You Can Lead a Horse to Water...

Okay, so I wrote in the run up to Goldman's earnings that the stock was a good buy on the gut reaction sell/short on the back of news of the SEC's lawsuit.  My basic intuition was twofold: the case seemed quite bunk (a feeling that has been reinforced since); and even if Goldman is found guilty, the approximately $14B hit to their market cap was a large overreaction.  My expectation was that Goldman would surpass earnings expectations by a mile and they did: EPS of $5.59 vs expectations of $4.16 (beating by approx. 40%).  The gross figures were revenues of $12.8B, $7.4B of which was from Fixed Income, Commodities and Currencies (FICC), and profits of $3.29B.  Enormous quarterly numbers, but the stock refused to budge. 

Clearly the trade I recommended was not much good (although had you bought at open Friday and sold at open Tuesday - the day of the earnings report - you would have netted a couple percent).  People who seek to improve themselves look at their decisions, and aided with the benefit of hindsight they isolate where they went wrong in order to avoid such mistakes in the future.  My mistake hereis quite clear.  The overriding negative sentiment from the SEC case (no matter how bunk) made it impossible for this stock to bounce nicely on a very strong earnings report.  The lesson?  In the short term, perceptions (animal spirits) outweigh fundamentals.  I feel very strongly that Goldman will continue to outperform and my ideas will be vindicated in the long run.

The SEC's Lawsuit Against Goldman - Revised

As I mentioned on Friday, my initial impression was that the 13% haircut Goldman's stock took in reaction to the SEC's lawsuit was an excellent opportunity to buy heading into their earnings report on Tuesday.  After having some more time to reflect and read up further, my conviction has been strengthened.

Forget about reading confusing, conflicting news reports about the SEC's allegations against Goldman.  The SEC has released a surprisingly readable (not full of legal jargon) report detailing their case.  If you don't want to read the 22 pages, I'll give you a summary.

Goldman was approached by John Paulson, who was looking to short the housing market.  Goldman figured that the best way to do this was to create a synthetic CDO which replicates the return on a reference portfolio of residential mortgage-backed securities (RMBSs).  To quote the SEC's report, the difference between a CDO and a synthetic CDO is that

"CDOs are debt securities collateralized by debt obligations including RMBS. These securities are packaged and generally held by a special purpose vehicle (“SPV”) that issues notes entitling their holders to payments derived from the underlying assets. In a synthetic CDO, the SPV does not actually own a portfolio of fixed income assets, but rather enters into CDSs that reference the performance of a portfolio" (point 13 of SEC report)

The implication of this difference is that in a synthetic CDO, there must, by definition, be a long and a short party.  Remember this, it is an important point.  Back to the story.  Goldman got ACA Management LLC, a firm quite experienced with this type of transaction (having performed upwards of 25 similar transactions prior to the one under discussion) to sign on as the manager of the proposed synthetic CDO (from this point forward referred to as Abacus).  Intending to short Abacus, Paulson had an incentive to have what he considered poor-quality RMBSs to be included in the reference portfolio.  ACA and Paulson met on a number of occasions and after some back and forth, a portfolio was finally agreed upon which included a large number of Paulson's suggestions.  Another very important point is that ACA had the final say of which mortgages went into the portfolio.  At one point ACA wanted more information on what exactly Paulson's role in the transaction was.  This is where things get particularly contentious.  Point 47 of the SEC report details the charge that Goldman misled ACA on this issue.  Since it is so important, I will include the entire point.

"On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “[0]% - [9]%: pre-committed first loss” as part of the Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “[0]% - [9]%” first loss equity tranche in this transaction." (point 47 of the SEC report)

What exactly does the SEC mean by "referenc[ing] a 'Contemplated Capital Structre' with a '[0]% - [9]%: pre-committed first loss' as part of the Paulson deal structure"?  While I am not privy to the jargon of the CDO industry, this looks more like obfuscation than misrepresentation by Goldman.  It is clear when reading the report in its entirety that the SEC had excellent access to Goldman's internal communications, as well as their communications with parties in the deal.  I feel that if Goldman had unequivocally indicated that Paulson was going long Abacus, the SEC would have been able to present a quote more condemning than this.  To me, point 47, the crux of the case, says effectively nothing.  Especially the final sentence.  May I have the rest of the quote to substantiate the SEC's claim that Goldman never intended to sell an equity tranche?  The next few points of the SEC's report detail evidence of ACA being of the impression that Paulson was long the equity tranche and Goldman failing to correct this misconception.

Operating under the incorrect assumption that Paulson was an equity investor, ACA went ahead with the deal.  It was subsequently marketed to other parties with ACA identified as the portfolio selection agent.  Ultimately the majority of the credit exposure was sold to a few European banks and they ended up taking a combined $1B in write downs, with the proceeds collected by Paulson's fund.

The SEC takes issue with Goldman's conduct on two fronts:

1. Goldman misled investors by failing to mention Paulson's role in the selection of securities in Abacus' reference portfolio
2. Goldman misled ACA over Paulson's interest Abacus

I should make it clear here that I am no expert in securities law, but it appears to me that since ACA had the final say on what was included in the reference portfolio, Goldman is in all likelihood following the letter of the law in making the now contentious statement that ACA selected the portfolio.  Whether Goldman followed the spirit of the law will not be the debate in the courthouse.  It should also be noted that when this deal was closed, people who were bearish on the US housing market were a small minority, and Paulson was a little-known M&A arbitrage hedge fund manager, rather than the prophet he is regarded as today.  I do not consider it unrealistic that had Goldman disclosed the fact that Paulson was the short and had been involved in the portfolio selection process, it would have actually been a selling point for Abacus.  What does a M&A arb guy know about the complex MBS-backed synthetic CDO market?  You want to talk about style drift.  But I digress.  The fact that Goldman lost money on the deal also undermines the SEC's charges.  This implies that Goldman themselves did not consider Paulson's role in the portfolio selection process a threat, and in fact put so little stock in his convictions that they actually bet against him.  This final point will go a long way in court (if the case ever gets there) as it indicates that Goldman did not intentionally mislead investors.

As for the charge that Goldman intentionally misled ACA re: Paulson's interests in Abacus, does anyone at the SEC really believe the evidence in support of this charge (as laid out in point 47) is going to stand up to Goldman's legal defense team?  I think that more substantial evidence of Goldman intentionally misleading ACA will prove necessary to return a guilty verdict on this charge.  However, I do think that the case as laid out certainly casts Goldman as grossly negligent in the very least.  Proving beyond a reasonable doubt that Goldman behaved in a fraudulent manner may prove quite difficult, but the damage to their reputation will be done regardless of the verdict.

I think that the timing of this announcement is another interesting consideration.  Over the last few weeks, Goldman has engaged in an aggressive PR campaign to exonerate themselves of responsibility for the crisis.  Highlights of this campaign include a cover story in Business Week complete with interviews with upper management as well as a letter to shareholders defending their conduct in the crisis which appeared in their 2009 annual report.  Perhaps the SEC was looking to undermine this PR blitz?  Maybe, but I think it a more likely explanation is linked to the push for financial reform. Some politicians are becoming complacent and reluctant to back proposed reform to reign in the big banks.  Now the supporters can point to the SEC lawsuit and say "See, these guys are defrauding investors, we need to come down hard on them to teach them a lesson", thereby acquiring support for reform.  By the time this case is settled in any fashion (court decision, settlement or dropped) it will have served its purpose in this regard.  Bruce Krasting at Seeking Alpha does a better job fleshing out this argument than I do.

It is also quite possible that I am dead wrong in my analysis.  Let us examine the consequences in this situation.  Goldman gets taken to task by the SEC and ends up paying a huge fine.  How big could it be?  Dick Bove, an influential analyst who covers the financial sector, estimates as much as $2 billion.  Other industry analysts offer considerably lower estimates.  Compare this to the drop in Goldman's market cap Friday ($12 billion).  That implies there needs to be six cases of this magnitude filed and won against Goldman to justify the drop. There is an argument that Goldman will lose a lot of business on the back of this announcement.  Maybe, but who is going to stop looking to Goldman when they need to buy or sell fixed income on the basis of this story?  That's where Goldman is earning all their money these days anyways.  At the end of the day, Goldman losing a some business isn't going to change their earnings figure (the medium term impact is more uncertain) and on this basis I stand by Friday's call to buy.

Good time to buy Goldamn Sachs

On Wednesday I commented on how I thought Goldman was going to post a huge quarter on trading revenues and thought the stock could go to $200.  Well today, the SEC sent Goldman a Wells notice which indicates that Goldman is likely to face a civil suit over one of their CDO products backed by mortgage backed securities.  The essence of the lawsuit appears to be that Goldman advertised to clients that the bonds put into the CDO were chosen by an independent asset manager, while the SEC contends that in fact they were picked by John Paulson, who was looking to short the housing market, and therefore picked bonds which he expected to be downgraded/lose value.  For those unfamiliar with the structuring of a CDO transaction, a relatively accurate simplification is that it tracks the value of the bonds "put into" the CDO.  If these bonds fall in value, so does the CDO.  If I understand correctly, Paulson was short this CDO via CDS contracts on it purchased from AIG as a part of the deal.

Whether or not Goldman ends up paying a fine, they are still going to post a huge quarter and the 10% drop in the stock in my opinion represents an excellent buying opportunity if you share this expectation.  Also, this news has wiped out over $10B in market cap, when the total value of the CDO was $2B.  I find it hard to believe that if Goldman loses the case (or settles), they will make a payout anywhere near this size.  It would be totally unprecedented.  This aside, it will be interesting to see whether Goldman includes a contingent liability for this lawsuit in their quarterly figures.

JPMorgan Q1 2010 Earnings

So JPMorgan was the first of the big US banks to report Q1 2010 earnings today.  The figures beat expectations of 64 cents per share by a dime and led to a significant stock market rally driven by the financial sector.  CEO Jamie Dimon was also quite upbeat on the economy, venturing as far as to say that various economic indicators were indicative of a strong recovery.  The firm even reversed $462M in provisions for credit losses, an indication that writedowns in the loan book will not be severe as earlier estimates.  This is very bullish for the US economy.  Trading continued to be the driver of performance, with fixed income trading revenue coming in at a record $5.46B and the investment bank as a whole contributing $2.47B to bank's total earnings of $3.33B. 

The fact that JPMorgan was actually able to surpass Q4 earnings ($3.28B) on the back of another record for fixed income trading is very bullish Goldman Sachs.  GS made $21.77 last year, riding enormous windfall profits in fixed income trading as their competitors scaled back operations.  GS is relative cheap right now at 8.5 trailing earnings on expectations that they will not be able to provide the same sort of returns moving forward, as competition re-enters fixed income trading in a big way and chips away at GS' bread and butter.  GS is known for managing earnings expectations and I remember making a mental note of an interview in January with COO David Cohn in which he said that he expects fixed income trading numbers to maintain or expand from levels seen in Q4.  Unless JPMorgan has been stealing GS's market share (something I view as quite unlikely) JPMorgan's figures indicate that the largest book runners have been able to defy expectations and maintain market share despite the heightened competition in this market, thereby supporting Cohn's comments.  On this basis, I am expecting GS to post a big number when they report.  If they continue to bow to populist pressure and keep the compensation ratio low, it could be an enormous number.  I won't be making a whole lot of calls on this blog, but I think GS is a good trade right now ($185).  They could run to $200 if Greece doesn't ruin the party in financials right now.

Bank of America should also be boosted by trading profits at Merrill, but they have a much uglier loan book than JPMorgan and on that basis cannot recommend BAC stock.

One addendum. JPMorgan's figures included a $2.7B write off for expected charges resulting from lawsuits surrounding the WaMu takeover.  I haven't heard a whole lot about said lawsuits, but will keep an eye out for more information.