Goldman Sachs & Cumberland Strategy Change

Goldman Sachs & A Cumberland Strategy Change
April 18, 2010

John Mauldin quickly added text about Goldman Sachs to his weekly letter. He wrote:

“Goldman Sachs is all over the news after being charged with fraud. The way I see it, this is essentially a charge that there was not full disclosure. And it appears to me that that is true. It also is true that Goldman will argue (or I think they will) that only very sophisticated investors who signed very lengthy offering documents were involved, and they should have known better. They were also reaching for yield.

“Last week I read a very interesting report from propublic.org about a hedge fund called Magnetar, which basically did the same trade as in the Goldman deal. And they did those deals with nine banks. You can read the whole article at http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going.

“Let me quote a few paragraphs.

‘From what we’ve learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn’t cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

‘Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses the banks didn’t disclose to CDO investors the role Magnetar played.

‘Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.’

Goldman and at least 8 other banks are going to have serious litigation costs, if they don’t actually have to eat the losses of the investors in these synthetic CDOs. Understand, these were not securitizations of actual mortgages. They were securitizations of derivatives that acted like these mortgages, and the worst tranches of them to boot. On top of their loan losses, there could be tens of billions of losses to investors in the CDOs they sold. This will play out over years.”

A Cumberland Strategy Change

In Cumberland’s view, the GS news is big and is not a one-off event. Since the announcement of the SEC suit, we have been polling everyone we talk to about GS. They are universally despised. The alleged wrongdoings have intensified an already large anger. GS arrogance has created a perception problem, and now GS has a reality problem. It could quickly become a criminal action. One lawyer said “just wait until we hear from Andrew Cuomo.”

Welcome to the modern post-crisis era. In the case of GS, we have an actual allegation of fraud. This is different than the Lehman repo 105 disclosures, although we expect fraud allegations to come there, too. In Lehman we have a failed firm. In GS we have an existing stock and a company that is the largest capital-market player on the US scene.

We expect that there are a lot more charges coming and they will impact GS and many other firms. And we will soon see state attorneys general piling on. The plaintiff law firms are already preparing class-action suits. Germany and the U.K. are launching their own investigations. These types of allegations are not going to be confined to SEC vs. GOLDMAN SACHS & CO. and FABRICE TOURRE. The allegations will not be limited to a single security series known as Abacus 2007.

At Cumberland we have raised some cash. We exited the capital-market ETF quickly. We expect this news will be the catalyst for some market correction. It is long overdue.

The GS news doesn’t impact other sectors and will be confined to the financials. Thus we remain overweight in the tech sector and in the industrial companies.

GS will be used by politicians to justify elements in the financial reform legislation. Will anyone ask how the proposed legislation would have prevented this alleged fraud? Also, the fact that the SEC is bringing these charges under existing law suggests that the law is in place and that enforcement is the real issue, not new legislation. And what would lead us to expect that the supervisors who didn’t prevent this alleged fraud in 2007 will be able to do so next time? They are and will be the same people.

Anyway, GS has added to the volatility in the market. There is more to come. and a little cash on the sidelines awaits some buying opportunities at lower prices.

We thank John Mauldin for saving us some writing time. His website link to the letter is: http://www.frontlinethoughts.com/gateway.asp?ref=reprint.