Hudson Mezzanine Funding: more trouble for Goldman?

Hudson Mezzanine Funding

According to numerous press reports (suggesting that in Spitzer-like fashion, the government wants to get this story into the public eye in advance of any possible charges), the SEC is investigating Goldman Sachs for its sale of a collaterized debt obligation linked to sub-prime mortgages called Hudson Mezzanine Funding.

This action follows the indict ment of Goldman on civil fraud charges in April based on another mortgage derivative transaction called Abacus.

As I’ve written before, from what has been made public about Abacus so far, the case against Goldman seems weak to me (remember, I’m an investor, not a lawyer, however).  The accusations appear to rest on the SEC belief that in the Abacus transaction Goldman had an obligation to act as a financial advisor to the participants, not simply as a broker.  The facts, on the other hand, seem to me to show that Goldman functioned merely as a go-between for a deal that the two parties negotiated with each other.

From the leaked information appearing in today’s newspapers, Hudson seems to be a more serious complaint, assuming the press reports are correct, in that:

–Goldman selected the securities for the Hudson deal from its own inventory,

–Goldman asserted in marketing materials that its interests were “aligned” with buyers, since it would own equity in the issue, but failed to disclose that it was taking a much larger short bet against it

–in an internal email, a Goldman salesman describes Hudson as “junk” that his better clients were “too savvy to buy.”

I presume the SEC contention will be that Goldman was in a position to know the contents of Hudson well since it owned them, and made positive public statements about the deal while privately holding a negative opinion and intending to short the security once it came out.

why lead with Abacus and not Hudson?

One possibility, raised right away by the Wall Street Journal, is that the SEC fundamentally misunderstood the nature of the Abacus transaction. 

 Another is that the agency was under political pressure to do something while a financial reform bill was being debated in Congress. 

It may also be that the SEC was only tipped to the existence of Hudson after it went public about Abacus.

why Goldman and not Morgan Stanley or Citigroup?

This morning’s Financial Times, in addition to having a report on Hudson on page 1, contains a very interesting article called “A tricky pick,” in which it discusses the collateralized debt obligation market.  Although the banner on page 1 touts the article as being about “Goldman and the Credit Boom,” the real eye-opener of the story is that it portrays organizations like Morgan Stanley, UBS, Bank of America and Citigroup as engaging in what appears to me to be much more highly unethical and destructive behavior than anything that Goldman has been accused of by the SEC.

My guess is that it’s because Goldman is that compared with a commercial bank, Goldman is relatively simple to understand.  Its activities are more focused and the lines of responsibility for any action are clearer.   Given that the sub-prime derivative business is inherently difficult for non-specialists to get their arms around, why make the task even harder by adding the issue of having to explain a complex  organizational structure?

Also, Goldman has little retail presence.  It does no image advertising.  So few people have strong positive associations with Goldman as “my” bank.  It has also  created resentment, rightly or wrongly,  from seeming to have profited from the financial crisis.  In addition, the company has been described as being “tone-deaf” to public opinion.  Perhaps describing what they do as being “God’s work” isn’t typical of its public relations efforts, but even one gaffe like that can do a lot of damage.

I think the one safe conclusion to draw from all this is that (justifiable) public anger at the financial meltdown isn’t going away.  That implies that neither will the efforts of the SEC to prosecute.  Whether the agancy has the right villain is still open to question, though.

fiduciary responsibility: Goldman, the Senate, the SEC

possible new fiduciary laws

Legislative proposals have been floating around Congress for a while that would create national standards for the conduct of financial fiduciaries toward their clients, as well as mandate that financial planners and brokers must act as fiduciaries when dealing with individuals.  This seems to me to be in reaction to the Madoff and Stanford ponzi schemes, where financial advisors seem to have been much more zeroed in on the large fees they were collecting for recommending the schemes than on the welfare of their customers.

After Goldman Sachs’ recent grilling by the Senate’s Permanent Subcommittee on Investigations, during which questioning senators quoted liberally from the conclusions of a similar committee looking into the causes of the 1929 stock market collapse, the idea has made it into a Senate bill that brokers should be fiduciaries in their dealings with institutional investors as well (or at least any government-related entities).

what a fiduciary is

To step back a minute, what is a fiduciary anyway?

In one sense, we’ll find out if this legislation passes, since it has to spell out in detail what a fiduciary is and does.  In general terms, though, a fiduciary is:

–a trusted advisor who

–has a certain level of technical competence in the area where he is taking up fiduciary duties and who

–acts for the benefit of his client, with no thought for his own personal gain.

Doctors, lawyers and court-appointed trustees are all examples of fiduciaries.

a financial fiduciary

A financial fiduciary has to have a certain level of technical competence and must look out for the financial welfare of his client.  To do the latter, however, it seems to me the fiduciary must have a deep knowledge of the client’s financial situation–including life goals, risk tolerances and investment objectives, as well as the size and disposition of the financial assets he possesses.  How else will he be able to judge whether an investment is appropriate for a client?

retail brokers are not fiduciaries, by and large–but I think they should be

There’s no national fiduciary standard for brokers or financial planners.  This means that at the moment, except where local laws require it, retail brokers and financial planners are not fiduciaries.  They must do things that are good for their clients, but they need not do what is best for their clients.  That’s an important distinction.

An example:  A broker finds two mutual funds that meet the client’s risk/return profile.

#1 is expected to net the client 9% per year.  The fund company pays the broker’s firm 40 basis points a year in fees.  This sale will qualify the broker to attend for free a fund company-sponsored “information meeting” in Hawaii.

#2 has consistently outperformed #1 in the past.  It is expected to return 10% a year.  Fees to the broker’s firm are 30 basis points.  No free trip.

Litigation has established (remember, however, I’m an investor, not a lawyer) that the broker can recommend #1 instead of #2 to the client.  Why?  The client will be better off with #1 than without it.  Since the broker is not a fiduciary, he has no obligation to  show #2 to the client or to highlight either the differences or the extra benefits of #2 to the broker.

Personally, I’m all for retail investment advisors becoming fiduciaries.  The most highly skilled advisors probably are as well.  I think there would be lots of fallout for traditional “load” mutual fund companies from this change.  But that’s not what I want to write about today.

the institutional world is different

In order to act as a fiduciary when executing a trade, a broker has to understand a client’s current investment position and his intentions.

As an institutional investor, my investment plans and my current portfolio positioning are my competitive advantage.  They are valuable intellectual property, my stock in trade, my equivalent of copyrights and patents.  I’m certainly not going to disclose this information to the brokerage intermediaries I chose to trade for me.  In fact, I may do everything in my power to disguise my intentions from him.

As an institutional investor, I’m invariably acting in the interests of clients.  In assessing the suitability of any investment, a fiduciary probably should know who the ultimate owner will be and what his investment plans are.  Again, my client list is also valuable intellectual property.  I’m certainly not going to reveal that.  I may also have clients who have specifically required that I not reveal their identities (usually because they don’t want to appear to be endorsing my management services).

In addition, although the broker has different information from mine–he sees what a wide variety of clients are trading–it may not be better information.  In the equity world, his analysts may have more industry knowledge than mine.  But because their livelihood is so closely linked to the health of the industry they follow, they may find it hard to see anything negative.  And mine certainly know more about the individual companies we own than they do.  And mine know more about related fields, which may be important, too.

To sum up, as an institutional investor I don’t need or want the broker to be a fiduciary.  I want him to be an intermediary in trading who guards my anonymity, thus protecting my intellectual property.  I may listen to his input, delivered, not from the trading desk but from his research department to my analysts, but it will be one of many factors I take into consideration.

In fact, if I’m a value investor, it’s music to my ears if a broker hates a particular stock.  Part of my modus operandi is to buy companies that have performed badly but where I judge other investors have already acted out all their negative feelings by selling.  My biggest worry is that my buy order will tip him off to the stock’s potential.  The last thing I want is for him to come to think that this is a good idea.  Yet, if he’s got to be a fiduciary, how else can he act on my behalf?

Washington doesn’t seem to understand this

The morning after the SEC announced it was suing Goldman for fraud, the Wall Street Journal ran an editorial in which it surmised that the SEC fundamentally misunderstood what the financial instrument that formed the basis for the suit is.   Nowadays, I automatically discount what the WSJ says as being partisan support for Rupert Murdoch’s political allies.  But I’ve come to think that, in this case at least, the comment is accurate.

An Op-ed column in yesterday’s Financial Times raises this point again.  It also talks about the oddity that while in its suit the SEC is defending the interests of two European banks against an American company, Americans are suing one of the two banks for fraud and the SEC hasn’t stepped in to help.

I also found it striking in the Senate hearings about Goldman that the senators didn’t seem to appreciate that the rise of large multinational corporations after WWII and the emergence of large “buy side” institutions after passage of ERISA pension legislation in the Seventies have profoundly changed the landscape for institutional investing.  Many of the functions the senators seem to think are performed solely by investment banks have decades ago shifted to their clients–either the finance departments of industrial companies or to giant investment management firms.

It seems to me the Goldman witnesses did themselves no favors by somehow giving their questioners the impression they had something to hide.  They certainly didn’t get the point across that there’s a difference between an investment advisor and a trader.  Then again, reflection, self-awareness and self-deprecation are probably not high on the list of attributes a trading firm like Goldman looks for in its employees.  They were probably also scared, because Washington has a lot of power and wants to be seen as doing something.

Maybe I’m just getting old, but I find this all kind of scary, too.

A Goldman Sachs mistake?

the Goldman press release

In a press release dated April 16 2010, Goldman made “further comments” on the SEC fraud complaint arising from an Abacus derivative transaction.  The first of four “critical points” made in the release is:

“• Goldman Sachs Lost Money On The Transaction. Goldman Sachs, itself, lost more than $90 million.  Our fee was $15 million.  We were subject to losses and we did not structure a portfolio that was designed to lose money.”

What are we supposed to make out of this statement?  At first blush, the meaning appears very straightforward.  Goldman thought this was a good deal, invested its own money in it expecting a profit and lost a large amount instead.

The New York Times commentary

New York Times ran a subsequent story about the transaction in question, in which it asserts that:

1.  Goldman never intended to participate in the transaction and did so only when the buyer of a portion of the deal backed out at the last minute;

2.  Goldman tried to sell this piece of the deal but was unsuccessful;

3.  The Times implies, but doesn’t state outright, that Goldman then neutralized its Abacus position by establishing an opposite position as a hedge, with the result that the money Goldman lost on Abacus was offset by gains on hedging.

Assuming the Times story is true–and doesn’t seem to have been retracted–the real state of affairs appears somewhat different from what the press release contends.

conversational context counts

Consider the following situation:

A man who’s an inveterate, and always losing, gambler takes part in a card game in which he loses $5,000.  He goes home and his spouse, seeing his downcast face, asks him how much he lost this time.  His reply:  “$10.”

What should we make out of that statement?

The short answer is, “It depends.”

The statement itself is factually correct.  The man did lose $10.  In one way of looking at it, the statement is just incomplete.

Lots of factors can make a difference in what’s being communicated, like body language, tone of voice, prior conversations of the same type.  But the one I want to focus on is the relationship between the two speakers.

In this case, the speaker is talking with his spouse, with whom he presumably has a relationship of open communication and trust.  Does he have an implied obligation to give a full and complete account, or is it ok to give the partial and potentially misleading one he renders?

I think that if the questioner were a friend at work or a nosy neighbor, the “$10.” answer would be ok.  But I think the spouse is entitled to the full story.  In this case, the “$10.” answer is inappropriate.

back to Goldman

Among the rituals in the give and take between publicly traded companies and professional securities analysts, one is that a company can’t answer a question with a factually incorrect statement.  But if it doesn’t really want to give out the information, it can give an incomplete response.  The unwritten “rules” of the game say it’s the questioner’s job to realize this possibility and ask a follow-up question.  If the questioner doesn’t and ends up forming the wrong conclusions, it’s the questioner’s fault for not being skillful enough to pin the company down, not the company’s.

In dealing with securities analysts (and, I suspect, with lawyers) , a Goldman answer of “$10.” would be perfectly fine.  I think that’s what he company has done in its press release.

I think the general public, on the other hand, regards itself as more like the loving spouse who is in a relationship of trust and expects a full and complete account.  Rather than looking at the Goldman press release and the subsequent NYT article and admiring Goldman for having made an elegant and artful statement about its Abacus situation, it’s easily possible the public won’t approve.  If so, and if this indictment is mostly about politics, Goldman itself may be helping to make the SEC’s case.

more thoughts on the Goldman Sachs indictment

I’ve been reading and listening to everything I can about the Goldman indictment by the SEC over the past few days.  The talking heads on financial TV are, as usual, verbose but clueless.  What’s more interesting is I find that legal experts being interviewed are unusually vague about what statute or principle of law Goldman is supposed to have violated.

And the more I think about the SEC complaint, the more I find myself agreeing, not with the SEC, but with Goldman.

My observations:

1.  Goldman doesn’t think it did anything wrong.  The tone of all its public statements conveys this.  Also, as a practical matter, the vast majority of the “toxic” derivative transactions were done in the UK, not the US, in order to take advantage (I think) of the more permissive regulatory environment there.  If Goldman had any qualms about this deal, it would have happened in London.

2.  No one seems to be disputing the general outline of the deal in question:  Paulson asked Goldman to find institutions (perhaps “patsies” or “schlemazels” would be better words) to take the long side of a sub-prime mortgage derivative transaction that it wanted to be the short side of.  Goldman located two, a bank and a financial services firm, both supposedly well-versed in sub-prime mortgages, who seemingly jumped at the chance.

3.  No one, other than Paulson and its clients, is arguing that designing this transaction was a nice thing to do to the long side.  But, then, it’s not nice when the opposing pitcher humiliates the home team in front of a stadium full of fans by striking out 15 and not allowing a run in a visiting-team victory.  It wasn’t nice when the UCLA men’s basketball team defeated 88 other teams in a row, either.  The Flyers aren’t being nice to the Devils.

That’s not the point.  The real issue is whether any parties acted illegally.

4.  The case may hinge (in this non-lawyer’s opinion) on a court deciding whether Goldman’s role in the transaction was to be an agent/middleman or to be a fiduciary for the bank, IBK, and the financial service company, ACA.  In other words, did Goldman have an obligation to disclose Paulson’s plans and intentions to IBK and ACA?

Goldman is clearly saying that it was only an agent.

Four points:

–both buyers, IKB and ACA, were institutional investors who had prior experience with sub-prime mortgages and who asserted to their own clients that they were experts in this area.  No one so far is claiming that this representation was fraudulent.  And generally an investor is regarded as “sophisticated” in the US if he has $100 million under management.  So although they may not have been the most skilled players in the game, both IKB and ACA probably have to be regarded as professionals.

–even the SEC complaint says Goldman farmed out the function of advising on the reasonableness of the deal to ACA, the bond insurance company that had the final say on what bonds were backing the Paulson transaction.  The biggest buyer of the actual transaction was an affiliated company of ACA, which presumably relied primarily on the ACA research and judgment.  This seems to me to reduce Goldman’s role to that of a facilitator or agent in the deal.

–Goldman arguably had an obligation not to disclose Paulson information to ACA or IKB and vice versa.  But Goldman also got Paulson and ACA into at least one fact-to-face meeting and kept them in communication with each other.  So ACA knew who Paulson was.

ACA could have asked Paulson about what it was doing and where it stood in the transaction.  What kind of analysts wouldn’t have? (Answer: bad ones.)  A blush or a stammer would have been enough information.  Maybe ACA understood Paulson’s intentions and thought the firm was wrong, or simply didn’t care.

–According to the Washington Post, the Paulson role in selecting “bad” securities may not have mattered anyway.  Any 2006-vintage sub-prime mortgage securities would have imploded.  I wonder if any has checked to see if the ACA-selected portfolio was better or worse than the original Paulson one.

6.  The more I look at it, the weaker and more Spitzer-like (go for the headlines; don’t worry about the trial) the SEC case seems to me.  The ramifications of losing the one action the agency finally brings after all the adverse publicity of Madoff, BofA-Merrill and similar cases can’t be good.

7.  The Goldman professional who oversaw the deal has just been put on paid leave.  This is the most sensible thing to do.  Keeping him in his job likely angers the SEC further.  His mind probably isn’t on his work anyway.  Even if he has done something wrong, firing him only turns him into a cooperative source for the SEC.

The action may be Goldman opening the door to negotiating a settlement, rather than enduring a steady stream of negative publicity.

financial indictments: suppose the worst is true?

The Goldman indictment

This morning’s Wall Street Journal has an article in it which, while neatly summarizing the SEC case against Goldman Sachs, also states that the SEC is investigating other investment/commercial banks for similar possible violations.  (By the way, the WSJ is also running an opinion column arguing that the indictment is a mostly political move, and more a “water pistol” than a “smoking gun.”)

how true? how pervasive?

Stock market reaction around the world to the Goldman indictment has been immediate and negative, giving rise to the question:  what happens to the overall stock market if the worst turns out to be true?

I would define “worst” as meaning

–that ultimately most big bank are brought up on charges similar to Goldman’s (a JPM indictment would be particularly bad) and

–that legislation is enacted that restricts the future profit-making activities of the banking sector.

My guess is that convictions and fines would be much less important for the fate of the financial sector on Wall Street than a loss of trust in the companies and a shrunken future stream of profits.

how I handicap the issue

1.  Start by observing that the financial sector makes up 16.5% of the S&P 500.  Just to pick a number out of the air, let’s say that if the combination of social stigma and legislation that limits growth were factored into today’s prices, that would take a third off the sector’s market capitalization.  That’s too much, in my opinion, but let’s just say.

This would amount to a fall in the S&P of 5.5%.

2.  We might reasonably argue that the transactions in question didn’t do much overall economic good and might have actually been damaging.  That is to say, they moved money from the pockets of one set of brokerage clients to another, but provided no real other economic benefit.  To the degree that they helped the housing bubble to expand, they might have been harmful.

If so, requiring fuller disclosure or otherwise making them harder to do wouldn’t really hamper economic growth.

3.  If we lived in the simplified world that academics inhabit, and if we knew 1. and 2. for certain, investors would probably make a very swift adjustment in the prices of financial firms (and no others), dropping the S&P to 1130 or so in a couple of days.  As far as the S&P is concerned, that would be the end of the matter.

In the real world, we don’t know many things for sure, however.

uncertainty has consequences

Uncertainty has two main consequences:

–although I think that whacking a third of the value of all financials is much too much, the market–an emotional beast–could overreact

–declines are almost never isolated to a single sector.  There are always relative value arbitrageurs, who will regard financials as cheap and sell other sectors to get the money to buy them.  This process means the entire market, not just the financials, will go down.

two conclusions

The first is that while the SEC action may not exactly be a tempest in a teapot, I don’t see that it is anywhere near important enough to undermine the case that we’re in a bull market–or to be anything more than a temporary setback to the market’s advance.  Ultimately, the simple-minded 5%-6% drop in the S&P will likely prove correct.  But we probably get there by a roundabout route.

My guess is also that financials won’t regain in the near future the stock market leadership role they have played so far this year.  IT is my candidate for its replacement, but that’s been my position for a long while.

the timing of the case?

The Goldman indictment comes at a delicate point for the market.  After declining in late January-early February, the S&P has been marching upward very consistently, to the point last week where it had achieved almost all the gains that even bullish market commentators had predicted for the full year.  The index was also flirting with its (technically/psychologically important) levels just before the Lehman collapse in September 2008.  So it was arguably due for some sort of correction.

To some degree, then, the Goldman indictment should be seen as the trigger, or excuse, for something the market was going to do anyway, rather than the cause.  But the correction will likely be deeper and more prolonged than it would be otherwise.  Maybe we have a repeat of the January-February decline.  One positive sign I’ll be looking for would be that other sectors would perk back up even though financials languish.