When the SEC first went after Goldman Sachs and John Paulson regarding the creation of a specific, synthetic collateralized debt obligation (CDO), we were surprised. The SEC alleged Goldman had colluded with Paulson's hedge fund to create a pool of mortgages designed to fail. Then, Goldman sold the security to investors without disclosing Paulson was on the other side of the bet.
The case is garbage because the instrument under question was synthetic – it simply tracked the movement of an existing pool of mortgages. The Abacus CDO in question could only exist if two parties were willing to take opposite sides of the bet. In short, the buyers of Abacus – a bond insurance firm and a German bank – had to know someone was betting against the CDO.
We were also surprised that the SEC would directly attack a Wall Street bank – the same banks it normally protects. From the April 21, 2010 Digest:
I couldn't believe the SEC would actually take on Goldman or any of the big banks. The banks are the SEC's patrons. The SEC's real purpose in life is to protect the banks (not you and me). Now, it seems clear to me suing Goldman about this issue – a case involving a synthetic CDO that the regulator will probably lose – is simply raising a red herring. Left unexamined is the much larger issue: the extraordinary amount of fraud in mortgage underwriting between 2004 and 2007.
It turns out the SEC's Goldman investigation really was just the warm-up. Today, the Manhattan U.S. Attorney's office launched a criminal investigation into the collateralized debt obligation (CDO) activities of Morgan Stanley.
The prosecutors allege Morgan created pools of subprime mortgages, sometimes bet against them for the firm's profit, then misled clients (to whom Morgan has a fiduciary duty) into buying them. The investigation centers around the creation of two CDOs named after the U.S. presidents James Buchanan and Andrew Jackson. Morgan's traders referred to these deals as the "Dead Presidents."
The case against Morgan is more serious than that against Goldman because prosecutors are now focused on tangible mortgages, not synthetic mortgages. If Morgan created these mortgage pools, shorted them, then sold them to clients as triple-A paper... the bank is in big trouble.
The situation reminds us of the AIG/Goldman Sachs credit default swap fiasco. Goldman manipulated AIG into selling it insurance on $20 billion of subprime mortgages Goldman held on its books. From the February 24, 2010 Digest:
Goldman didn't merely buy insurance on a bunch of random subprime CDOs. It actually bought insurance on special CDOs it had put together and sold to its own clients. In other words, Goldman knew more about these CDOs than anyone else. Goldman bought insurance on these CDOs because it knew they'd collapse. This is tantamount to building a house, planting a bomb in it, selling it to an unsuspecting buyer, and buying $20 billion worth of life insurance on the homeowner – who you know is going to die!
The Morgan Stanley investigation is still in the early stages. But we believe Morgan was involved in fraud – just like every other bank on the Street. Eventually, this lawsuit will lead to the end of Morgan Stanley.
While the government has just now decided to crack down on Wall Street, its actions up to this point have hugely benefitted the financial industry. As we've said before, an extra $2.7 trillion in the economy and a federal-funds rate at zero together mean big profits for banks. From the February 3, 2010 Digest:
In paper-money systems, the value of bank reserves is set by central bankers. So when the central bank wants to make lending more profitable, it can simply lower the cost of borrowing reserves. This allows banks to lend more money and to make more money doing so.
Right now, America's central bankers have set the cost of bank reserves at an all-time low. They want to make it easy for banks to create more money through lending. And they want to make lending as profitable as possible, so the banks can recoup their housing-bubble losses. As a result, the profit margin on lending money is at its widest point since 2003. Banks' lending margins have rarely (if ever) been wider, thanks to the central bank's manipulation of short-term interest rates. Now is the time to buy banks. But which banks should you buy?
On Monday, we reported Goldman Sachs made money trading every single day in the first quarter. Today, three other banks – Citigroup, Bank of America, and JPMorgan – also announced perfect quarters. Four of the biggest banks in the country (the first, second, third, and fifth biggest) managed to trade profitably for 61 consecutive days. And these profits are thanks to our friends at the Federal Reserve, who have manipulated the yield curve to make these absurd profits possible.
We don't know how much longer these record profits can continue – there's still a lot of money sloshing around the economy. And we don't see the Fed raising rates any time soon. We do know one thing: It's difficult for things to get much better for Wall Street. Be wary.
If you don't own gold yet, you probably never will. But that won't stop us from pounding the table on the precious metal. It's almost the only safe investment we see... anywhere. Equities are overvalued. Global currencies are doomed as a result of the U.S. and EU bailouts. And while gold is trading at new highs, it's still going much, much higher.
Markets have a difficult time valuing gold. We see it as the ultimate credit default swap. The U.S. issues bonds in denominations of $10,000, so the cost of insuring a U.S. bond has risen from around 7% in 2008 to over 12% today (calculated using the price of gold divided by 10,000). Would you pay 12% of the value of the bond to insure it? We would...
Buying gold bullion is one of our favorite ways to play gold (though we know few of you will actually buy the physical metal). You can also buy a gold ETF like SPDR Gold Shares (GLD). But it's hard to know how much gold this ETF actually owns. And it's simply a proxy for bullion.
For the highest returns, you should be buying gold mining stocks. When the gold market inches up, these stocks soar. But gold mining is a volatile sector... You've got to be careful when investing in it. That's why if you're considering these investments, we recommend you read Gold Stock Analyst, written by our friend John Doody.
John makes buying gold stocks easy for new investors. All you have to do is buy every stock in his famed top-10 list and wait. So far this year, John's top 10 has outperformed gold by 100%.
Today is your last chance to get John Doody's work at a large discount. We highly recommend you subscribe to his letter... It's one of the few newsletters we actually read (other than our own, of course). Click here to learn more about Gold Stock Analyst.
New highs: iShares Silver ETF (SLV), Altria (MO), DirecTV (DTV), HMS Holdings (HMS), AuEx Ventures (XAU.TO), Seabridge Gold (SA), Silvercorp Metals (SVM), Eldorado Gold (EGO), Inter-Citic Minerals (ICI.TO).
More subscribers making fortunes from the market's panic last week... If you've got more stories, we'll take 'em... feedback@stansberryresearch.com.
"No offense to Porter, Dan, or Sean, but could we have a Digest once a week written by Steve or Frank or Brian? Variation in opinions is a good thing and their voices also deserve to be heard." – Paid-up subscriber John Chamberlain
Goldsmith comment: If you want insight from Steve, Frank, Brian, and other S&A analysts, check out our other free, daily e-letters – DailyWealth and Growth Stock Wire.
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Goldsmith comment: We're glad you're enjoying DailyWealth Premium, Ed. We've been thrilled with Steve's work so far. For anyone else interested in DailyWealth Premium, I'd urge you to at least test it out. It's our most affordable research product. For only $9 per month, you will receive daily insight from Steve Sjuggerud along with your regular free DailyWealth issue. Steve covers commodities, stocks, currencies... He even discusses what's going on in the different newsletters we publish. There is no other way to receive so much information for so cheap. To test it out, click here. Again, it's only $9 per month.
"Last Thursday, I was in an airport waiting to board a 3:40 PM flight. I had bought Jeff Clark's Short Report May, IYT 80 puts at $0.82. When I checked my iPhone, the last price was 2.80, so I tried to sell at 2.80. The market was dropping so fast, I couldn't get my price up fast enough. I saw the bid at 3.00 and the ask at 7.00! So, I put in $4.00, and got it. The market turned around, and 10 minutes later, these were selling for under 3.00. Today, they were $0.50. I made about 400% on the trade in less than 15 days. Thanks Jeff." – Paid-up subscriber Bill Malone
Regards,
Sean Goldsmith
Baltimore, Maryland
May 12, 2010