When the Patina Fades... The Rise and Fall of Goldman Sachs???
I have warned my readers about following myths and legends versus reality and facts several times in the past, particularly as it applies to Goldman Sachs and what I have coined "Name Brand Investing". Very recent developments from Senator Kaufman of Delaware will be putting the spit-shined patina of Wall Street's most powerful bank to the test. Here is a link to the speech that the esteemed Senator from Delaware (yes, the most corporate friendly state in this country). A few excerpts to liven up your morning...
Mr. President, last Thursday, the bankruptcy examiner for Lehman Brothers Holdings Inc. released a 2,200 page report about the demise of the firm which included riveting detail on the firm's accounting practices. That report has put in sharp relief what many of us have expected all along: that fraud and potential criminal conduct were at the heart of the financial crisis.
... Only further investigation will determine whether the individuals involved can be indicted and convicted of criminal wrongdoing.
... Lehman structured its repo agreements so that the collateral was worth 105 percent of the cash it received - hence, the name "Repo 105." As explained by the New York Times' DealBook, "That meant that for a few days - and by the fourth quarter of 2007 that meant end-of-quarter - Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was." [Hey, I can name several banks that are doing that right now. One might even rhyme with the name Max]
... Even worse, Lehman's management trumpeted how the firm was decreasing its leverage so that investors would not flee from the firm. But inside Lehman, according to the report, someone described the Repo 105 transactions as "window dressing," a nice way of saying they were designed to mislead the public.
... Mr. President, the SEC and Justice Department should pursue a thorough investigation, both civil and criminal, to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet - and that means everyone from the Lehman executives, to its board of directors, to its accounting firm, Ernst & Young. Moreover, if the foreign bank counterparties who purchased the now infamous "Repo 105s" were complicit in the scheme, they should be held accountable as well.
... Mr. President, it is high time that we return the rule of law to Wall Street, which has been seriously eroded by the deregulatory mindset that captured our regulatory agencies over the past 30 years [Preach on my brother from another mother...]
The allure of deregulation, instead, led to the biggest financial crisis since 1929. And now we're learning, not surprisingly, that fraud and lawlessness were key ingredients in the collapse as well. Since the fall of 2008, Congress, the Federal Reserve and the American taxpayer have had to step into the breach - at a direct cost of more than $2.5 trillion - because, as so many experts have said: "We had to save the system."
But what exactly did we save? [Don't get me started...]
First, a system of overwhelming and concentrated financial power that has become dangerous. It caused the crisis of 2008-2009 and threatens to cause another major crisis if we do not enact fundamental reforms. Only six U.S. banks control assets equal to 63 percent of the nation's gross domestic product, while oversight is splintered among various regulators who are often overmatched in assessing weaknesses at these firms.
... a system in which the rule of law has broken yet again. Big banks can get away with extraordinarily bad behavior - conduct that would not be tolerated in the rest of society.
Mr. President, what lessons should we take from the bankruptcy examiner's report on Lehman, and from other recent examples of misleading conduct on Wall Street? I see three.
First, we must undo the damage done by decades of deregulation. That damage includes financial institutions that are "too big to manage and too big to regulate" (as former FDIC Chairman Bill Isaac has called them), a "wild west" attitude on Wall Street, and colossal failures by accountants and lawyers who misunderstand or disregard their role as gatekeepers. The rule of law depends in part on manageably-sized institutions, participants interested in following the law, and gatekeepers motivated by more than a paycheck from their clients. [Amen!!!!!!! Ladies and gentlemen, Reggie brings you:
When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM's derivative exposure is even worse than Bear Stearns and Lehman's derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don't we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008, three months before their collapse) and Lehman ("Is Lehman really a lemming in disguise?": On February 20th, 2008, months before their collapse) by taking a close, unbiased look at their balance sheet. Don't let anyone tell you that these companies' collapse couldn't have been seen coming. I saw them coming and I clearly articulated it in BoomBustBlog just as I am warning YOU, NOW! And now, back to the esteemed Senator's speech...]
Second, we must concentrate law enforcement and regulatory resources on restoring the rule of law to Wall Street. We must treat financial crimes with the same gravity as other crimes, because the price of inaction and a failure to deter future misconduct is enormous.
Third, we must help regulators and other gatekeepers not only by demanding transparency but also by providing clear, enforceable "rules of the road" wherever possible. That includes studying conduct that may not be illegal now, but that we should nonetheless consider banning or curtailing because it provides too ready a cover for financial wrongdoing. [My dear Senator, might I suggest allowing accountants to return to making accounting rules rather than lobbyists and politicians. A clear and quick reinstatement of the mark to market rules (and insuring that they are aptly enforced) will go a very long way with practically no legislation. Please, please see "About the Politically Malleable FASB, Paid for Politicians, and Mark to Myth Accounting Rules". Of course, a practical action such as this may very well force the market to return to being valued off of fundamentals versus rumors, innuendo, gossip and 5 SPARC servers arguing with each other through high frequency trading algorithms...
If the engineered bear market rally is running off of the FASB generated lies, then we certainly do have another crash coming, don't we? ]
The bottom line is that we need financial regulatory reform that is tough, far-reaching, and untainted by discredited claims about the efficacy of self-regulation...
We wanted to make certain that the Department of Justice and other law enforcement authorities had the resources necessary to investigate and prosecute precisely the sort of fraudulent behavior allegedly engaged in by Lehman Brothers...
Many have said we should not seek to "punish" anyone, as all of Wall Street was in a delirium of profit-making and almost no one foresaw the sub-prime crisis caused by the dramatic decline in housing values. [HA! I think the technical term for this statement is..... BULLSHIT!!!
The Commercial Real Estate Crash Cometh, and I know who is leading the way! (a year before the CRE crash) It wasn't hard to see that commercial real estate was ready to implode and that GGP was about to collapse under its own weight. Why didn't our regulators see what I saw?
Yeah, Countrywide is pretty bad, but it ain't the only one at the subprime party... Comparing Countrywide Countrywide and Washington Mutual's collapse were visible AT LEAST a year in advance!
As I see it, 32 commercial banks and thrifts may see the feces hit the fan blades (a year before they started to fall) It wasn't hard to see that nearly all of these 32 banks would be facing the threat of insolvency. Why didn't our regulators see what I saw?
The Next Shoe to Drop: Credit Default Swaps (CDS) and Counterparty Risk - Beware what lies beneath! Warned a year ahead. 'Nuff said...
Here's Another "I Told 'ya So" for the Muni Buyers: Two years ago I warned that our municipalities will probably start defautling
Is this the Breaking of the Bear?: On Sunday, 27 January 2008, three months before their collapse
"Is Lehman really a lemming in disguise?": On February 20th, 2008, months before their collapse
and Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion in Equity 11/29/2007 I made it clear that not only are these companies insolvent with business models based upon near fraudulent relationships with ratings agencies, but the entire MBS business will come crashing down - 3 years ago.]
This is about addressing the continuum of behavior that took place - some of it fraudulent and illegal -- and in the process addressing what Wall Street and the legal and regulatory system underlying its behavior have become.
As part of that effort, we must ensure that the legal system tackles financial crimes with the same gravity as other crimes. When crimes happened in the past (as in the case of Enron, when aided and abetted by, among others, Merrill Lynch, and not prevented by the supposed gatekeepers at Arthur Andersen), there were criminal convictions. If individuals and entities broke the law in the lead up to the 2008 financial crisis (such as at Lehman Brothers, which allegedly deceived everyone, including the New York Fed and the SEC), there should be civil and criminal cases that hold them accountable...
If we uncover bad behavior that was nonetheless lawful, or that we cannot prove to be unlawful (as may be exemplified by the recent reports of actions by Goldman Sachs with respect to the debt of Greece), then we should review our legal rules in the US and perhaps change them so that certain misleading behavior cannot go unpunished again. [Oh, I will assist you on expounding on Goldman a few paragraphs below. I hope you are reading this blog!] This will not be easy. As the Wall Street Journal's "Heard on the Street" noted last week, "Give Wall Street a rule and it will find a loophole."
Systemic issues in Uncovering and Prosecuting Fraud This confirms what I heard On December 9 of last year, when I convened an oversight hearing on FERA. As that hearing made clear, unraveling sophisticated financial fraud is an enormously complicated and resource-intensive undertaking, because of the nature of both the conduct and the perpetrators. [My Senatorial Friend, you should more time in the blogosphere. Not only would you have realized that it was quite possible to see the crash of 2008 coming, but it is also quite possible to see the crash of 2010 coming as well as unraveling financial fraud. Our system is wrought with regulatory capture. If someone is paid (either directly or subvertly) not to see something, they probably will not see it - reference How Regulatory Capture Turns Doo Doo Deadly and Lehman Brothers and Its Regulators Deal the Ultimate Blow to Mark to Market Opponents.]
Rob Khuzami, head of the SEC's enforcement division, put it this way during the hearing:
"White-collar area cases, I think, are distinguishable from terrorism or drug crimes, for the primary reason that, often, people are plotting their defense at the same time they're committing their crime. They are smart people who understand that they are crossing the line, and so they are papering the record or having veiled or coded conversations that make it difficult to establish a wrongdoing."
In other words, Wall Street criminals not only possess enormous resources but also are sophisticated enough to cover their tracks as they go along, often with the help, perhaps unwitting, of their lawyers and accountants. [Listen, a thief is a thief. Some are smart, some are not. Wall Street comes nowhere near having a monopoly on craftiness nor intelligence. I have given many instances in the paragrahp above where I have caught companies in many a shenanigan and anticipated in illustrious detail the biggest crashes of this lifetime that no one apparently saw coming. I did this with a small cadre of analysts and an unbiased eye. It had nothing to do with my being smart! Imagine if I was paid to do this and more without outside influences and biases!]
Is Lehman Brothers an Isolated Example?
Mr. President, I'm concerned that the revelations about Lehman Brothers are just the tip of the iceberg. We have no reason to believe that the conduct detailed last week is somehow isolated or unique. Indeed, this sort of behavior is hardly novel. Enron engaged in similar deceit with some of its assets. And while we don't have the benefit of an examiner's report for other firms with a business model like Lehman's, law enforcement authorities should be well on their way in conducting investigations of whether others used similar "accounting gimmicks" to hide dangerous risk from investors and the public. [I don't know about the government, but I definitely have my guys digging deep holes.]
The Case of Greece
At the same time, there are reports that raise questions about whether Goldman Sachs and other firms may have failed to disclose material information about swaps with Greece that allowed the country to effectively mask the full extent of its debt just as it was joining the European Monetary Union (EMU). We simply do not know whether fraud was involved, but these actions have kicked off a continent-wide controversy, with ramifications for U.S. investors as well.
In Greece, the main transactions in question were called cross-currency swaps that exchange cash flows denominated in one currency for cash flows denominated in another. In Greece's case, these swaps were priced "off-market," meaning that they didn't use prevailing market exchange rates. Instead, these highly unorthodox transactions provided Greece with a large upfront payment (and an apparent reduction in debt), which they then paid off through periodic interest payments and finally a large "balloon" payment at the contract's maturity. In other words, Goldman Sachs allegedly provided Greece with a loan by another name.
The story, however, does not end there. Following these transactions, Goldman Sachs and other investment banks underwrote billions of Euros in bonds for Greece. The questions being raised include whether some of these bond offering documents disclosed the true nature of these swaps to investors, and, if not, whether the failure to do so was material.
These bonds were issued under Greek law, and there is nothing necessarily illegal about not disclosing this information to bond investors in Europe. At least some of these bonds, however, were likely sold to American investors, so they may therefore still be subject to applicable U.S. securities law. While "qualified institutional buyers" (QIBs) in the U.S. are able to purchase bonds (like the ones issued by Greece) and other securities not registered with the SEC under Securities Act of 1933, the sale of these bonds would still be governed by other requirements of U.S. law. Specifically, they presumably would be subject to the prohibition against the sale of securities to U.S. investors while deliberately withholding material adverse information.
The point may be not so much what happened in Greece, but yet again the broader point that financial transactions must be transparent to the investing public and verified as such by outside auditors. AIG fell in large part due to its credit default swap exposure, but no one knew until it was too late how much risk AIG had taken upon itself. Why do some on Wall Street resist transparency so? Lehman shows the answer: everyone will flee a listing ship, so the less investors know, the better off are the firms which find themselves in a downward spiral. At least until the final reckoning.
As I said more than a year ago: "At the end of the day, this is a test of whether we have one justice system in this country or two. If we don't treat a Wall Street firm that defrauded investors of millions of dollars the same way we treat someone who stole 500 dollars from a cash register, then how can we expect our citizens to have faith in the rule of law? For our economy to work for all Americans, investors must have confidence in the honest and open functioning of our financial markets. Our markets can only flourish when Americans again trust that they are fair, transparent, and accountable to the laws."
The American people deserve no less.
Whoa! That was some speech coming out of a the senate. You see, it is admirable that Senator Kaufman, and even Senator Dodd are trying to reign in entities that are distorting the financial landscape, but I feel they could accomplish so much more if they really knew how to pick apart these companies to see what is beneath the hood, how it works, and how it has been applied to transactions in the past.
In the post, "Smoking Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer Beware!" I illustrated the swap deal that appears to be at the center of one of Senator Kaufman's issues:
According to people familiar with the matter interviewed by China Securities Journal, Goldman Sachs Group Inc. did as many as 12 swaps for Greece from 1998 to 2001, while Credit Suisse was also involved with Athens, crafting a currency swap for Greece in the same time frame.
Under its "off-market" swap in 2001, Goldman agreed to convert yen and dollars into euros at an artificially favorable rate in the future. This helped Greece to use that "low favorable rate" when it recorded its debt in the European accounts-pushing down the country's reported debt load.
Moreover, in exchange for the good deal on rates, Greece had to pay Goldman (the amount wasn't revealed). And since the payment would count against Greece's deficit, Goldman and Greece came up with another twist: Goldman effectively loaned Greece the money for the payment, and Greece repaid that loan over time. And the two sides structured the loan as another kind of swap. So, the deal didn't add to Greece's debt under EU rules. Consequently, Greece's total debt as a percentage of GDP fell from 105.3% to 103.7%, and its 2001 deficit was reduced by a tenth of a percentage point in GDP terms, according to people close to Goldman.
Another action that smacks of Hellenic manipulation, at least to the staff of BoomBustBlog: for years it apparently and simply omitted large portions of its military-equipment spending from its deficit calculations. Though, European regulators eventually prevailed on Greece to count everything and as a result, in 2004, there was a massive revision of Greek deficit figures from 2000 (a budget deficit of 2.0% of GDP in 2000 to beyond the 3% deficit limit in 2004), by then Greece had already gained entrance to the euro. As in my trying to prepare for the coming sovereign debt crisis, timing is everything, isn't it???
This is far, far from the only instance where it appears Goldman may have not given full disclosure to its prospective and actual clients. Before we get to a few other anecdotal instances, let's review exactly how profitable this company really is if we were to take an objective, risk-adjusted view. After all, the apparent shenanigans that are mentioned throughout this post and by Senator Kaufman are quite risky, aren't they?
Goldman is a very, very well run company. It is loved by some, reviled by others, but in the end it is respected for something that it truly does not deserve. That something is the ability to make an above average return on risk adjusted capital. Goldman takes gobs of risk! From an economic income perspective, it is mediocre to average at best. See "For Those Who Chose Not To Heed My Warning About Buying Products From Name Brand Wall Street Banks"
GS return on equity has declined substantially due to deleverage and is only marginally higher than its current cost of capital. With ROE down to c12% from c20% during pre-crisis levels, there is no way a stock with high beta as GS could justify adequate returns to cover the inherent risk. For GS to trade back at 200 it has to increase its leverage back to pre-crisis levels to assume ROE of 20%. And for that GS has to either increase its leverage back to 25x. With curbs on banks leverage this seems highly unlikely. Without any increase in leverage and ROE, the stock would only marginally cover returns to shareholders given that ROE is c12%. Even based on consensus estimates the stock should trade at about where it is trading right now, leaving no upside potential. Using BoomBustBlog estimates, the valuation drops considerably since we take into consideration a decrease in trading revenue or an increase in the cost of funding in combination with a limitation of leverage due to the impending global regulation coming down the pike. Using your method, our valuation would drop from where it is to an even lower point.
Second, it still has a bunch of trash on its balance sheet, seeReggie Middleton vs Goldman Sachs, Round 2. If you look at the period of the most recent credit bubble, Goldman did everything that the other failed and bailed out banks did: leveraged up on trash assets, invested in and sold the worthless junk, and ran to the government for aid and bailouts:
So, what is GS if you strip it of its government protected, name branded hedge fund status. Well, my subscribers already know. Let' take a peak into one of their subscription documents (Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb - 131 pages). I believe many with short term memory actually forgot what got this bank into trouble in the first place, and exactly how it created the perception that it got out of trouble. The (Off) Balance Sheet!!!
Contrary to popular belief, it does not appear that Goldman is a superior risk manager as compared to the rest of the Street. They may the same mistakes and had to accept the same bailouts. They are apparently well connected though, because they have one of the riskiest balance sheet compositions around yet managed to get themselves insured and protected by the FDIC like a real bank. This bank's portfolio looked quite scary at the height of the bubble.
As a matter of fact, it looks just as scary today as it does at the height of the bubble, but since very few people read balance sheets, no one really notices.
You know what most people don't realize is that it looks quite scary now as well.
Senator Kaufman justifiably takes issue with Goldman selling European sovereign debt securities without full disclosure. If the honorable Senator were to dig a little deeper, he would find that there may be a lot more to that theory than he initially believed...
In April of 2006, a Goldman Sachs formed "Goldman Sachs Alternative Mortgage Products", an entity that pushed residential mortgage backed securities to its victims clients through GSAMP Trust 2006-S3 in a similar fashion to the sales and marketing of the CRE CMBS that is being pushed to its victimsclients as described in the links above. The residential real estate market faced very dire fundamental and macro headwinds back then, just as the commercial real estate market does now. I don't think that is the end of the similarities, either.
Less then a year and a half after this particular issue was floated, a sixth of the borrowers defaulted on the loans behind this product, according to CNN/Fortune, where the graphic below was sourced from.
Here's an excerpt from the article of October 2007 (less than a year after the issue was sold to Goldman clients, clients who probably didn't know that Goldman was short RMBS even as Goldman peddled this bonus bulging trash to them):
By February 2007, Moody's and S&P began downgrading the issue. Both agencies dropped the top-rated tranches all the way to BBB from their original AAA, depressing the securities' market price substantially.
In March, less than a year after the issue was sold, GSAMP began defaulting on its obligations. By the end of September, 18% of the loans had defaulted, according to Deutsche Bank.
As a result, the X tranche, both B tranches, and the four bottom M tranches have been wiped out, and M-3 is being chewed up like a frame house with termites. At this point, there's no way to know whether any of the A tranches will ultimately be impaired...
,,, Goldman said it made money in the third quarter by shorting an index of mortgage-backed securities. That prompted Fortune to ask the firm to explain to us how it had managed to come out ahead while so many of its mortgage-backed customers were getting stomped.
Just one month later from Bloomberg:
Feb. 23 (Bloomberg)
Representative Darrell Issa, the ranking Republican on the House Committee on Oversight and Government Reform, placed into the hearing record a five-page document itemizing the mortgage securities on which banks such as Goldman Sachs Group Inc. and Societe Generale SA had bought $62.1 billion in credit-default swaps from AIG...
The public can now see for the first time how poorly the securities performed, with losses exceeding 75 percent of their notional value in some cases. Compounding this, the document and Bloomberg data demonstrate that the banks that bought the swaps from AIG are mostly the same firms that underwrote the CDOs in the first place.
The banks should have to explain how they managed to buy protection from AIG primarily on securities that fell so sharply in value, says Daniel Calacci, a former swaps trader and marketer who's now a structured-finance consultant in Warren, New Jersey. In some cases, banks also owned mortgage lenders, and they should be challenged to explain whether they gained any insider knowledge about the quality of the loans bundled into the CDOs, he says. [Let's not play games here. The banks knew what trash was hidden where!]
"It's almost too uncanny," Calacci says. "If these banks had insight into the underlying loans because they had relationships with banks, originators or servicers, that's at the least unethical." [At the very least. I think it's called ILLEGAL!]
The identification of securities in the document, known as Schedule A, and data compiled by Bloomberg show that Goldman Sachs underwrote $17.2 billion of the $62.1 billion in CDOs that AIG insured -- more than any other investment bank. Merrill Lynch & Co., now part of Bank of America Corp., created $13.2 billion of the CDOs, and Deutsche Bank AG underwrote $9.5 billion.
These tallies suggest a possible reason why the New York Fed kept so much under wraps, Professor James Cox of Duke University School of Law says: "They may have been trying to shield Goldman -- for Goldman's sake or out of macro concerns that another investment bank would be at risk."
This is all gathered from anecdotal, occasional blogging. If someone such as myself were to really dig in and search for smoking guns, I am confident smoldering canons will be revealed. I think the electorate should stand be behind Senator Kaufman for his willingness to clean up a system which has become too one--sided, too political, and (darest I say it), too corrupt.
More of Reggie on Goldman Sachs:
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