"I'm doing God's work," said Goldman Sachs CEO Lloyd Blankfein in a newspaper interview last November. Today the Securities and Exchange Commission begs to differ, charging Goldman with defrauding investors in (pick a year, any year!) 2007. Specifically, the SEC alleges that the firm peddled a collateralized debt obligation (CDO) structured, and then shorted, by one of its own clients.
The client, hedge fund Paulson & Co., packed the CDO portfolio with residential mortgage-backed securities of the subslime variety, the kind built to fail during the mortgage frenzy of the mid-aughts. Then Paulson paid Goldman $15 million to market the ticking time bomb to well-heeled suckers. Goldman did so, failing to disclose to investors how or by whom the securities were selected. Meanwhile, Paulson purchased credit default swaps from Goldman as a bet that the portfolio would blow up. Which it did. Paulson made about a billion on the deal. The CDO investors were out the same amount.
MIT's Simon Johnson, blogging at baselinescenario.com, calls today's disclosure a watershed moment, the "Ferdinand Pecora moment" for which he has been waiting. He suggests that Blankfein has some explaining to do:
Either Blankfein knew what was going on – and is therefore liable before the law – or he was clueless and therefore incompetent. Either way, the much vaunted risk management and control systems of Goldman, i.e., what is supposed to prevent this kind of thing from happening, are exposed to be what we have long here claimed: bunk.
And don't think Goldman was the only one playing fast and loose. In the words of Minyanville's Jeff Macke: "if Goldman is dirty, Citi is Pig Pen from Peanuts." The selling of financial dark matter was (still is?) an industry-wide problem with consequences yet to be fully suffered.
I wish the SEC had made its announcement 48 hours earlier. Since July I have been trading around a bearish position on the U.S. financial sector, using an inverse exchange-traded fund. The sector nearly imploded in September 2008 before the TARP bailout bought the big banks some time. But with a new wave of mortgage defaults expected this year, I figured that time was about to run out. Silly me. When JP Morgan Chase reported boffo first-quarter earnings on Wednesday and sent bank stocks en fuego, the pain became too great. I sold my ETF shares and started looking for tech longs instead.
Now the bank trade is back on. The SEC announcement comes after a relentless stock-market rally that has left even the bulls scratching their heads. In other words, we were due for a correction anyway. Add to the mix the risk of sovereign debt default (don't forget, Greece cooked its books with interest-rate swaps sold by Goldman Sachs, another piece of God's work) and a broken circle of trust, and we could have a rout on our hands. Options expiration may help prop the market today. Monday, though, could get interesting.
The stock market has been discounting a narrow slice of reality, the relative prosperity of a castle economy. Those inside the walls get to share the free money printed by the Federal Reserve and build their wealth on inflated paper assets. The unemployed and underemployed stranded outside the moat cannot understand what the party is all about. Could it be that the retail-sales boomlet in March was merely an artifact of transitory stimuli? I'm thinking of higher-than-normal tax refunds, redirected mortgage payments by strategic defaulters (the so-called "squatters' stimulus"), extended (for how long?) unemployment benefits, deep auto discounts (the Toyota-defect stimulus), an early Easter, summer-like weather, and temporary census hiring. Take those away, and what do you get?
A double dip.