Disclosure: Short the market through SDS (double inverse to SP500)

The European Central Bank (ECB) has acted much too slowly and without the consensus of its constituent countries during the current European sovereign debt crises.  Rather than learning the lessons taught by the American Fed Reserve, Treasury and Congress in 2008, the ECB has equivocated, delayed actions and then subsequently had to reverse itself damaging its own credibility in the process.  The head of the ECB, Jean-Claude Trichet, likely initiated the path to disaster by moving to raise European interest rates in early 2010 against the advice of other central bankers, including American US Treasury Secretary,  Tim Geithner.  This had the effect of further eroding already crippled Euro state economies including those of the southern tier of states: Greece, Italy, Portugal and Spain.

In the past two months, sovereign debt problems have grown worse with the indebted states paying higher interest rates, in large part because of the early 2010 ECB announced actions to tighten money supply.  The lack of ECB commitment to support the over-levered states and work with them to reduce debt also contributed to the unwillingness of bond holders to continue lending at reasonable interest rates, pushing rates and budget deficits higher.  It doesn't help government insolvency prospects that the debt has become more expensive to refinance and that higher interest payments further undermine national budget deficits. 

There are only two ways out of these crises.  And until very recently, Trichet and the ECB didn't appear interested in either approach.  The least favored, other than breaking up the EU altogether, is to undergo sovereign defaults on the debt owed.  This would allow for restructuring of the terms of payment through a process similar to bankruptcy, but without a court or judge.  The resetting of bonds would lower interest payments and possibly principal payments reducing the burden on the distressed states.  The problem with defaulting on debt is the ripple effects it will have through the global financial system.  It would likely result in an unwinding of derivatives and a series of bank and investment fund failures in a replay of 2008.  This would be very unsettling for world capital markets and could result in a second and deeper recession than in 2008-09 as lending and consumption freezes up.  Higher unemployment and even civil chaos could be the result.

A second approach, more desirable for its less onerous consequences, would be to devalue the Euro by monetary quantitative expansion (QE), i.e. printing money.  Of course, today money is not physically printed to increase the amount in circulation.  It happens via accounting entries to each countries currency account at the ECB.  A CNBC story today proposed that 10% of GNP be credited to each EU country's account.  This would immediately increase national currency balances in Euro terms.  Currency is an asset on the national balance sheets, so immediately goes to reduce the deficit, if artificially so.  By having more currency in circulation without any commensurate liabilities or national productivity increase as measured by GNP, it would also serve to devalue the Euro by the same 10% amount.  This is essentially what has been taking place in the marketplace anyway, as the Euro has lost over 20% of its value versus the American dollar so far in 2010.  But to have the market make the adjustment can be unsettling for global markets and not as controlled as if the ECB manages the process.

The devalued Euro currency would be used to repay sovereign bond debt.  Since the Euro would be worth less (an additional 10% reduction on top of the 20% devaluation to date in 2010), the bonds would be worth 30% less in an alternate currency, including gold.  Interest payments on the bond principal would also cost 30% less in alternate currencies.  So, in this way, bonds are reset to a lower principal level, without the negative global consequences associated with forcing bond holders to accept changed terms through the process of default.

If this inflationary action is not taken, the debt reduction programs underway in Europe will reduce currency in circulation and will act to deflate the Euro.  Deflations result in a higher value currency versus alternate forms of currency, including gold.  Without any counteracting inflating of the Euro, it will rise against the US dollar, possibly to 1.50 or 1.60 EU to the $1.00.  This will further hurt European competitiveness and will extend the global economic contraction.

Here is a link to the CNBC article by Warren Mosler that recommends devaluing / inflating the Euro.

As I post this article, the economic leaders of the G20 nations are meeting in Busan, South Korea to discuss global economies and the policies needed to continue the recovery from the 2008-09 debt crisis.  We are at a critical moment and the central bankers and government leaders must make the right policy moves on monetary policy, debt management and economic growth.  Tim Geithner has been pressing the European nations and Japan to encourage consumption so that America and China do not have to bear the entire global load. 

The next 2-4 weeks will tell the story whether the Europeans get it right and manage their currency and sovereign debt in a way that does not panic the capital markets and kill the global economic recovery.  There is some promising news as on June 2, Trichet reversed the course previously set and offered to extend the low rate environment to ease the pressure on the over-indebted Euro states.

Hey everyone, Jared here, I just wanted to take a minute to explain to everyone how important it is to always check your credit score. The other day I ordered my credit score since this past year has been pretty rough for me and I wanted to see where I was sitting. Much to my surprise and dismay, I found that my credit had been hurt by a bunch of fraudulent charges on credit cards that were taken out under my name but were never in my possession. Luckily this happened pretty recently so I was able to fix the problem before it did any serious damage. If you would like to view your credit score there are many ways to go about it, but I have found that creditscorequick.com is a great way to get your full, accurate score for a reasonable price. Don't let identity theft happen to you, with the economy the way it is right now, the last thing anyone needs is to be a victim of identity theft.

Those who talk finance with me know that I have an abiding respect for investor Bill Ackman.  It comes close to man-love, I must admit.  Bill is eloquent, thoughtful, intelligent, well-informed and any other adjective that gives praise.

My first experience reading about and listening to Bill came about this time last year when I was struggling with whether to invest in General Growth Properties.  At the time last April, GGP was entering bankruptcy.  But the market and economy had just begun to turn and I had personal experience with GGP properties and management and thought the company had excellent mall properties and was well run.  I wanted to invest in GGP which was then selling for only $0.65 per share and had a total capitalization only around $200M on a business with properties once valued at $30B.  If it were possible to solve the debt problem at GGP, then the company had an excellent chance of survival.

Enter Bill Ackman into my life.  As I was researching GGP, I came across research that Bill had put together as his hedge fund, Pershing Square Capital Management.  He had done a very thorough job researching GGP and was able to show that with even modest "cap rate" assumptions, GGP would do very well.  All it needed was time to restructure its debt.  Ackman proceeded to take an active role in buying time for GGP, first by offering to provide bridge (DIP) financing (later provided by another party), helping convince the court of the merits of GGPs survival and later by joining the GGP Board of Directors. 

As the year 2009 progressed, Ackman's activism and my confidence in his research proved very profitable for both of us.  I have now exited my GGP investment (much too early) but Ackman, to my knowledge, remains on board and has seen his investment return over 20-fold.  I admire this type of clear vision and the courage to act on it.

Ackman was a noted short trader earlier in his career.  He gained notoriety for his big short position in credit card company MBIA in 2005, for which he was investigated by the now-notorious Elliot Spitzer, then New York State Attorney General.  He was able to demonstrate to Mr. Spitzer his innocence and turned the table on MBIA by exposing the Attorney General their fraudulent practices, the reason for his short position  (presaging the debt crisis to come).  He took a "sow's ear" and turned it into the proverbial "silk purse".  That taxes moxy.  That takes class.

Given his career path and the level to which he has risen, Ackman is very intimate with the inner workings of Wall Street.  He shows himself to be rational and level-headed and has a thorough, first-hand understanding of the arcane financial instruments that Wall Street has created.  So, when he gives his opinion on the Goldman Sachs situation, I listen (much more so than to EF Hutton).  Today as guest host on CNBC Squawk Box, Bill Ackman shared with us his assessment.  He comes down on the side of Goldman Sachs for all the reasons I have provided in the past two weeks, but with the conviction that can come from only an insider.  Here is an excerpt from the show:

Goldman Sachs did not commit fraud and the insurance company that bought the product that is the subject of a government investigation should have known the risks, Bill Ackman, founder and CEO of hedge fund Pershing Square Capital Management, told CNBC Tuesday.

“I don’t believe that Goldman committed fraud,” Ackman told “Squawk Box Europe.” “(ACA, the counterparty to Goldman - Paulson Partners) took their own risks.  "They’re sophisticated investors.” “I don’t think the (Securities and Exchange Commission) has a good case,”  Ackman said.

“Having been the subject of investigation in the past  (for the MBIA case referenced earlier)… I don’t feel sorry for Goldman Sachs, but they’re not being treated fairly (either).”

Not only does Ackman contend that Goldman is innocent of the charges of fraud, as I also maintain, in addition, it would even have been unethical if Goldman had disclosed that hedge fund manager John Paulson was shorting the housing trade to any investors taking long positions, Ackman said.

Ackman argued that sophisticated investors (the German and Dutch bank that bought the long positions from ACA) have the information at their disposal to make their own decisions, and are also responsible for their own mistakes.

“Imagine that Soros and Buffett were on the two sides of this transaction,” he said. “We wouldn’t even be talking about this now.” 

But later in the interview, Ackman states that the true victims are the taxpayers as they do not know they are party to the trade via "too big to fail" and taxpayer rescues.  This is true in Germany and the UK, as well as in America.  It is the taxpayer that has to cover the losses made by overly aggressive bank managers who are playing with OTM (other people's money) in order to win large bonuses.

So, it is not Goldman Sachs that should be taking the fall for the financial crisis, but the bank managers that lost money and the regulators / government officials that are charged by the public with protecting the financial system.  The "witch hunt" that is today's Congressional hearing is completely misdirected and intended to make the Congressmen who failed in their sworn responsibilities, look better, much better, than they really are. 

At the end of this segment, the former SEC general counsel, Simon Lorne, appeared with Bill Ackman. Mr. Lorne offered his highly informed opinion that the case by the SEC against Goldman Sachs is "weak". This is the position I have maintained. The facts will show that there was no "fraud". If anything, there may have been some technical error of omission where disclosure is involved. This might justify a fine of some sort, even a large fine given the stakes involved. But Mr. Lorne says it all much better than me:

Disclosure: I am long GS with October Call contracts; If I could be, I would be short the Congress;

And now for the rest of the story, as Paul Harvey liked to say.

Today's post is a follow on to my post from last Friday, August 16.  At that time, Goldman Sachs, GS, was being charged by the SEC in a civil suit for failing to disclose John Paulson's (Paulson Companies) participation in a CDO fund invested in sub-prime mortgages.  This failure constitutes fraud if it is intended to deceive.  The failure might be found a technicality in court of there was no intent.  The SEC is hungry for a scapegoat for the banking crisis.   GS, which went through the crisis almost unscathed, is an attractive  target in the mind of the Obama Administration both because it is large and because it profited during the crisis.  Getting GS would satisfy some of the populist blood-lust of Obama's public, even at the expense of the overall economy, as it hurts banks which just now on the mend.

But, as is often the case, this might be much ado about nothing.  I thought as much last week and now the details are appearing that prove this point.

The first big new piece of information comes from an article written in the Wall Street Journal on Monday.  In this article is a portion of an interview with Paolo Pellegrini who was the deal maker for John Paulson on the contested CDO case. 

With this release the story became a little clearer the last couple of days.  It turns out that Obama's government might be trying to deceive the public itself.  The SEC covered up, or at least did not make public, the fact that they had an interview with Pellegrini of the Paulson company.  In that interview it was revealed by Pellegrini there were discussions directly with ACA at the time of the selection of the CDOs and that ACA was made aware that Paulson would be taking the opposite side of the transaction (going short) which ACA needed to get the deal done. We also found this week that the SEC vote was partisan, (3) Democrats to (2) Republicans in favor of filing the lawsuit with Obama appointee, Mary Schapiro, casting the tie breaking vote.

Here is a little background on Pellegrini's role in the deal, from WSJ on April 19, Monday:

http://finance.yahoo.com/retirement/article/109342/paulson-point-man-on-cdo-deal-emerges-as-key-figure?mod=retire

The main contention of the SEC in bringing the civil charges against Goldman is that it deceived "the public" when it failed to disclose its client, Paulson Companies, was taking a short position in the sub-prime CDO deal, while Paulson had a hand in selecting the mortgages. Now it is revealed, that ACA, the "third party", was in fact the first party and the primary buyer of the CDOs it created, around $950M of the $1B.  Goldman bought $90M itself.   And, in fact, it sought out Pellegrini from the Paulson Companies to do the deal, not the other way around.  So it seems this was a one-on-one deal and both the buyer and seller were in conversation about what comprised the deal.  So, there was complete and full disclosure.

This blows a very wide hole in the SEC's case and in fact, brings a huge question mark to the motives for bringing the charges. These potential political motives are now under investigation by the Congressional watchdog committee run by CA Rep Darrel Issa, top Republican on the Congressional Oversight Committee.

http://corner.nationalreview.com/post/?q=YzRjOWZjZDdkYzhjYzVjOGIwMjU5MjNkZjVjNDc0OGU=

Steve Liesman of CNBC is on top of this case. Here is more detail from a piece on Wednesday morning:

http://www.cnbc.com/id/36640296

Also, this testimony (from Pellegrini to the SEC) reinforced the key point I have been making: ACA knew that Paulson was taking a short position. ACA was looking for someone to take the other side of the deal which is why they chased down Pellegrini on vacation in Jackson Hole to have meetings. They let Pellegrini suggest mortgage packages (RMBS) to get Paulson on board the deal. Also, ACA was the primary buyer of the CDOs and so there was complete disclosure directly to the buyer as to whom was the seller.

The SEC case looks like it may be going down in flames and there is a good chance there will be discovery of political motivations behind the accusations.  Should be fun to watch.