Top Gun FP Client Note: Blowout Earnings Overshadowed by SEC Suit Against Goldman

NOTE: Every week I write a Client Note for my clients.  For a limited time, I am allowing non-clients to sign up and receive the Client Note.  You can sign up at the top right hand corner of the website.  I will also be posting the notes on my blog with a 24-48 hour delay from time to time.  Here is this week’s.
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Earnings season kicked off in earnest last Tuesday afternoon when Intel (INTC) reported a blowout 1st quarter.  Revenue was up 44% and net income 277% from the year ago period emboldening CEO Paul Otellini to call it “Intel’s best first quarter ever”.  Intel’s numbers helped power the S&P through 1200 on Wednesday.
 
The same afternoon CSX (CSX), one of the country’s largest railroads with operations concentrated on the east coast, also reported a solid quarter.  Rail volumes have stabilized at low levels but pricing improved in the 1st quarter with rail revenue per unit up 8.9% to $2,199.  That resulted in a 11% increase in revenue and a 21% increase in net income.
 
On Wednesday afternoon, UPS (UPS) preannounced a good quarter including a slight year over year increase in US domestic daily volume.
 
Thursday after the close, Google (GOOG) reported excellent 1st quarter earnings with revenues after traffic acquisition costs up 25% and net income 33% compared to the year ago period.  Even so, Google shares dropped $45 (7.6%) on Friday, aggravated by the SEC’s suit against Goldman Sachs.
 
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The SEC’s fraud suit against Goldman on Friday stole the show.  The SEC charged Goldman with failing to disclose material information in its marketing of a synthetic CDO known as Abacus 2007-AC1.  Parties on one side of the transaction lost $1 billion on Abacus 2007-AC1 while John Paulson’s hedge fund, which was on the other side of the deal, made $1 billion.
 
The SEC claims that Paulson was involved in selecting the mortgage backed securities that went into the Abacus CDO, so that he could short it, but the buyers were not informed about Paulson’s involvement.  According to the SEC, this was “material” information and failure to disclose it amounts to fraud.
 
As I first learned about and began to research the SEC’s charge on Friday and over the weekend, I was appalled that Goldman would do something like this.  How could they let Paulson select the worst mortgage backed securities to make up a CDO that they would then sell to their clients without telling them?  Clearly this was unethical and probably illegal. 
 
The one thing that didn’t add up was how Goldman expected to preserve its relationship with the clients it sold the CDO to after it blew up.  As a middleman, Goldman’s business is completely dependent on relationships and trust.  Setting up a client in this way would lead to a severing of the relationship and the loss of its future business.  Beyond being unethical and even illegal, acting in this way didn’t even make sense for Goldman from a business perspective.
 
It wasn’t until yesterday that it became clear to me that the SEC had engaged in a shady sleight of hand.  The whole case depends on an equivocation between a CDO and a synthetic CDO.  A CDO contains actual pieces of mortgages and other assets.  A synthetic CDO contains derivatives; not actual financial assets but contracts referencing the performance of financial assets.
 
Abacus 2007-AC1 was a synthetic CDO consisting of credit default swaps on a variety of mortgage backed securities.  Paulson was involved in the construction of the portfolio of CDSs though ACA managed the process.  In contrast with a regular CDO, a synthetic CDO like this by its very design has long and short parties.  One party sells the pool of CDS that make up the synthetic CDO and another party buys them.
 
Seen in this light, the SEC’s charges lose all their bite.  IKG and the other parties long Abacus 2007-AC1 knew someone else was on the other side of the trade.  That was at the very core of the deal.  Goldman didn’t disclose that it was Paulson because it is normal business practice for a market maker not to disclose the parties in a transaction like this.
 
The best piece written on the whole fiasco that I have read is The Wall Journal’s editorial “The SEC vs. Goldman” (e-mail me for a link to the full piece) from Monday’s paper.  This excerpt goes to the heart of the matter:

More fundamentally, the investment at issue did not hold mortgages, or even mortgage-backed securities. This is why it is called a “synthetic” CDO, which means it is a financial instrument that lets investors bet on the future value of certain mortgage-backed securities without actually owning them.

Yet much of the SEC complaint is written as if the offering included actual pools of mortgages, rather than a collection of bets against them. Why would the SEC not offer a clearer description? Perhaps the SEC’s enforcement division doesn’t understand the difference between a cash CDO–which contains slices of mortgage-backed securities–and a synthetic CDO containing bets against these securities.

More likely, the SEC knows the distinction but muddied up the complaint language to confuse journalists and the public about what investors clearly would have known: That by definition such a CDO transaction is a bet for and against securities backed by subprime mortgages. The existence of a short bet wasn’t Goldman’s dark secret. It was the very premise of the transaction.
[Another good article on the subject, which, however, doesn’t draw the obvious conclusion, is Andrew Ross Sorkin, “When Wall Street Deals Resemble Casino Wagers”, The New York Times, April 20, B1].
 
Unfortunately, because CDOs and synthetic CDOs are arcane financial instruments, there has been a lot of confusion and misunderstanding about the nature of the transaction in the media coverage.  Even usually sophisticated financial reporters have swallowed the SEC’s narrative without qualification, failing to draw the key distinction between a CDO and a synthetic CDO.
 
Once the fog is cleared away, it is obvious that the SEC’s motive is transparently political.  The main appeal of the case is not the legal merits but the high profile names of the parties involved.  It puts political pressure on Congress to pass pending financial reform and it supports the politically convenient narrative that greedy and corrupt Wall Street banks caused the financial crisis.  That interpretation justifies increased government involvement and regulation in financial markets.

YTD Returns (through 4/16)
S&P: +6.91%
DJ Total: +8.30%
Top Gun: +0.82%
 
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Greg Feirman
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Top Gun Financial (www.topgunfp.com)
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