SEC: Goldman Sachs May Have Crossed the Line from Conflicted Investment Banker to Fraudulent Communicator

It always disappoints me when the financial media cannot wrap their hands around certain business stories. Here I am today watching the CNBC coverage of the SEC's fraud charge on Goldman Sachs (GS) and the network has half a dozen reporters and anchors all talking at the same time and confusing what exactly was happening, even though they played the SEC's conference call live on the air and it was pretty clear what was being alleging.

At any rate, let me review what exactly the SEC claims Goldman Sachs and its Vice President Fabrice Tourre did that was fraudulent in this particular case. The SEC is charging both the firm and the employee in charge at the time with omitting and misstating important disclosures related to the structuring and issuance of a CDO called ABACUS which was backed by sub-prime residential mortgage securities.

One of Goldman Sach's most prominent hedge fund clients, Paulson and Co, actually helped create the CDO by deciding which mortgage-backed securities were to be included in ABACUS. In addition, Paulson and Co took a short position in ABACUS after it was issued, meaning that it helped structure a CDO that it planned on shorting.

Many on CNBC are incorrectly reporting that this clear conflict of interest is what the SEC is targeting in its complaint. In fact, Paulson and Co. is not being charged at all. Not only that, having a hedge fund help structure a CDO in and of itself does not violate any securities laws. Neither would it be illegal for that same hedge fund to short the CDO after it was created and sold to the public. While this is yet another situation where Goldman Sachs appears to be engaging in transactions that are filled with conflicts of interest with their various sets of customers, these conflicts are not illegal. Rather, they simply beg the question whether Goldman will lose customers due to the perceived conflicts.

All of that said, what exactly is the SEC's charge related to? It turns out that in the marketing and disclosure materials prepared for potential investors in ABACUS by Goldman Sachs, it was claimed that ACA Management LLC, an independent third party expert in mortgage-backed securities, was hired to select which mortgages were packaged into the CDO. There were no disclosures made to investors that the hedge fund Paulson and Co. was also involved in selecting the securities.

Now you may be wondering why on earth ACA Management would agree to let a hedge fund assist them in structuring ABACUS, given that they are supposed to be an independent third party taking on such a job. The SEC hints it may have the answer. They are charging that the lead Goldman Sachs employee on this deal told ACA that Paulson and Co. was going to invest $200 million in ABACUS, which would likely calm any fears they had about the interests of ACA and Paulson and Co. being aligned while they collaborated on the creation of ABACUS. Fabrice Tourre, the Goldman VP in charge of the deal, seems to have both omitted disclosures related to Paulson's involvement, as well as misrepresented to ACA what Paulson's investment objectives were once ABACUS was issued.

The key point here is that the SEC is charging Goldman Sachs with fraud related to the disclosures made (and not made) relating to the creation and issuance of ABACUS. Therefore, the obvious conflicts of interest here by themselves would not have been illegal had Goldman adequately disclosed to investors the true facts behind the creation of ABACUS.

Now, how does this news alter my opinion of the stock, if at all? Goldman Sachs shares opened today at $185 and are now trading down 15% ($25) to around $160 each. You may recall I wrote a bullish piece on Goldman Sachs back in March explaining why I was accumulating the stock in the 150's. Until today that investment had proved very timely and given that even with today's drop, the stock is still above my purchase price, I am not likely going to be doing any heavy bargain hunting at current levels.

If the shares fall back to around the 150 level or even lower as more people react to the SEC's charges, it is quite possible that I would get more of my clients involved with the stock and/or add to existing positions for those who are already long. While I do not expect there to be much of a negative financial impact on the firm from these charges (Goldman's fees related to ABACUS were only $15 million), it is reasonable to expect that customers of the firm will have even more questions about conflicts of interest surrounding Goldman's dealings, including the possibility that other employees are lying about deals they are putting together personally.

Goldman surely has its hands full trying to alleviate these concerns with clients, but they can likely argue that this was an isolated incident involving a rogue employee and minimize the customer fallout from these allegations (as long as this proves to be an isolated incident rather than a pervasive problem at the firm). Given the stock's valuation based on book value and earnings, I still believe it represents a solid long-term value for investors interested in owning part of the most dominant investment banking firm in the world.

Full Disclosure: Peridot Capital was long Goldman Sachs at the time of writing, but positions may change at any time. And yes, you can be assured that there are no material omissions or misstatements in this disclosure.

Despite Recent Rise, Goldman Sachs Still Fetches Single Digit P/E

In recent weeks I have been accumulating shares of Goldman Sachs (GS) for my clients, more so now than any other time since I began managing money. In a market environment where over the course of a single year most stocks have gone from severely undervalued to fairly valued, it remains pretty easy to make the case that Goldman stock is undervalued, despite a $20 increase just recently.

Why is the stock still cheap? No doubt due to the negative press coming from both political and consumer circles. Somehow Goldman Sachs is being made out to be a bigger problem for our financial services economy than sub-prime mortgage lenders and insurance companies that chose to insure everything on the planet without ever setting aside any money to pay future claims. Goldman Sachs never gave out mortgages like candy on Halloween and although they did benefit from the AIG bailout (their claims were paid out 100 cents on the dollar after the government bailout) people should be mad at AIG and the government long before blaming Goldman Sachs for owning insurance policies.

The investment case for Goldman stock, however, does not really involve a political or moral viewpoint (many of us will disagree on those points anyway). The real issue from an investor standpoint is that Goldman is the best of breed investment bank in the world ( this was one of the key takeaways from the credit crisis, in my view anyway), has seen many of its competitors go out of business or dramatically scale back operations, and yet at around $170 per share the stock still trades for less than 10 times estimated 2010 earnings.

Why do I think such a valuation is too meager? Well, all we have to do is rewind the clock back to before the credit crisis and recall what the investment banking landscape looked like. Back when the Big 5 investment banks were still in existence (Goldman, Morgan, Merrill, Bear, and Lehman) there was often a valuation discrepancy. It is actually very interesting to revisit how these stocks used to be valued by the market. Ever since it finally went public back in 1999, Goldman typically fetched a premium to the group (they have always been seen as the cream of the crop). Morgan Stanley and Merrill Lynch were very diversified and strong global franchises, and therefore were close runners up while Bear Stearns and Lehman Brothers were generally seen as less attractive, mainly due to an over-reliance on fixed income businesses for their revenues. They typically traded at a discount to Morgan and Merrill (about 10 times earnings versus 12 times) while Goldman often commanded a premium (15 times earnings or more).

This is interesting, of course, because the credit crisis essentially proved that the market was very accurate in its evaluation of the five large investment banking institutions. Bear and Lehman collapsed thanks to their heavy concentration in fixed income (many of those bonds and securities were backed by mortgages). Merrill Lynch and Morgan Stanley were on the brink but managed to find partners to help them back (Bank of America bought Merrill and Morgan got a large investment from overseas). Goldman, meanwhile, came through the credit crisis relatively unscathed (and would have been okay even if they had only gotten 80 or 90 cents on the dollar for their AIG contracts). For the most part, the market got it right.

Fast forward to today. We know that Lehman and Bear were the worst of breed and that Goldman is still tops. And yet Goldman Sachs stock today trades at a lower valuation than Bear Stearns and Lehman did pre-crisis. How does that make any sense? Has the credit crisis not proved that Goldman traded at a premium for good reason?

Going forward, I believe the valuation range we will see for investment banks will continue to be 10 to 15 times earnings. Maybe the lower end of the range is more likely near term as investors worry about political and consumer backlash. Maybe Morgan Stanley fetches a 10 P/E instead of 12 times, but Goldman should still command a premium to reflect their investment banking franchise. Granted, maybe that premium is only 12 times earnings.

Still, from my perch buying Goldman stock at less than 10 times earnings is a tremendously attractive risk-reward opportunity. The only way such an investment comes back to bite anyone is if either, one, the P/E drops significantly below 10, or two, Goldman's earnings have peaked and will trend lower in coming years. Frankly, I see both of those possibilities as extremely remote, especially longer term. Instead, I think Goldman Sachs should be able to earn around $20 per share and after the policy fallout has passed longer term, the P/E ratio should rise to 12 or higher. In that scenario, Goldman shares would fetch $240 each, or about 40% above current levels.

Full Disclosure: Clients of Peridot Capital were long shares of Goldman Sachs at the time of writing, but positions may change at any time

KBW is Right, Berkshire Hathaway Stock No Longer Cheap

From MarketWatch

"Berkshire Hathaway was downgraded to market perform from outperform Monday by insurance analysts at Keefe, Bruyette & Woods who said a recent rally has left the shares fairly valued. Berkshire's class B stock was included in the Standard & Poor's 500 index this year and a lot of mutual funds that track the equity benchmark had to buy, pushing up the price. They also cut their price target on Berkshire's class A shares to $125,000 from $135,000."

I think this is a good sell-side call, and I am not one who typically praises Wall Street analysts. Since it was announced that Berkshire was being added to the S&P 500 on January 26th, the stock has surged nearly 20% in about a month. It now trades for 1.4 times book value and 1.8 times tangible book value. While neither ratio is extremely high, the stock does trade at a premium to both its peers (rightfully so) and near the upper end of its historical average. It appears the S&P 500 announcement has resulted in such a large surge in the share price that I would agree with KBW that buying at current levels is not a very attractive entry point.

Glass-Steagal Act Should Not Be Core of Financial Regulatory Reform

There has been a lot of talk lately about the repeal of Glass-Steagal in the 1990's and the potential that such a move contributed greatly to the financial crisis. Glass-Steagal, originally passed in 1933, had many parts to it but it is most widely known to have disallowed commercial banks that gathered customer deposits and gave out loans from also being investment banks that would underwrite securities and trade for their own account.

The logic of Glass-Steagal makes sense; banks should not use depositor or government capital to fund internal hedge funds. Should the enormous risks the trading desks take turn sour, it puts customers' deposits in jeopardy and reduces the amount of lending the firm can do. Not to mention the fact that cheap government funding is given to banks to boost lending and the economy, not to generate trading profits for the firm's partners.

Despite the soundness of the law, those who maintain that the repeal of Glass-Steagal was a leading contributor to the financial crisis are off base. Why? Because most of the casualties of the financial crisis were not banks at the time. Off the top of my head I can name AIG, Fannie Mae, Freddie Mac, Lehman Brothers, Bear Stearns, and Merrill Lynch.

None of those firms were commercial banks but they lost the most money. Those losses came from poor mortgage underwriting, poor insurance underwriting, and extreme leverage ratios of up to 40-to-1. More effective government regulation surely could have helped prevent such monumental downfalls (minimum underwriting standards and leverage limits to name a couple), but a combination business model of commercial and investment banking was not the culprit by any stretch of the imagination.

Now there were commercial banks that failed or nearly did during the recent crisis. Wachovia and Citigroup are the two big ones. But again, Glass-Steagal would not have prevented this. Citigroup was hampered by its leverage and significant holdings in mortgage backed securities, CDOs, and SIVs. Wachovia failed after it acquired a California-based mortgage lender that pioneered interest-only, pick-a-payment, and option ARM mortgage products. Such poor, undocumented, mortgage underwriting doomed them from the start, not investment banking (Wachovia did little, if any).

I am all for better regulation of the financial services sector, but many of the ideas floating around do not really address the core issues the industry faces. Not only that, existing regulators and laws easily allow for better regulation, without further changes, even though modern products such as credit default swaps and futures contracts clearly need to be regulated going forward.

Executive Compensation Restrictions Work In Everyone's Favor

The core difference between the Bush and Obama administrations in terms of how they doled out government bailout funds was what, if any, terms came with getting the money. Former Treasury Secretary Paulson gave out the first half of TARP funds with no strings attached. Secretary Geithner, conversely, wanted to make sure the government funding came with restrictions, including how much executives of bailed out firms could earn while they still owed the taxpayer billions of dollars. Skeptics argued that this was a way for Washington to gain control of the private sector, but in reality it really was just a way to maximize the odds that the government got repaid.

The Obama administration's auto task force required that GM CEO Rick Wagoner resign because they knew that under his leadership we would never get our money back, not because they wanted firm control over GM. In fact, the CEO they handpicked, Fritz Henderson, just resigned after the GM board (not the government) insisted he move faster in making necessary changes, something GM-lifer Henderson was unwilling to do.

Executive compensation restrictions have served as another way to increase the chances that TARP funds are repaid. The restrictions made it more difficult for Bank of America to find candidates to be the banking giant's new CEO. As a result, BofA raised $19 billion in new capital last week in order to be in a position to immediately repay its $45 billion in TARP loans. I do not know anyone who expected the entire $45 billion to be repaid this quickly, and therefore it appears the pay restrictions did exactly what they were intended to do; give TARP recipients incentive to repay the money as fast as they could.

This is just one of the many reasons I think Treasury Secretary Geithner has done a very solid job so far. There will always be critics who blame everything they don't like on certain people, but a lot of these decisions are proving to have worked.

Speculative Trading Lends Credence To "Rally Losing Steam" Thesis

A disturbing recent trend has emerged in the U.S. equity market and many are pointing to it as a potential reason to worry that the massive market rally over the last six months may be running out of steam. Investment strategists are concerned that a recent rise in speculative trading activity is signaling that the market's dramatic ascent is getting a bit frothy.

This kind of trading is typically characterized by lots of smaller capitalization stocks seeing massive increases in trading volumes and dramatic price swings, often on little or no headlines warranting such trading activity. Indeed, in recent weeks we have seen a lot of wild swings in small cap biotechnology stocks as well as some financial services stocks that were previously left for dead.

For instance, shares of beleaguered insurance giant AIG (AIG) soared 27% on Thursday on six times normal volume. Rumors on internet message boards (not exactly a solid fundamental reason for a rally) which proved to be false were one of the catalysts for the dramatic move higher, which looked like a huge short squeeze.

Consider an interesting statistic cited by CNBC's Bob Pisani on the air yesterday. Trading volume on the New York Stock Exchange (NYSE) registered 6.55 billion shares on Thursday. Of that a whopping 29% (1.9 billion shares) came from just four stocks; AIG, Freddie Mac (FRE), Fannie Mae (FNM), and Citigroup (C). Overall trading volumes this summer have been fairly light anyway and the fact that such a huge percentage of the volume has been in these severely beaten down, very troubled companies should give us pause for concern.

While not nearly as exaggerated, speculative trading like this is very reminiscent of the dot com bubble in late 1999 when tiny companies would see huge volume and price spikes simply by issuing press releases announcing the launch of a web site showcasing their products.

I am not suggesting the market is in bubble territory here, even after a more than 50% rise in six months, but this kind of market action warrants a cautious stance. Irrational market action is not a healthy way for the equity market to create wealth.

Fundamental valuation analysis remains paramount for equity investors, so be sure not get sucked into highly speculative trading unless there is a strong, rational basis for such investments. Companies like AIG, Fannie, and Freddie remain severely impaired operationally and laden with debt.

As a result, potential buyers into rallies should tread carefully and be sure to do their homework.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Meredith Whitney's "Buy Goldman Sachs" Call Lifts Market, But Comes A Little Late

My frequency of posting has diminished here lately, mainly due to the fact that not much interesting seems to be happening (at least from my perspective). I always err on the side of posting less rather than writing just for the sake of doing so without having much to say.

Stocks are rising smartly today after renown banking bear Meredith Whitney (now at her own firm) actually had positive things to say about investment banking giant Goldman Sachs (GS), upgrading the stock to a "buy" and raising her price target to $186 per share. GS shares are trading up 7 points to $149 each.

While the market is making a big deal about this call today, we have to remember that everyone knows Goldman Sachs is firing on all cylinders lately, so this should come as no surprise. Getting in the stock ahead of earnings (especially on an up seven point day) may backfire for some people tomorrow (GS reports earnings tomorrow morning) who are getting excited about Whitney's bullish note.

Frankly, the best time to get into Goldman was when the stock was down a lot (you know, when Warren Buffett bought a 10% preferred from the company and got equity warrants). As you can see from the chart below, GS shares had a huge move down, and even before today had made a ton of it back already.

While Whitney's call looks late to me, she has taken earnings estimates well above consensus, which makes the stock by no means expensive even at $149 per share. Whitney's 2010 profit estimate is nearly $20 per share, so there is no reason the stock couldn't trade higher from here if she is right. Still, I would have loved this call had it come when the stock traded below $50 near its low, or even after a double to $100. Now it has already tripled.

In terms of the large commercial banks, Whitney appears to be hedging her bets (probably because deep down she knows that the worst is behind us for the banking sector). She is bullish near term (thanks to a booming mortgage business), but bearish long term. This seems like a hedge because, if anything, logic would dictate one being bearish on banks in the short term (while the economy is still in the dumps), and bullish longer term (because the recession is certain to end).

Part of her long term bearish view is the fact that she thinks the unemployment rate is going to reach 13-14 percent. It seems odds for a banking analyst to be making predictions like that. Not that economists are any good at forecasting the jobless rate (they're not at all), but to think the unemployment rate will rise another 4% from the current 9.5% seems overly negative to me, especially given the source. After all, many people are expecting positive GDP as soon as the third quarter of this year.

All in all, I think the market is placing too much importance on Whitney's comments this morning. Not much has changed, really. We already knew Goldman was printing money, mortgage refinances were doing well, and that the economy was still rather poor. It seems like Whitney is making both bullish and bearish comments at the same time to cover her bases.

As a result, I don't think there is much to go on from her views at this point. Unless you think the economy will never recover (and the unemployment rate will hit 13 or 14 percent), I would just buy your favorite bank stocks at attractive prices and hold them for a few years. There is still plenty of money to be made in the sector if you have patience.

Full Disclosure: No position in GS at the time of writing, but positions may change at any time

NYT Economics Reporter Details Personal Credit Crisis

An interesting story of how even those who follow the financial system intimately on a daily basis can get pulled into the mess.

From the 5/14 edition of the New York Times: My Personal Credit Crisis by Edmund Andrews

Meredith Whitney Quitting Oppenheimer Helps Show Contrarian Indicators Still Work

As my clients know well, I am a contrarian when it comes to investing in the market. To me, buying a stock is no different than shopping for a new house, car, or wardrobe at the mall. You get your best deals when you are either buying things other people don't want (store sale racks, foreclosed properties), or buying things when other people aren't shopping for them (winter coats well into the season).

As a result of natural human behavior, many market participants use contrarian sentiment indicators to guide their investment strategy. Measures of investor bullishness and consumer confidence, for example, are proven contrarian indicators. Sometimes certain events can even mark emotional extremes.

Consider banking analyst Meredith Whitney's decision on February 18th to leave her sell side job at Oppenheimer to start her own firm. Prior to October 2007, few people even knew who Whitney was, but after she became one of the first analysts to point out a possible capital shortfall at Citigroup (C) she immediately became the face of the banking crisis (thanks to the financial media) and has been extremely bearish on the group ever since.

So, we have a relatively unknown banking analyst make a good call on a large bank stock, the media picks up on it and runs with the story for months, and less than 18 months later she has enough of a following to start her own firm. These kinds of events often mark extremes, in this case, the depths of the banking crisis. For an analyst who made her career by being unrelentingly bearish on banks, it stands to reason the banking sector would be struggling mightily around the time she quit her job to go out on her own. It makes sense to question whether negative sentiment would be peaking around that time.

Of course, I wouldn't have used this example if it didn't serve as a positive data point for the contrarian indicator thesis. We won't know for another year or two if Whitney quitting actually was a great contrarian indicator or not (it's too soon to call the bottom in the banks), but it took only 12 trading days for the bank stocks (and the market itself) to put in a fierce and dramatic bottom on March 6th. Since then the market has risen 36%. Financial stocks have fared even better, soaring 105%.

Another contrarian indicator I follow is the number of worried emails and phone calls I get from my clients about their investment portfolios. If I get a few clients expressing concern over a period of days, that signals to me that sentiment is extremely negative and a bottom may not be far off. This personal indicator of mine peaked on March 2nd, merely four days prior to the market's bottom.

All in all, contrarian indicators measuring sentiment among investors and other market participants can still be a very valuable tool when managing one's investments. I recommend keeping them in mind as you continue to follow the market and your portfolios.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time

U.S. Bank Stress Test Cheat Sheet

All we've heard about this week has been the stress tests, so I figured I would summarize the important aspects for everyone. Hear is what you need to know if you are following the large cap U.S. financial sector.

Capital Ratio Requirements: Banks must have enough capital to maintain the following ratios:

*Tier 1 Capital of 6.0%

*Tangible Common Equity (TCE) of 4.0%

Deadlines: For banks that need more capital, here is their timeline:

*Articulate plan for raising capital by June 8th, 2009

*Implement plan by November 9th 2009

*Maintain target capital ratios through December 2010

Sources of Additional Capital:

The regulators have indicated that raising private capital is the preferred source of raising capital. The banks may also choose to sell certain assets and use cash earnings to reach the targets. If those options are not sufficient to reach the desired capital levels, the banks may convert their TARP preferred capital into mandatory convertible preferred stock, which can be converted, on as needed basis, into common equity in order to boost capital levels to the needed levels.

Here are the results:

As for individual stocks, I have long been writing positively about COF, PNC, and USB on this blog. COF and USB passed and PNC needs to raise the least of all the banks, a meager $600 million. These results are not surprising to me, and I continue to like all three stocks long term.

Full Disclosure: Peridot Capital was long shares of COF, PNC, and USB at the time of writing, but positions may change at any time