April 25, 2010
“If you lie down with dogs, you will get up with fleas.” Proverbs
In his list of “10 Things You Don’t Know (or were misinformed) About the GS Case” Barry Ritholtz (www.ritholtz.com) opens with “……Based upon what is in the SEC complaint, parts of the case are a slam dunk. The claim Paulson & Co. were long $200 million dollars when they were actually short is a material misrepresentation—that’s Rule 10b-5, and it’s a no brainer. “
The revelations about Goldman Sachs, John Paulson’s hedge fund & Mr. Tourre constitute an on going saga. The price of GS stock suffers as more information is made public. One newest exposure is that five GS insiders sold stock in GS after the firm received a Wells Notice 8 months ago and before the SEC made the complaint public. There is some question about whether or not they traded on inside information since the nature of the detailed allegations in the SEC charges were supposedly not known to them and the notice of the SEC probe may have been routine and not material. (Wall St. Journal, April 24).
Another development that adds to the debate is a letter that John Paulson has sent to his investors. We are personally aware of three investors who have withdrawn or plan to withdraw funds from Paulson. They are concerned about how Paulson achieved his investment returns now that there is a question about the construction of the investments he used. In his letter, Paulson says he “suggested” securities to be used but the actual and final decision was made by ACA and that “Paulson’s role in the ABACUS transaction was appropriate and conducted in good faith.” Paulson reminds his investors that the securities were originally rated AAA by Moody’s and Standard & Poor’s ratings services.
Ratings agencies are on the defensive. On Friday, the former managing director of the Moody’s team which rated ABACUS testified before the Senate Investigative Committee that he did not know about Paulson’s activity when he rated it. “It’s something that I would have wanted to know” he said. “It just changes the whole dynamic of the structure.”
On this coming Tuesday, GS CEO Lloyd Blankfein is scheduled to appear before the same Senate committee. CNN reports that Four Goldman exhibits were released by Sen. Carl Levin, D-Mich., who chairs the Permanent Subcommittee on Investigation of the Senate Homeland Security Committee. The e-mails, Levin said, “show that, in fact, Goldman made a lot of money by betting against the mortgage market” and contradict the firm’s claim that it was merely buying and selling securities for clients. The dispute previews an expected showdown on Tuesday when Blankfein and other Goldman executives appear before Levin’s committee.
There are numerous questions without current answers. One of them involves Paulson & Co. John Paulson has not been charged with any violation and may not have broken any law. It is not clear how much of his 2007 investment returns originate in this ABACUS construction vs. other less controversial investments. Paulson does not detail that in his letter and therefore leaves that question open to speculation about his investment style. He does note that it changed when he says “as important as credit protection purchases were to our performance in 2007, our investment focus completely shifted in the fourth quarter of 2008.”
It is interesting to contrast Paulson’s letter with one sent by Magnetar Capital, another hedge fund firm that used CDOs. They detailed their approach to CDOs and their actual positions. They directly confronted their detractors with facts. Their eleven page letter to their investors is written with clarity and seems to be very credible.
So where does this ongoing saga eventually lead? For us the cliché “there is never just one cockroach” applies. We expect more allegations as the SEC continues to investigate ABACUS and other structures like it. We expect other firms will be named. The financial sector is now under attack and the attack occurs in the middle of the debate about the Financial Reform legislation. Much of that proposed legislation seems counterproductive to us. It will be costly to firms, it will inhibit new business formation and it will certainly alter the roles of existing agencies including the Federal Reserve.
Markets sense that a sea change may be coming. Financial stocks are trading on future expectations since the present earnings they are reporting were derived from yesterday’s results. Those earnings reflect an operating regime which is now in question. GS stock is a prime example. Earnings were huge; the market ignored them. The stock went down.
At Cumberland, we have sold our positions in the ETFs that were concentrated in this sector. Some of these have been held for a while and were profitable. The sales included the ETF which represents the capital markets firms and GS was one of the larger weights in that index. The financial group has rallied strongly over the last year. We took profits and will watch from the sidelines.
Entering this sector now may become highly rewarding in the future if the outcome is beneficial to an investor. But it also risks catching a falling knife if fines levied on firms and liabilities from damages grow at a time when more or most or all of these firms face a new regime of regulation and supervision and taxation. Clearly, the national political body is hostile to Wall Street firms. In many cases, that is deserved. Sentiment studies suggest that favorable sentiment views of financials have fallen by half since December. We are scheduled to discuss this issue on CNBC tomorrow (Monday) morning at 10 AM when the Schwab Active Trader Sentiment Survey is released.
Readers who wish to read the Paulson letter, the Magnetar letter and the Ritholtz list of 10 Things may send me their snail mail address and I will send them an envelope with printed copies of each of these three items.
David R. Kotok, Chairman and Chief Investment Officer