Friday, April 16, 2010

Wrong Side of the Trade

The most prominent investment bank in the country has been hit with a civil fraud charge by the country’s top securities industry watch dog. Every pundit within sight of a camera, every blogger, every tweeter must make comment. Right?

Right! Small Cap Strategist is no exception.

The Goldman Sachs (GS: NYSE) situation is so compelling. It provides a forum to debate who got us into the current financial crisis in the first place. There are so many possible culprits depending upon your personal situation or political bent: the evil, lying mortgage loan applicants without the means to pay their debts; the evil, lying mortgage loan originators who greedily supplied shaky, poorly documented loans; the evil, lying investment bankers who kept up a constant clamor for more loans to slice and dice into exotic securities. Some might even blame a fourth group - the stupid, lazy investors who bought up the mortgage-backed securities and deserve their losses for their incompetence.

As entertaining and even therapeutic as that debate might be, it misses the real issue. Goldman Sachs is charged by the Securities and Exchange Commission with having taken an indication of interest from one customer - a short (expecting the mortgages to default) for hedge fund client Paulson & Company crafted as one of those fancy collateralized debt obligations (CDO) - and then selling the same bundle of CDOs to third parties - clients who took long positions (expecting the mortgages to pay off).

Investment banks originate securities all the time. Some customers bet long and some bet short. Yet in this case, Paulson & Company appears to have entered into the investment banking process, helping to select the very securities they intended to bet against. Goldman kept that little bit of information from the rest of the investors who were presented a prospectus that pitched a long position.

Anyone who has ever taken a Series 7 securities exam knows this is fraudulent dealing. For that matter it is hardly so nuanced that even the guys in work shirts drinking beer at the neighborhood bar can see that something was wrong with Goldman’s actions - if they indeed acted as the SEC charges.

Paulson & Company is not charged, but one has to wonder whether that is to follow. Paulson representatives issued a statement denying wrongdoing and saying Paulson played no role in marketing the securities to third parties. Then again, for their trade to work Paulson would have expected some other investor to take the opposite, long position.

The Paulson Credit Opportunities Fund turned out triple-digit returns for those investors who listened to John Paulson’s prediction of a housing market collapse. (no relation to Henry Paulson, former Treasury Secretary). Could John P. be a little less prescient than some have made him out to be? Maybe he is just another hedge fund manager who knows how to set up a deal in his favor.

Regardless of whether the SEC is successful in getting the fraud charges to stick, one thing will be clear. Ordinary homeowners and taxpayers ended up as the party on the wrong side of the mortgage trade.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

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