Goldman Sachs will lose
How can Goldman Sachs win against the government when it's public enemy No. 1?
If there were a betting line on the trial of the Securities and Exchange Commission vs. Goldman Sachs, the SEC would be the overwhelming favorite.
That's because unless Goldman gets a jury of its peers who live at 800 Fifth Avenue, the people who will debate the evidence most likely will side with the government. How could they not? When you have the government vs. public enemy No. 1, who would you think gets the benefit of the doubt? Who on Wall Street do you think is guilty until proven innocent these days, least of all the firm that President Obama and the SEC seem to love to hate?
How about the merits of the case? First of all, they really don't matter. The SEC almost never loses a trial. Once the SEC has decided to bring a case, the only safe thing to do as a defendant is to cave. Give up the target, give up the target's supervisor -- that's the way of this business. Always has been.
But Goldman committed to a different strategy, a highly unusual one of defiance. We do not know what happened between the time Goldman received its Wells Notice from the SEC indicating that the government was going to proceed with a formal fraud prosecution and the time when the SEC filed the fraud charges. But I understand that the two events were far apart and that the government pretty much sprang the fraud charges on Goldman.
Did Goldman's lawyers, Sullivan & Cromwell, overplay the bank's hand? Did Goldman, fearing the potential ripples of a fraud charge -- pursuit by New York Attorney General Andrew Cuomo, losses that could mount if potentially defrauded clients went after Goldman for damages -- want to hammer out an agreement that cut exposure or minimized damage, but the SEC would hear none of it? It's not at all clear, but what is clear is that Goldman was caught off guard by the fraud filing.
Perhaps the government's shocking timing was meant to drive home the need for financial reform. Perhaps the toughness relates to the scolding the SEC got from federal judge Jed Rakoff regarding its pursuit of truth and justice against Bank of America (BAC) in relation to disclosure issues involving Bank of America's purchase of Merrill Lynch. Either way, that Goldman Sachs learned of the charges by watching TV demonstrates that this is no normal procedure.
The fact that Goldman issued two responses, the first saying that the bank disagreed with the SEC and the second amounting to a scorched-earth approach that implied no talks, just trial, speaks to how unready Goldman was for the revealing of the charges and how unsure Goldman is of its position.
Why not just say, "We disagree with the commission?" Or, "Goldman is studying the charges and disputes them"? No need to draw the line in the sand and suggest that there's no reason for compromise, thus bringing on the court case and a potential jury trial in front of a no-nonsense judge, Barbara Jones, a former Southern District of New York prosecutor not known for a pro-defendant leaning.
One could understand how Goldman thinks it can win:
- It had invested in the deal it supposedly thought was stacked against investors, according to the fraud charge, and lost $90 million. Already I have heard from pro-prosecution pundits that the $90 million was just a dodge, insulation against potential fraud charges. What nonsense that is. If that's the case, why not just lose $9 million? That would be good enough for those purposes.
- Every trade has another side, and it is unethical to reveal who set up the basket. Anyway, most baskets are set up by clients. Goldman got an agency to review it. Goldman was not under any duty to reveal the name of Paulson & Co., the hedge fund that put the basket together. Plus, it is only hindsight that a late-2006-breed basket that bet against the price of housing by a hedge fund not then known for its clairvoyance was doomed to fail. The fact that Wells Fargo (WFC)-issued mortgages were left out is not dispositive toward a finding of a stacked deck, at least in my opinion.
- The purchasing clients were all institutional. I think Goldman would not be able to stand up to scrutiny if these were unsophisticated investors buying the Abacus offering.
But all of these are meaningless abstractions if this case goes to a jury. Do you think a juror will even understand the concept of a basket? I think the average juror will think of Goldman as a creator of vacuum cleaners that it knew were defective and offered no warranty. That would be a killer argument, albeit one that we know is not in keeping with reality.
Which brings us back to the possibility of Goldman losing and then having to pay off the losses to the Abacus clients and to potentially all other clients of all other similarly designed pieces of paper. We know that Goldman has $2 billion in exposure on this one, call it a buck a share. Could there be more?
Given that Goldman's market cap shed $10 billion, I am sure there will be, but I don't know whether it will be as much as $10 billion. Of course, given that Goldman sells at 6.5 times earnings, it isn't like you are looking at an Intuitive Surgical (ISRG) or an Amazon (AMZN) when it comes to valuation.
So, you can see how the bears can easily argue that the exposure is far greater. Analysts who are bearish on Goldman can easily say the following: "Goldman will lose, and it will wipe out Goldman's earnings for 2011." In fact, that's what I would say if I were positioned negatively.
As it is, we heard from an analyst that Goldman chief executive Lloyd Blankfein would have to leave to forestall criminal charges brought by the Justice Department. No firm can handle a U.S. government fraud charge, so that would be likely if the SEC referred the case to Justice. But that's a huge "if," because we know that the government doesn't want a repeat of Arthur Andersen, where tens of thousands of jobs were lost because of a fraud charge.
All of this analysis adds up to one thing: The Goldman quarter, as great as it will be, doesn't meant that much, although it should, something we told Action Alerts PLUS subscribers in a clinical analysis of the case this weekend.
I know someone on air Friday implied that I was on the take of Goldman Sachs -- an unfortunate charge.
My take is that I was simply trying to state the case of Goldman Sachs, one that I think will, ultimately, not matter, but I didn't want to feel constrained from speaking the truth, no matter how biased it might sound.
I am, however, making it very clear, that the truth is a secondary issue. The jury is primary. And unless the jury has never read a paper or a Web site and never turned the TV on during the financial crisis and is well-off enough not to feel the sting of the Great Recession, it seems pretty obvious to me that Goldman Sachs has been dealt a very losing hand.
Random musings: Be sure to watch video from my director of research, Stephanie Link, and her take on which stocks to buy in the wake of Goldman's woes. And there's much, much more up-to-the-minute coverage on our flagship site.
At the time of publication, Cramer was long Bank of America and Goldman Sachs.
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