April 19, 2010
Good morning. It was a very interesting close to the week last Friday, with the combined Google earnings disappointment and the civil complaint lodged against Goldman Sachs affecting the market. Still, the SPY managed to close only slightly down on the week at 119.36. That represents a loss of only .19 or .2%. The VIX, however, closed Friday with powerful gain of over 13% at 18.36, the highest close since the 25th of March. I was actually very surprised, and somewhat disappointed, that the market did not close even lower on Friday. With GS down 23.57 and GOOG down 45.12, the rest of the market actually held up very well, with the S&P down only 21 points. Those of you in the SPY Protected Index Program probably noticed that we were involved in an expiration type ratio backspread, a spread that benefits from unusual movement in the stock. We had a couple of solid adjustments as the SPY had rallied during the week, and at the last few minutes of trading Friday would have seriously benefited from a last minute sell-off. It went a little our way, but more would have been nice as collectively we would have benefited more than $200,000 per point under 119 in the SPY. At least our spread had us in the game and ready to take advantage.
Clearly the news about Goldman Sachs on Friday was a shocker, both in terms of substance and timing. The substance is that the SEC’s new enforcement arm is taking on Wall Street’s most storied firm, and doing it in a way that does not seem to give us the normal outcome (without admitting or denying any wrongdoing the firm will pay $2M to the SEC and revise behavior going forward). In this case it would seem that the SEC really wants to identify wrongdoing and get some money back to those allegedly aggrieved. The timing, seemingly dovetailing with the President’s Financial Reform package struggling its way through Congress, is certainly causing suspicious eyebrows to be raised by the conspiracy theorists. What does seem clear, and what has been obvious to anyone in the business for years and years, is that major firms like Goldman seem very comfortable being on every side of a transaction and in their own mind are immune to any sort of conflict of interest.
In this particular complaint it is alleged that one of the relatively young (but very well compensated) Vice Presidents, Fabrice Tourre, put together a Collateralized Debt Obligation of mortgages of various qualities, allowing input on the selection by a third party. That third party, Paulson and Company, went on to essentially bet against the baskets of mortgages that they helped put together, as Goldman recommended the same basket to a couple of European Banks. So the complaint alleges that Goldman essentially withheld very important information from their European customers, making them more willing to buy a security that virtually became worthless. The decline in the value generated large profits for Paulson and Co. as they had taken a short position. It sure seems like Goldman is very comfortable, and always has been, advising people on every side of a transaction, something that surely would never fly in law, real estate, or common sense. How many or you would be comfortable in court if your attorney also represented the person you were suing, or the person that attacked you?
How have we, as a society, allowed certain firms and industries to take us places that are moral dead ends? I really believe that, as a firm, Goldman is amoral. Their position of influence has allowed them to do things that virtually every American would feel is a conflict, yet instead of being called on it and forced to change, they are almost rewriting morals standards. Ignore this particular issue for a little while, and instead let’s focus or just a regular IPO, something that Goldman is deeply involved in. If a firm, like PTI for instance, were to grow to the point where it should go public we might hire a firm like Goldman to advise us and to value us to the rest of the world. Now PTI would pay handsomely for this, both as an hourly fee and for guarantees of consulting work and such after. At the same time Goldman is collecting higher than normal commissions (or otherwise devising a list of key clients) that they allow to participate in IPO”s. If it is a “hot” IPO these people are essentially being advised that the stock is worth way more than the price Goldman is telling PTI, even though we are paying for the right valuation. So the same firm is telling me that PTI’s stock is worth $20, while telling a whole other group that has paid somehow for their “privilege” that the stock is worth $30 at least. How can one firm be on both sides here? Add to that that the firm will actually be an owner of the stock (as an underwriter) for some period of time. So they are an advisor to the seller, advisor to the buyer, getting paid specifically for conflicting advice on both sides, and they are going to profit on the trade between both sides. Nice!! Yet it has gone on so long it has become the new morality.
How can any trade where a broker takes an opposite side from his client not be a potential conflict? If I advise you to buy a certain stock, then I turn around and sell it to you, how is it possible for that to not be a conflict? There might be that once in a while thing where the market is not liquid and something has to happen fast, in which case the firm might actually be providing a service by taking the other side of a trade, but I will say it is rare and another contra party could most likely have been found. By and large we at PTI have found it is very possible to do large trades in somewhat illiquid areas if you aggressively work the order. It would be a lot easier, and potentially more profitable, to just say “We can’t find someone willing to take you out at $16, but we will step up and take you out at $15.25, when I might have already found a $15.75 bid in Europe.” Once I put myself in the profit equation on the trade itself it is surely clear (to me anyway) that I can no longer be trusted as your agent. Yet these guys are make billions each year doing just that. I think there should be a reform package, but it could probably go on one page and consist of a few basic principals of trade. Remember, the SEC was a large part of the problem, how can they also be the solution? Mary Shapiro to go from seeing nothing to being all over this stuff? Not likely. Take for instance the huge sell trades in C and a few other bank stocks Thursday afternoon. You don’t suppose someone got wind of this complaint early and did something, do you?
Time to buy Goldman stock down here? Stock is down 18% in two days as of this moment, and as of now is a nice seven time earnings. In addition, Goldman comes out with earnings tomorrow and they usually surprise to the upside. Clearly, it depends of where you think they come out on this lawsuit. If you think it comes out like it seems to always have in the past, one VP or so takes the fall, small fine, some restitution to German Banks, revise procedures, be more careful, not admit or deny, et., you probably want to start picking a price to jump in. If you want to see if this time the problem might grow instead of recede, and maybe this new SEC fellow might be onto something that will only grow after he talks to Goldman people, then you want to stay clear. Which you think is right, or how cynical you are about government legal talent, will determine your course of action. We will keep a sharp eye on the option volatility to see if some opportunity will arise.
What happened to GS and GOOG on Friday is exactly why we put on long premium positions near expiration if implied volatilities are low. The world was pricing in that there would be no outside shock to the market last week, yet there was one. We were not that far away from a day where S&P’s could have been down 40 or 50, and our spread would have paid off handsomely. The market still does not want to roll over, and maybe will not for a long time, but if the implied volatilities remain as low as last week we will continue to try and take advantage of the low price. I also think the bonds may have rallied back to a point where we should look at shorting them again.