Goldman Charged with Fraud; Proof of North Korea Attack?

Saturday, April 17, 2010

A week of strong earnings reports was capped off with a bombshell. The SEC announced Friday morning that it is charging Goldman Sachs with fraud for its failure to disclosure important details in its marketing of a particular CDO it created and sold to investors. John Paulson, manager of the world's third largest hedge fund, Paulson & Company, and "hero" of Zuckerman's Greatest Trade Ever, was involved in the security selection process of the ABACUS CDO while investors believed the selection process was completed by an independent, objective third party. Goldman failed to disclose Paulson's involvement in ABACUS, a security in which Paulson subsequently bought credit default swaps on through AIG in order to profit from its probable failure. The deal for the CDO was closed on April 26, 2007; by January 27, 2008 99% of the securities in the CDO had been downgraded. Paulson & Co. made $1 billion on the trade. Shares of GS lost 12.8% on the day dragging down the S&P 500 1.6%.

This is clearly a major development and I'll just add a few of my thoughts. This case seems rather meek and I doubt GS will be hampered much in the long-term. The true winners will be the lawyers and PR firms working on behalf of Goldman. Goldman will probably settle out of court, admit no wrongdoing and pay a $100-200 million fine. The Reformed Broker put together a perfect breakdown on what the future holds...not much. Yet, I'm sure Matt Taibbi is dancing as the Vampire Squid finally stands accused. And for all of Zero Hedge's conspiracy theories about Goldman controlling the US government, they obviously didn't control quite enough people. Other entanglements could be possible future class action suits against GS or others and more SEC suits against other investment banks should the actions be judged as widespread. The interesting part of this case is some of its implications for the role of investment banks and each side of a transaction.

It all comes back to disclosure. Goldman could have avoided this had it disclosed that Paulson & Company were involved in picking the mortgage-backed assets that comprised ABACUS. Though, investors may have then been dismayed and not invested. Yet, these investors wanted CDOs such as this because it came with a AAA to A-rating depending on the tranche and offered high yields relative to other assets rated as having similar risks. The entire trade would never have been possible without the major failure of ratings agencies in defining the risk associated with these subprime mortgage assets. An investment bank's job is to match buyers and sellers as a market maker. Paulson wanted to short the highest-yielding mortgage assets while investors wanted to buy them. The real problem arising is the asymmetric information between buyer and seller. Paulson dedicated hundreds of man hours into researching and understanding the terrible mispricing of these securities. Buyers were just looking for highly rated, high yielding securities. While Paulson has no fiduciary duty to the investors in ABACUS the lack of disclosure by Goldman is the crime. Perhaps the buyers would have performed greater due diligence had they known a prominent hedge fund was effectively taking the opposite side of the trade.

What a kick to ol' Mike Mayo. After being mostly bearish for this entire rally, Mayo capitulated and upgraded Goldman two days ago. What a blind side! It's interesting to note the complexion change in the market going into Friday that I believed I was seeing before the open. I highlighted how the earnings of GOOG, GE and BAC were good but the market had not really responded in the same manner it had to reports earlier in the week from INTC, JPM and YUM. The announcement on GS gave investors a reason to sell and this could very well mark the short-term top in the market.

I lost my shirt on Friday with my largest one-day losses of the year basically wiping out my April gains thus far. Oops! I made a series of bad decisions and kept on pushing in the face of P&L losses. What can ya do? I was off for the day and suffered the consequences.

I am still long Nike (NKE) giving my core position until the $74 area. The stock printed new all-time highs of $76.00 on Friday making me very committed to the position and thus causing me a great deal of pain as the GS news broke. I paired down my position and I am once again waiting for a breakout through that level. Continued holding of $75 implies that the trade is still alive and the very short-term uptrend move is intact.

There is some troubling news coming out of South Korea as the sunken ship from last month was brought to the surface yesterday. Initial studies are showing that the explosion did not occur within the ship, but that it was a possible torpedo from an outsider. Also, gauging from where the ship sunk and where the it was hit, it seems that the outsider was in South Korean waters. Clearly, early indications point to North Korea as the perpetrator of the attack. With South Korea as one of America's allies, the implications of this could come with grave consequences, not the least of which would be a declaration of war by South Korea.
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