Financial Sense

Are there more Cockroaches in the Kitchen

by Hans Wagner, TradingOnlineMarkets.com | April 20, 2010

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If you have you ever seen a cockroach in the kitchen, you know there are more that what you see. The same concept applies to improper financial activity by companies. When you find one bad action, you will more than likely find others. The Securities Exchange Commission (SEC) is suing Goldman Sachs for failure to disclose “vital information” regarding a synthetic collateralized debt obligation, named Abacus 2007-ACI. The SEC accuses Goldman of creating the sub-prime residential mortgage-backed securities portfolio and then selling it to investors, knowing that the security was filled with mortgages that were likely to fail causing the value of the package to fall. The SEC press release and complaint make for some interesting reading.

John Paulson, a hedge fund investor made billions shorting the CDO market including an estimated $1 billion from this transaction. Paulson is not related to former Treasury Secretary Paulson. According to the filing, Paulson’s firm paid $15 million to pick the securities that became part of the portfolio. Paulson’s firm created a short position against the CDOs. Paulson’s firm said they did not the market the ABACUS product. Neither Paulson nor his firm was charged.

A Goldman vice president, Fabrice Tourre was charged with fraud. The SEC indicated he was the prime person responsible for creating and marketing this product.

At a minimum, Goldman faces a lengthy period of bad publicity, as Washington will paint them as the primary example of what is wrong with Wall Street and the U.S. financial system. Will there be more lawsuits? Most likely, as many large and well-heeled investors lost a lot of money. This is one big cockroach.

This leads me to where are the other cockroaches. ProPublica is a journalism website that is reasonably good at identifying and disclosing interesting events that affect all of us. On April 9, 2010 they published an interesting article on “The Magnetar Trade.” The Magnetar Trade set up the riskiest portion of the CDOs into portfolios. Once in place, the funds placed bets that part of the deals would fail, generating huge profits for themselves. Like the Paulson & Co trade, they sought to make substantial profits from the deterioration of the underlying housing market and the sub-prime mortgages. While there is nothing illegal on the part of the hedge funds in making these bets, this trade displays the high risk deals of the some of these hedge funds. To be fair to the hedge funds, had the housing market continued to climb, they would have lost big time on their short bets.

In addition, as described in the ProPublica article, the major banks were part of many of these Magnetar type deals including Merrill Lunch, Citigroup, JP Morgan Chase and UBS. According to ProPublica, at least nine banks participated in creating these portfolios. The article claims that the marketing materials and prospectuses did not disclose to investors the role Magnetar played in creating the CDO portfolios. After reading one the 260 page prospectuses there is no specific mention of Magnetar. There were many statements of the risk “qualified investors” were assuming. The problem with disclosure is someone can always find a case where someone should have mentioned the risk. It is this lack of disclosure on the part of the banks that opens the door for the lawsuits even when the products are sold to sophisticated investors. This is where the cockroaches are hiding. By the way, for those wondering a Magnetar is a neutron star that decays rapidly and possess the strongest magnetic power in the universe. An interesting analogy.

Goldman and the other banks will be subject to a number of lawsuits from investors who lost billions of dollars on these deals. The banks will face bad PR along with expensive litigation to defend themselves. Along the way, there will be calls for disgorgement and payback of the losses investors incurred. Finding and disposing of all the cockroaches will take years. The negative affect on the banks will be significant including more pressure to add new regulations on their activities. Not many people will step up to defend the banks as this builds over time.

For investors this raises the question, if and when should I venture into the field and buy the banks. Dick Bove, a noted bank analyst came out late Friday to say he would buy Goldman Sachs. Given their situation, that is a bold recommendation. I still like the fact that Citigroup has an exceptionally strong presence in the emerging markets that will drive its growth for several years. However, the fallout from the sales of CDO portfolios that were not disclosed fully is a risk we need to understand. On the positive side, the government owns a significant minority of Citi and they will tread carefully even as they are selling their shares. Stay tuned for further updates on the banks and on Citi.

Copyright © 2010 Hans Wagner
Editorial Archive

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling. One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas. Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

Bio As a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market. Feel free to visit the site at http://www.tradingonlinemarkets.com/�

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