txlaw

It's too hard to say whether the market will pull back anytime soon, but I can tell you that I have a 20% cash position just in case and that the positions I hold are all still very undervalued. I am overweight financials at the moment.

Thanks for posting that, Myth. The lawyer, David Boies, is a very famous American trial lawyer. He represented the DOJ in the Microsoft antitrust suit, Napster when they were sued by the RIAA, and Al Gore in Bush v. Gore. I believe he also represented Andy Fastow in the Enron debacle (Fastow, the most culpable person in the room, got off easy by singing like a canary). You have to be very careful listening to what David Boies says because he's a genius and because he's probably choosing his words carefully in order not to lose potential business. He likes taking on hard (and lucrative) cases like this. I have a couple quibbles with some of the things that were said by the guests. Andrew Ross Sorkin repeats the "two sides of the trade" argument, and Boies talks about how everyone likes to hate on short sellers. But as I have argued previously, this is a "hide the ball" argument. (I found a pretty good post by a blogger that more fully articulates my position; see http://www.interfluidity.com/v2/784.html). The real problem is that there was an implication in the marketing material that the reference portfolio was being selected solely by a long only investor when, in fact, a short investor was also involved in picking and choosing what to include. Andrew Ross Sorkin also brings up an example with WEB that is misleading. First, I don't think the SEC case is based on the particular identity of the individual who helped select the reference portfolio at issue. That's an argument that's being thrown out there so that Goldman and others can argue that the whole suit is based on hindsight bias. The key is that there was a person who allegedly helped select the reference portfolio and who was short the porfolio but who was not disclosed to the investors. When I say investors, I mean investors other than ACA. Second, Sorkin's WEB example is an extension of the "two sides of the trade" fallacy. In Sorkin's example, there is no long-only selection agent who is selecting the portfolio. His example would be more appropriate for a trade where Goldman was the intermediary brokering an OTC credit default swap contract. David Boies also briefly mentions that the case is about "affirmative misrepresentation." But I'm not so sure that's the case -- I believe omissions can also be actionable. So the question is whether nondisclosure in the context of the deal was enough to violate the securities laws. It is always easier to prove fraud when there is an affirmative misrepresentation; when culpability rests on omission of a material fact, it is usually a more difficult case to prove. The guests are all absolutely right about the politics involved, though.

It's somewhat of a coincidence that I'm hearing more about Crohn's lately (after hardly knowing anything about it). Yesterday my neighbor was telling me that people are getting treatment by exposing themselves to hookworms, of all things. http://en.wikipedia.org/wiki/Helminthic_therapy There was an interesting first person account of using hookworm to treat severe asthma that was posted several years ago on Kuro5hin.org. http://www.kuro5hin.org/story/2006/4/30/91945/8971 It was a more controversial topic when this guy originally did it. It is pretty fascinating account to read. Apparently this approach works on many autoimmune diseases by giving your immune system something else to attack (instead of your immune system attacking its own body) Weird! I was just listening to a This American Life episode today called Enemy Camp 2010, where one of the stories involved a dude who cured his severe allergies by giving himself hookworm. The guy now sells hookworm that he collects from his own feces as a cure for allergies and other autoimmune ailments. He says he's astonished that more people aren't lining up to buy hookworm from him for things like Crohn's. http://www.thisamericanlife.org/radio-archives/episode/404/enemy-camp-2010

Rabbitisrich, your argument is the most sound argument against finding Goldman liable that I've heard so far on the board. The other arguments are just rehashes of Goldman's PR/attorney propaganda. The salient question is whether the info about Paulson's involvement was material enough to be disclosed and whether Goldman should have known to disclose it. You believe that this was not material or that it's too close to call (in the grey area). That is a legitimate stance on the issue.

Totally agreed!

Wiessman, for what it's worth, I've made a somewhat detailed argument against Goldman in another thread. Not sure if you've taken a look at it. See

Mungerville, I was thinking exactly the same thing.

Agreed on the need to update the statutes and regs for modern finance. They were definitely wrong. Not so sure though that many of the bad actors who worked at Goldman would ever be concerned with the firm's reputation. Management would certainly be concerned, but the employees who were only looking to strike it rich in a short amount of time wouldn't necessarily care that much about the firm's primary dealer status. That's the problem with having so many different types of business housed under one "investment banking" roof. There are inherent conflicts of interest, and the culture of some subsidiaries -- prop trading desks -- can infect the more client-centric subsidiaries.

Here is a much better WSJ article on the real issues involved with the case. http://online.wsj.com/article/SB20001424052748703594404575192473240271764.html

I completely disagree that this is a fundamental rewrite of securities law. I am not a securities lawyer, but from what I know of the Securities Exchange Act, it is written very broadly to catch all sorts of fraudulent behavior. Furthermore, to rebut any charges of fraud by noting that there is always two parties to a transaction is preposterous. If you do a deal with someone where you are long and they are short the underlying asset, if they fail to disclose material information or affirmatively misrepresent the nature of the transaction, that is grounds for claiming fraud in many cases. Indeed, that happens all the time in Main Street transactions. If anything, this is a fundamental change in the enforcement behavior of the SEC, which has grown fat and lazy over the last couple of decades (or perhaps it never was that great an enforcer). Underwriters will no longer be able to get away with as much as they have in the past when marketing their offerings. The "everybody's doing it" excuse will no longer hold any water with this SEC, which has to restore its own badly damaged reputation. Also, remember that at the moment, it is the government, not any buyers who suffered losses, who is suing, although those suits will surely follow. Reputational risk has become less and less important of a factor in regulating the behavior of the investment banks because the employees have been able to offload all the risk onto their shareholders. All the employees who created this mess were able to cash out to some degree before the crisis. There was no partnership at stake. It's the whole argument over the partnership versus public company nature of investment banks. The "old school" rules don't apply in this new world of publicly held investment banks.

This is the single biggest misunderstanding about the entire sad episode. The structure was never guaranteed to crash. It was not engineered to fail. The game was far from fixed. You will be surprised how fixed the game is. I have worked for a broker/top 10 investment bank in the past, and market makers regularly take advantage of their clients b/c they have more information. Example: if you have a stop loss on your position, it's registered on the system. with a bit of searching and maybe some technology, your broker will hunt for these stop losses, and especially if its a small volume position, will clear out all the stop losses with their own capital, and then buy it back and on sell that in a rising market or to buyers ('ask' side of the book) who are willing to pay a higher price. They can do this b/c they can see all the orders on the system, and see the market depth of volume. this i found especially happened in the forex markets where the markets are unregulated without a central exchange. Brokers and market makers are talking to each other every day in the forex markets. Market makers have all the power in unregulated markets. Another example is in a highly volatile market, brokers/market makers will increase the spread you pay just as you are about to put a trade in, especially if you have a limit order registered on the system. My feeling is that b/c the CDS and CDO markets were unregulated the same sorts of advantages and behavior occured in those markets to/from the market makers. If you think the game isn't fixed, then you are either inexperienced or naive. Market makers, especially ones that have smart, greey and energetic people working for them (i.e. Goldman Sachs) always win ... or always try and fix the markets in their favor. The markets are not a casino, however the behaviour is similar to how the house always tries to fix the game in their favor with activity + insight. You think that GS with their position in the market place, wouldn't have been able to see Paulson's positions? and his thesis/reporting materials? Fabrice Tourre was well aware of the fact that there was a housing bubble in place as early as 2005/06 (it's a long read but NYT reported Gretchen Morgenson was in the loop way before everyone else: http://www.nytimes.com/2009/12/24/business/24trading.html) Well, you won't find me arguing against the notion that market makers/brokers are front running or taking advantages of spreads to the detriment of their customers or whatnot. My point was that the specific conduct of Goldman at issue should not be analogized to a broker/market maker because they were actually making representations regarding an offering in their marketing materials. And in this case, there is no question that Goldman understood Paulson's thesis. I mean, he specifically told them that he was bearish on the reference portfolio and that the data proving his case was readily available.

Actually, the idea that the SEC doesn't understand the difference between a cash CDO and synthetic CDO is truly asinine. As I have noted above, that's a red herring argument. The Journal is predictably espousing an opinion aligned with those on the wrong side of financial reform because of the upcoming elections. Don't get me wrong, I read the WSJ every day for its news content -- but the opinion page is shit, just like the NYT's.

Let's clear up a couple of issues here. First, nobody is getting prosecuted. The SEC has filed civil fraud charges against Goldman Sachs, and Goldman Sachs only. No complaints have been filed against Paulson & Co or any other investors who may have taken similar actions (for example, Magnetar). Second, the fact that we’re dealing with synthetic CDOs is irrelevant. Nobody is faulting the investors who purchased credit default swaps from Goldman on the mortgage-backed securities referenced in the synthetic CDO. The fact that there is a long and short side to a CDS trade is not the issue. Of course the synthetic CDO investors knew that this was the case. However, these investors did not know that the pool of short bets (CDSs) was assembled under the influence of someone whose incentives were not aligned with these purchasers. The underwriter, GS&Co, specifically indicated that the portfolio was being assembled by a party, ACA, that clearly had the same incentives as the purchasers. ACA was long the reference portfolio because they were guaranteeing the CDO bonds. Third, ACA’s incompetence is irrelevant to the claim that Goldman committed fraud by failing to disclose material information. ACA put their stamp of approval on these CDOs as collateral manager and paid for it by entering runoff when the shit hit the fan. There's no question that ACA has no excuse for their incompetence. But many Goldman defenders seem to be focusing on the part of the SEC complaint that states that ACA was misled because it is the easiest allegation to rebut. Fourth, who was on the right side of the trade is also irrelevant. It doesn't matter how Goldman or anyone else thought the reference portfolio would perform. The key is that Goldman failed to disclose info that may have given potential investors pause before buying these synthetic CDO securities. Wouldn't you think twice about purchasing a portfolio of securities marketed to you if you knew that the portfolio was assembled by someone who was net short these securities (or similar securities)? The key issues are: (1) whether Paulson & Co was involved in the selection of the reference portfolio, and (2) whether this information – Paulson & Co’s involvement – was material to the point where it should have been disclosed to potential investors. Whether the information was material depends on the context of the situation. Paulson & Co states that ACA had "sole authority" over selection of the portfolio and that they did not sponsor the creation of the ABACUS program. The SEC claims that Paulson was heavily involved in the selection of the portfolio and never states that Paulson had “authority” over selection. Additionally, the SEC’s complaint only talks about Paulson being the sponsor of a particular ABACUS transaction, not the entire program. The PR people and Paulson’s lawyers have carefully crafted their response to the complaint. In Goldman’s marketing material, they specifically talked about ACA’s role as the collateral manager and guarantor for the CDOs, implying that ACA and ACA alone would be involved in putting together the synthetic CDO. Indeed, internal conversations indicate that Goldman wanted to leverage ACA’s credibility in order to sell more of this stuff. But Goldman conveniently failed to mention that in this particular transaction someone other than ACA was also involved in selecting the reference portfolio. And that’s where the SEC will get them because I think the failure to disclose that info was material. Note: I am neither long nor short GS.

Yeah, I really hate the whole broker/market maker argument that Blankfein and the Goldman PR department keep repeating over and over again. When I buy a stock through my online discount broker, the broker doesn't make any representations regarding the prospects of the underlying business -- they merely act as a conduit for the transaction between the individuals who are either long or short on the trade. My broker does offer some research tools and opinions from third parties, but the broker itself makes no representations regarding the stock. This situation is different. Goldman actually underwrote these investment vehicles, playing the part of a manufacturer/assembler. In order to offload their assembled product, they selectively and inaccurately disclosed information about the selection of the underlying reference collateral. They made it appear that this third party financial guarantor, ACA, was the only entity involved in selecting the underlying reference collateral. But in reality, the sponsor of the SPE, Paulson & Co, was quite involved in the selection of the reference collateral. Furthermore, Goldman omitted the fact that the sponsor was actually net short the underlying reference collateral -- they may have even given the buyers the impression that Paulson was long only. This was a truly despicable and material misrepresentation/omission on Goldman's part. This enforcement action brings up the philosophical question about whether it's a good idea to allow a prop trading operation, broker/market maker, asset management company, and investment bank to be housed under one roof. Essentially, the client agnostic operations get the good reputation of the investment bank division, and the investment bank no longer has any skin in the game because their exposure can be hedged out across the entire company. The incentives are even more perverse because the client agnostic operations dominate in terms of providing the firm's profits. I think we want a system where the investment banks are concerned about the quality of their offerings and are not merely trying to maximize the volume of and spread associated with these transactions. At the very least, these companies should give the buyers of their assembled products full and complete disclosure.

Koo's thinking is colored by his experience with Japan. I agree that in the US and certain other countries, companies will get healthier quicker, which could potentially lead to a Japanese lost decade speeded up. Hoisington is correct to criticize the effectiveness of government spending in normal times, but these are not normal times, and he always fails to consider the counterfactual situation, which is what Koo's thinking is all about. We have Keynesian spending policies not because that is always the right thing to do, which is how many "conservatives" characterize the policy response (it fits very well with a political narrative about profligate "liberals" who always want to throw money at a problem), but because this is an unusual situation where the government must borrow and spend money in order to prevent an economic equilibrium where GDP is much lower and where unemployment is much higher. The next step is to ween the country off of life support and let the private sector replace the government as borrower and spender. Also, there's a big distinction between QE and fiscal stimulus, which people don't seem to get. They think it's all one and the same thing, but it's not. Koo is very explicit about his distaste for bringing down interest rates and implementing extraordinary measures (QE) as the solution to our problems. Note that if you believe Koo or David Rosenberg, you believe that interest rates will remain surprisingly low for a long time. This comports with Hoisington's forecast of deflation and low interest rates. It is Hoisington's insistence that the US government is trying to spend our way to prosperity that is maddening. That's not what is happening, despite what politicians might say. The writing has been on the wall for a long time, and now the US is implementing reactive policies that are necessary due to the lack of foresight on the part of our policymakers in the last couple of decades.

Yeah, that's a good point. You're right that a lot of operations are housed abroad in jurisdictions with low tax rates. Actually, I'm not even sure how multinational corporations really figure out how much of their income is subject to US corporate income tax. Perhaps there should be some combination of a VAT and corporate income tax. This is complicated stuff.

Yeah, the adjusting for inflation is definitely a problem with taxing capital gains. But they should still try to do it that way instead of coming up with some arbitrary number that can be gamed by affluent people who probably have disproportionate influence over the government.

Well, I'll leave it to you to come up with your own estimation of intrinsic value, but the way I value most companies is by thinking of them as equity-bonds. I try to figure out what the owner earnings yield will be over several years at the price I have paid, usually by making very conservative estimates of owner earnings. I then try to figure out what the earnings yield should be based on the risk involved in the business. I usually take into account debt by adjusting the market price by adding in net debt per share. However, I will sometimes modify this approach, for example, if we're dealing with nonrecourse debt. Note that companies with lots of debt allow for huge run ups before you get to the intrinsic value earnings yield. For this sort of going concern valuation, I generally try to pick businesses that should be around for more than 10 years because no one is going to give you back your principal if your business is dead after 10 years. If the business is going to fail as a going concern over the long run, then I would generally go with a pure discounted cash flow model (cigar butt valuation). With cyclical companies, you have to try to figure out what the earnings yield will be over the course of the cycle, though you can of course take advantage of Mr. Market's overvaluation at the top of the cycle. That's essentially my approach, which I am constantly refining. Right now, I am considering SFK a learning opportunity. I generally stay away from cyclical commodity industries that I think are in decline because it's hard to figure out the full cycle intrinsic value, especially when there is a chance that the investee company will go under due to the way it is financed. But you also find opportunity in these situations, and I think that SFK investors are gonna do quite well over the short run. We'll see.

Wow, what a thread. Eric, I am also intrigued about Australia's dividend franking system. One of the great benefits of having such a system is that it would encourage companies to distribute their earnings rather than retaining them if they could not earn a better than average return on investment than the individual investor. The dividend franking system would take away one argument (double taxation) that management always has to justify retaining earnings, which more often than not seems to be merely a way of boosting management's pay (more assets under management, greater salaries). By making dividend payments the standard, it would also force the finance guys to run companies more conservatively, as most would have to take into account that a lot of their cash flow would be paid out to shareholders. In some ways, I think we have had a "retained earnings" bubble for several decades due to the double taxation policy. Having said the above, I don't think we can get rid of (or even reduce) the corporate tax rate until we change things about the individual tax system. First, all investment income (dividend income and capital gains) should be taxed the same as earned income, subject to the highest FIT bracket the investor is in and subject to payroll taxes. Unlike Australia's system, which I believe distributes credits to individuals at the corporate tax rate, I would build the system like so: (1) Corporations would accrue income tax liabilities at a very high rate, perhaps at 40%. (2) At the end of the year, if the corporation distributes some of its retained earnings through a dividend, the tax provision would go down by excluding the dividend payments from income; (3) It would then be incumbent upon the individual who received the dividend to pay tax on that income at his highest FIT bracket rate plus payroll tax. So, Eric, your FUR dividend would get taxed at 40% plus payroll, while Myth's dividend would get taxed at a lower rate. A teacher making $35K a year would have their FUR dividend taxed at the lowest rate plus payroll. I would also add many more tax brackets, taxing the higher brackets at progressively higher rates. For example, any annual income earned over $10 M should be taxed at 60% rates or even higher (note that the numbers I've used are arbitrary). Actually, I think the ideal tax system is a progressive cash flow consumption tax. Consumption would be taxed in a progressive manner, and savings and investment would not be taxed at all. So let's say that over the course of the year, you earned $50K and you used $40K on consumption and put the rest in the bank. You would pay some amount of tax on the $40K you spent over the year, which would probably be relatively low because we'd assume that this amount was used primarily for necessities rather than discretionary items. On the other hand, if you earned $200K, put $100K into the bank and your brokerage account, you'd pay a higher tax rate on your $100K of consumption. A cash flow consumption tax system would prevent Eric from taking advantage of tax shelters because debt financed consumption would be taxed. The key is that savings and investment would not be taxed. This sort of tax regime is administratively difficult to pull off at this time, however. The tax authority would have to have a system where they could withhold tax over the year and redistribute cash back to you at the end of the year based on how much you consumed versus saved/invested. I wouldn't be surprised if we would be able to pull of such a system in a couple of decades with new technology and administrative improvements. Many if not most tax law profs agree that a cash flow consumption tax would probably be the best for society in terms of the effect that taxes have on investment decisions and increasing societal welfare.

Oh, forgot to include Pershing Square as well.

http://online.wsj.com/article/SB20001424052702304798204575183743131019082.html So we have Brookfield and Fairholme vs. Simon and Paulson & Co.

I love how economists like Hoisington and John Taylor refuse to even consider the counterfactual, which is that without the policy response that was implemented, we would have gotten another Great Depression. Hoisington loves to set up the policy response as spending our way to prosperity when it's really spending to prevent economic collapse. Note that it would be impossible to really rely on econometric data in this recession because balance sheet recessions do not occur with the same frequency as normal recessions. Below is a link to a recent Richard Koo presentation. I would love to hear a direct rebuttal to this presentation from Hoisington, which I believe is the most compelling, nonconventional argument for the US policy response. It's total BS to say that this is standard economic thought. The Friedmanites have been running amok for years. http://www.scribd.com/doc/29914022/Koo-April-2010

Excellent analysis. Thanks for posting! I didn't realize how the technical factors would be in our favor after conversion to a corporation.

NPR episode on the container ship market over the last couple of years. Very good info for those interested in Seaspan and other container ship lessors. http://www.npr.org/blogs/money/2010/04/podcast_6.html

Myth, you're probably right about just holding on. Thanks Vanshon for posting the transcript.