financial sense because if the buyer eventually defaulted, the value of the property would have risen to more than make up for the loss on the loan. And typically, owners would simply refinance, borrowing more on the value of the property – and use the money for paying the loan or other discretionary purchases
Owning a home could actually become a self-funding venture.
Caveat Emtor?
So during this manic time period, investor appetite for mortgages naturally increased. Think about it… When buying mortgage securities, you were essentially loaning money to purchase properties that continued to appreciate in value. The collateral was becoming more valuable, meaning that every day your loan became more secure.
In this environment, it’s hard to understand why Goldman wouldn’t offer mortgage products to investors who were begging for more supply. If you’ve read John Paulson’s book The Greatest Trade Ever (a great read I might add) you would see just how strong the demand was for these securities and how the momentum fed on itself.
I guess my main question is – was Goldman really wrong to sell ill-fated mortgage securities to willing and experienced professionals? I know there is more to the story than this, but the bottom line is that these CDOs weren’t being sold to individual investors who knew nothing about the market. They were being sold to pension funds, endowments, hedge funds – to institutions managed by professionals who should have researched what they were buying.
Part of the SEC’s accusation centers around the fact that Paulson & Co. helped to pick out the individual mortgages or baskets that went into the CDO securities. This is certainly something that should have been disclosed to buyers – if the seller has access to non-public information that the buyer cannot uncover, then the playing field is tilted.
But what worries me is the moral hazard that is emerging in the financial markets. More and more, it seems that we expect gains to be privatized (meaning if companies MAKE money, they get to keep it), but losses are socialized (the government steps in to make losers whole).
What ever happened to a fair market where willing buyers and willing sellers met to exchange goods (be they industrial, agricultural or financial goods)? If I make a trade and lose money, the responsibility is mine. My job is to cut my losses, learn a lesson from the mistake, and move on to bigger and better trades. The same should be true of all market participants, and if you or I buy products that we don’t understand, then we shouldn’t be involved in that market in the first place!
But I digress…
Where To From Here
My suspicion is that the market won’t completely fall apart at this juncture in the game. The bulls have been entirely too strong and we have been conditioned to “buy the dips” (even though there have been precious few dips to buy recently). Investors with any capital on the sidelines have largely been kicking themselves for not participating and promising to put their capital to work the next time we get a correction.
So this buying pressure brought on by classical conditioning will likely stabilize the market in the short-term. So I wouldn’t bet the farm on a major short position Monday morning at the open.
However… I DO think that over the next two months we will have a significant negative move in the market and give up a good portion of recent gains in speculative positions. Even though a lawsuit against Goldman has very little to do with most industrial, technical, medical or retail stocks, the political risk introduced into the market could have the effect of decreasing the multiple investors are willing to pay on stocks across the board.
Currently, the majority of short positions have been closed as traders have been punished for any bearish bets. Short sellers usually help to stabilize falling markets because they represent pent up buying pressure as they buy to cover their positions and collect their profits. With these participants largely out of the market, the decline could turn out to be much more severe.
Prices are currently at levels that imply a full, robust recovery, so any change in this expectation will cause “long and leveraged” managers to re-think their positions. So after an initial buying period, don’t be surprised to see the market head south in a hurry.
I’ll be using the next week to brush up on my short watch list and look for names that have the most risk, the highest multiples, and investors with the strongest confidence. While many of these names will be tough to short (due to the strong price momentum), watching the charts carefully for good entry points, and managing risk with stop orders could turn out to be a very profitable endeavor. I have felt like the first quarter didn’t offer too many opportunities for large profits, but the climate today makes me excited about the new opportunity for traders willing to play both the long and the short side of the market.
FD: Author does not have a position in GS
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April 19th, 2010 at 9:15 am
Excellent commentary, thanks. Your point about Goldman not being wrong for selling undesirable financial products is one that many retail investors still don’t understand. They exist to make money, not to make every investor in the world money.
I agree with the conclusion as well. I’m even convinced retail investors were net buyers on Friday, as they’ve been hearing a pullback would be healthy and ultimately bullish. Prices are in the clouds and nobody outside of Wall St is selling…. yet
April 19th, 2010 at 9:15 am
We all hate GS. But the reality is that the banks are no different than used cars salesman. Buyer beware. If you got suckered into a bad deal, tough luck. Own up to it. You didn’t read the fine print. Also, I agree that professional money managers didn’t do their homework. They got suckered by GS and lost money. It is no different than if you get a hot stock tip from your neighbor and then you buy it, the stock goes down and you lose…you can’t blame your neighbor. You have to do your own DD. And thats what happened with those subprime mortgages….everyone blindly followed. If a deal is too good to be true, it probably is.
I hate Goldman and all those frauds out there, but they won. They are evil and they know how to make money. Everyone else should have been more prudent and shouldn’t have acted hastily. Banks shouldn’t have extended those risky loans. The general public is very gullible and stupid….you can’t blame the bank that you lost your house because you bought a $500,000 home and it dropped to $250K and now your mortgage skyrocketed….you should have known the rate was going to jump…its written in your package that you didn’t read! tough luck people…and now the smart and rich people have to bail out all the suckers… so sad!
April 19th, 2010 at 9:16 am
The SEC has not charged GS for creating the CDO nor will It be able to charge GS for shorting it afterward, even if and when that is proven to be true. GS is being charged for misrepresenting that the ACA was an unbiased and independent entity that used an objective selection process to construct this Financial Instrument. That, my friends, is why the SEC’s charges were so specific and is also why I think they will win this. I agree that the market will not drop precipitously on Monday but I do believe it will close lower and possibly Tuesday as well. I guess we’ll just have to wait and see. With so many downdrafts in the World’s Economic outlook, I don’t see how anyone (not even the Bulls) will be able to stay aloft in the months ahead.
April 19th, 2010 at 9:17 am
W.D. –
You caught the vital point so many are missing concerning the nature of the charge against GS. On the other hand, you may be overly pessimistic about the economy and markets.
April 19th, 2010 at 9:17 am
Gee, everything made sense until that nonsequiter last sentence. What “downdrafts,” may I ask?
Last time I looked almost any reportable corporate, industry and/or government number was showing signs of trending up strongly.
April 19th, 2010 at 9:18 am
You don’t think confidence was shattered on Friday? Not a big crack in investors’ confidence? People want to know a lot more about the details as well as “connecting all the dots” and the market was fortunate this was announced on a Friday and not on a Monday or Tuesday.
I think you’ll see a correction and maybe a more lingering attitude that the market is somehow tainted.
The pendulum swings both ways and when you have so many saying it’s a bull market to try to get momentum moving, an SEC fraud case swings it back the other way pretty quick.
April 19th, 2010 at 9:18 am
The SEC-Goldman issues –no matter whose side you may be on– are all about what happened, i.e., that’s “ed,” as in past tense. Other than creating some nice work for some lawyers, this is a near-meaningless event for the national or world economies, and will be so recognized after the usual short handwringing period, where the shorts make some money on the panicky.
April 19th, 2010 at 9:19 am
I guess you forgot how fast the market can drop when it reaches the tipping point and stops kick in and hedgies dump and few shorts to covers.
The last time the market tanked, the economy was just entering a recession, people had some confidence in the government. Their fingers where not on the sell trigger as now.
Sell in May and go away!
April 20th, 2010 at 2:21 pm
To TACK, How about the ‘downdrafts’ in Greece.. and Portugal… and maybe even Spain. Or maybe it’s China with the red hot economy that the Chinese HAS to reign in by reducing It’s level of imports; Or maybe it’s the Real Estate Bubble in China… You know, kinda like the one that brought the US and consequently the rest of the World to it’s knees. I know I know. Some are in denial about this just like it was in the US This is in ADDITION to the ‘Sword of Damocles’ that the SEC is dangling over the heads of the largest Financial Institutions in the world. Even something like a volcano in Iceland can threaten an already fragile recovery. Really the list is longer that even the most avowed pessimist could possibly construct. P.S. on my prediction for today’s Market’s. I was only partially correct. The Dow was up to a respectable level while the S&P just barely eked out a gain. The Nasdaq and the Russell Indices were both down. The market’s rally came mostly on the revelation that the SEC’s vote to proceed against GS was not unanimous The two Republicans on the commission voted against it. Hmmm…. Imagine that.
April 20th, 2010 at 2:22 pm
It’s much more important to follow what actually happens, not the endless negative chatter.
Did Greece collapse? Portugal? Spain? Anybody? How long has volcano-phobia lasted? Goldman-itis? All this stuff is noise.
Despite all the endless palaver about this or that “crisis,” they do and will turn out merely to be the new “fear du jour,” as corporate earnings and revenues –where the rubber really meets the road– continue to advance. Those that make contrarian plays against each new anxiety attack will continue to make money, while those that react to each new forecast of doom will not.
This market is climbing the very classic “wall of worry.”
April 20th, 2010 at 2:22 pm
Tack -
While circumstances may be ripe for a mild stock market correction, given the scale of the recovery over the past 14 months, I agree with your assessment about the ‘noise’ and ‘wall of worry’.
While the recovery should soon enter a consolidation and more modest growth stage, I doubt that it is over by any means.
April 20th, 2010 at 2:23 pm
You asked for some of the downdrafts and I gave them to you. I don’t see anyone in the media treating these events as unlikely or unimportant considerations. ALL of these threats to the Global recovery are real and anyone who takes them lightly does so at their own peril.
April 20th, 2010 at 2:23 pm
Of course, the media treats them as “real.” The media hyperventilates about every perceived negative in the universe. I’m surprised we’re not being warned weekly about being struck by an asteroid (if global warming doesn’t kill us first, of course, or, remember swine flu? [lmao]).
The peril lies, precisely, in paying the slighest attention to the media, which has an astounding track record of being ill-informed or flat-out wrong on almost any prediction, most all of them negative.
April 20th, 2010 at 2:24 pm
I think these are a little more real and imminent than an asteroid hitting the planet but I appreciate and thank you for the exchange.
April 20th, 2010 at 5:52 pm
We’ve got a pretty polarized discussion here. Half seem to think this is a “BFD” (pardon the Biden reference) – and the other seem to think that “this too shall pass” and expect market’s to get back to normal.
I honestly think the truth is somewhere in the middle. Goldman getting sued by the SEC is a BIG DEAL. And I certainly didn’t mean to imply this wasn’t the case. The action has ramifications that will take weeks and months to sort out. We’re talking about risk for all other securities underwriters, for the financial industry as a whole, and essentially for our economy (as this lawsuit has ripples that spread into the very bedrock of free capitalism)
Remember, for a minute that when this security was being put together, John Paulson was a nobody – essentially a small-time hedge fund manager looking for a big break. The investment bankers thought he was a nut but liked him because he was helping them generate big fees by taking the other side of his trades. So if the concept is that a “mastermind” was picking out the mortgages that were destined to lose, keep in mind that Paulson had yet to be proven to be a mastermind…
Anyway, despite the fact that I think the suit really is a big deal, the current bull market is so very strong that it will likely take some time to set in. That’s why I expected a relief rally shortly after Friday’s air pocket (although I must say I didn’t expect it to reverse the majority of losses on Monday and Tuesday).
The true test comes NOW after we have had time to adjust and evaluate the long-term ramifications. If the market can press to new highs and continue to operate with momentum, then I will have to step back, close shorts and take short-term stabs at the long side (while managing risk and continuing to build a short-list)
But if we are unable to retake the highs, if risk is actually going to be a factor when deciding what to invest in, if momentum stalls and “story stocks” lose their appeal, we could enter a short-sellers dream – an era of falling expectations and declining multiples.
If you’re a bull, it’s a concept you should at least be aware of and have a hedging plan to help you survive. If you’re a bear, you should already have a game-plan in place complete with momentum stocks on the chopping block and an eye for particular profit points…
And if you’re an agnostic?? Well, then you probably know all this already…
April 22nd, 2010 at 1:28 pm
I have been a momentum trader over the last year and I have to admit I was later than I wanted to be when I decided that we had a significant rally going so I made all of my money playing both ends against the middle. I only made about 1/3 to 1/2 of what I would’ve made if I had been all in on the Bull. For me the volume issue has been always the sticking point but it has never been so bothersome as it has been since the 9% correction we saw earlier this year.
What I am seeing now in addition to this issue is the additional ones of an overbought Market that has trended upward AS an overbought Market and, as you pointed out in your piece a market that has priced a Defacto V shaped recovery into equity prices. This in itself would not be so troublesome if it not for the fact that there is so much elsewhere that can serve as the next catalyst to take this Market down in a significant correction, a correction that could turn into a full blown retreat.Things can go wrong so very quickly. Dubai should have been a wake-up call to anyone who thought we were out of the woods. and then came Greece with all the ‘PIIGS’ trailing behind it. Now Portugal . Today’s Auction of Greek Bonds was very telling. The point spread was enormous. What it showed was that buyers would rather hold German Debt for 10 Years than to hold Greek Debt for just 13 weeks! What does this tell you about the real confidence in how well the Greek ‘Bailout’ is going to work and yes my word choice was deliberate. You might as well take that “Loan” and start a Big Bonfire with it cause it ain’t never coming back.
As a matter of brevity I’ll mention only in passing the troublesome developments in China and both National and State Debt problems in the US. Now there is the SEC’s vendetta against the Big Banks, Dick Bove called the Govt. move against the Banking Industry ‘A Death Wish’, He’s not what I would call a Bear since he is still Bullish on GS
How’s this for a ‘Long Black Train’?
Anyway just one or even two of these things would be worrisome if we still believed in the myth that the World Economies were somehow ‘Decoupled from each other. That theory now, is as much a pile of ashes as that ‘Bonfire’ would be.
If I’ve learned anything over the last two years it’s that when real fear grips the Market.all bets are off and you can’t hit the sell button fast enough Even the Bulls get slaughtered.. Am I still trading the Market? Yes. but I’ve rotated out of most all of my positions except Pharma and Healthcare and into selective inverse ETFs . I believe, and mind you I KNOW there are a lot of people who would disagree with me, we haven’t SEEN fear like were going to see the next time. During the last big sell-off (3/09) we didn’t have or at least didn’t know about all the other sharks in the water. Now we do. The problem with surprises is …well….. they take you by surprise: Like last Friday’s announcement. I’ve gone longer than I wanted to but I want to ask for your input on a couple of last questions. Taking into consideration the aforementioned very real problems, do you think that a major sell-off like we had a year ago is non sequitur? Have I become too cautious in staking out my portfolio positions? If not what is/are your criteria for getting in/out of the market? Just curious.