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.

I think not.  This is a politically motivated action brought against GS by an SEC controlled by the Obama Administration.  That motive is to demonstrate to the public that the Federal government will hold accountable banks for activities leading to economic damage.  There is a lot of pressure on the Obama Whitehouse to attack and punish "Wall Street" in retribution for the economic crisis and housing crash.  Goldman is the "poster child" for perceived banker abuses and is seen by some as the cynical and greedy conductor of fraud to take advantage of innocents.  But in reality, the processes charged in the SEC case as fraudulent are typical everyday practice. 

The people on both sides of the sub-prime mortgage CDO trade are large, institutional investors who should know their risks and be prepared to accept losses.  This is true of any trade.  There are buyers and sellers of every financial instrument and subsequent winners and losers.  It is common, in fact, for financial instruments to be created by "market makers" like Goldman Sachs at the request of a buyer or seller who believe they have insights that will allow them to profit at someone else's expense. 

This is how financial markets work.  The market maker may have an opinion of its own about which side is right and which side is wrong.  For this reason, an independent third party is brought into to assess and vet the investment vehicle to insure it is fairly created and accurately represented.  This appears to have happened with the GS CDO in question. 

Jim Cramer, who at one time in the early 1980s, worked for Goldman Sachs and understands the inner workings of the investment banking world, explains what happened:

Before people went too far in their attacks on Goldman Sachs, as today’s charge of fraud by the SEC will train even more proverbial guns on the Wall Street titan, Cramer felt the need to clarify the case. He wasn’t exactly defending the firm, but he wanted viewers to know exactly what happened.

First, full disclosure: Cramer got his start on Wall Street at Goldman [GS  160.70    -23.57  (-12.79%)   ] , and he still has friends there. But he insisted that that was in no way the reason he was challenging the SEC. He said that while he wouldn’t want to be associated with the trade, that didn’t mean there was anything “illegal … immoral or even unethical about it when you pull it apart,” he said.

So here it is pulled apart:

Goldman created a product, a collateralized debt obligation, for hedge fund Paulson & Co., which “at the time wasn’t known as a particularly smart client,” Cramer said, that allowed for a bet against the value of housing. To make sure the product was vetted ahead of its sale, Goldman hired an independent company, ACA Management, to do just that. And they released a report telling potential buyers exactly what was in there.
 

Now, Cramer would never have bought the CDO, but not everyone was as bearish on housing as he was in late 2006, which is when the product was put together. Though he could see how less informed clients may have found it attractive. But in the end, no one forced people to buy this CDO. And “a sucker was born the minute the trade was made,” he said, “and the loss booked soon after.”

So did Goldman do something illegal when it vetted the product, letting everyone know what was in it? Or was the buyer just plain stupid for wanting it in the first place?

“I think the latter,” Cramer said.

He likened the situation to the tech boom of the late ‘90s. If someone created a similar product to bet against these stocks, it would have been an entirely legal, but losing proposition until 2000. It was only after that run that the bet would have paid off. Well, housing was exactly like that, Cramer said, going into 2007. And the buyer of this CDO fully expected to continue making money, only to be shocked awake when the market collapsed. Now Paulson & Co. is known as a house of genius, while the people who went long on housing are the fools.

We learned today that Goldman sunk $90 million of its own money into the CDO. While Cramer’s not sure if that absolves the company, he does know one thing: The SEC is under tremendous pressure to bring cases against Wall Street right now. And he knows that Democrats in Washington are fighting for financial reform. So this is a great time to bring this case before the public and punish the firm perceived as the most arrogant and least reformed in the room.

But while arrogance may be a terrible personality trait, Cramer said, it isn’t illegal. And he’d be the first person to call out Goldman if the company were wrong. But he doesn’t think this is one of those cases. If anything, this was a case of “overzealous prosecution,” he said.

“That’s exactly what I think happened today against Goldman Sachs,” Cramer said. “And I think you’ll see it exactly as I do as time goes by.”

There has been much hand-wringing over Dubai and other countries and their sovereign debt problems since the end of November.  There is a fear that the exposure of this debt might be the tip of the iceberg.  It is feared that the government debt crisis will spread from the small and traditionally weak and underfunded economies of Portugal, Spain, Greece, Italy and Ireland (the PIIGS) to the more substantial and traditionally strong economies of France, Germany, Japan and the United States bringing with it the fear of a global sovereign debt melt-down.  This opinion is emotional and uninformed

All the "sovereign debt default" talk about Dubai, Greece and Spain is old news that is just now getting press because what was already in motion at the top of the debt bubble in 2007 is finally coming to fruition.  Now that the commercial bank crisis has been for the most part averted, the sovereign debt issues that are closely related come to the fore. The Dubai problems were obvious two years ago or more. And Abu Dhabi and other UAE brethren have little patience for the profligacy of Dubai. They will backstop Dubai only after those who overextended get taken out. Then they will ride to the rescue and take control of many of the assets.

Same thing in Spain or Greece. Spain dug itself a deep hole by committing significant debt to aggressive expansion of public works, most notably the 3GW solar power expansion.  The EU will backstop those countries, but only at a price. It is in no one's interest to let the fire burn out of control. I compare this to hot spots after a forest fire. If they don't threaten to flare up and ignite new fires, you let them die out on their own.  Other times you douse them (with financial liquidity in this case) to put them out before they spread. If the infection spreads to Japan, that would be a much more serious event than Dubai, only because of the size of the Japanese economy and the relative importance of the yen. But I think the global central bank leaders have an eye on this and will prevent a Japanese economic collapse. As long as all major economies pull together, there is no reason to think we will have a financial calamity. Economic collapses require the public to panic (and stop spending). Panic is totally a psychological phenomena and can only be brought about by careless or reckless political actions (or inactions).

It is very important to note that the countries that are in danger of defaulting, are not key world economies. The talk of a major economic power like Germany, Japan or the USA being forced into insolvency is from someone ignorant of what it takes to force a financial default. Defaults don't just happen, they are initiated by a creditor. If the debtor is large enough as compared to the creditor, then it is non-sensical or impossible for the creditor to force the default. The punishment will fall as much or more on the creditor as compared to the debtor. To force a smaller debtor to default, though, makes sense. Assets can be seized and held or resold to recoup the investment. Just who would force the USA, Germany or Japan into default? Who could gain? Who could manage the assets that were forfeited for the debt? There is no private money (hedge funds, ala John Paulsen) with the size to force a large sovereign to default.  China is the only creditor nation with the size to force such a default. But China won't do it because it would be suicidal. China, the creditor, needs the developed world as much as the debtors need China and other developing, export-driven creditor nations. It is totally symbiotic, or co-dependent if one wants to be cynical about the situation.

To make my point about the relative size of creditors and debtors as it relates to default: I just made a good return recently on General Growth Properties (GGWPQ.pk) because I understood this dynamic. GGP was in technical default because of the financial crisis and its inability to roll forward short term debt taken on during the two to three years prior to the financial collapse. It was / is still cash flow positive and can cover the costs of its interest obligations, much like sovereigns with their ongoing ability to raise revenue from tax.  But GGP wisely had filed for bankruptcy as a single entity and had pulled all its various mall properties under the single corporate parent umbrella. This made GGP in effect, too big to fail. No single creditor had the legal power to force all the properties into a firesale. The court (Judge Gropper) saw it the same way and made the decision to force the parties to work out the mortgagtes (to refinance). When the creditors found out they were not going to be able to drive a hard bargain and take away the mortgaged property for much less than market value, they had to deal. Now GGP is close to exiting bankruptcy with all its property intact.

Even though sovereigns are unlikely to default in a cascading way, the global economy still remains weak.  It will take consumers and businesses a long time to regain their confidence to buy and bankers to lend.  For the overall American market, from this point on, the economy must improve significantly to get the SP500 much above 1200. But I think that is the higher probability over the next year or two as compared to a melt-down. Politically, I think President Obama is finding out that it isn't prudent to be too anti-business. He seems to have finally gotten the point that the top priority is jobs. Health care and environment are lower priority since there is no money to pay for them if we don't have near full employment and full tax revenues. We aren't hearing too much health care talk from the Admin or Congress the past 2-3 weeks. To demonstrate his new-found love for business, Obama just had T-Sec Geithner spell out the capital gains tax freeze and investment tax credits for 2010. This will help jump start business and improve consumer sentiment as people start getting jobs.

As Obama and other world government leaders turn their attention towards restarting business, the world economy will heal and the markets will respond. Asian stock markets might be a little overdone just because of being the crowded trade, so I have backed off on them, for now. I have moved almost everything back to domestic large cap stocks or energy / commodities. I think 2010 will be a "consolidation" year with only a little index movement, maybe from 1100 to 1250. 2011 might be a similar year, with gradual improvement from 1250 to 1400. That would get us back to May 2008 which was about where the final dive started (down to 666). Maybe we pull back 100 points (10-12%) somewhere in the next 2-3 years. But by 2014 we can pass 1550 and set new highs, if the government continues to be supportive of business and doesn't get too radical (seems more likely right now than 6 months ago).

I am buying up some of the banks that look like they are turning the corner and will be survivors. I have a bunch of the leveraged financial index, UYG, which is weighted towards the survivors like GS, JPM or WFC. But I also am buying some BAC now (as of two weeks ago). Even Citi might be a buy at this point, now that they have a plan to exit TARP. But I am passing on them for now.

Otherwise, my theme is Tech, commodities, energy and materials. Tech is due for a positive replacement / upgrade cycle after 10 years of being down.  Microsoft's (MSFT) Windows 7 should be the catalyst in 2010 once the IT budgets are approved. Just buy the XLK if you don't have any favorites. SMH is the semicon index which has more beta than the XLK. My favorites in commodities tend to the miners and energy stocks, though I have recently picked up some Potash (POT).  I also have call options on (FCX) and (BHP).  This is a better way to play the weak dollar trade than gold, in my book, as operating leverage contributes to performance and generates cash flow which actually has value to an investor.  They have all outperformed Gold in 2009.  Commodities and Energy will benefit from the global economic expansion that is the natural reaction to the collapse. I find it interesting that Suncor (SU) was going up the last two days while oil futures are going down. I find that a very positive sign. I have really loaded up on Pennwest (PWE) and Provident Energy (PVX) .

Warren Buffett spoke today, to the fabulous Julia Boorstin of CNBC (what great hair she has!). I don't particularly care for Buffett's politics and his ideas on taxation. But when it comes to economics and business prospects, Buffett is without match, as his investing record shows.

I agree entirely with him about the outlook for our economy the next few years. He makes the statement: "I don't know if the movie is 2 or 4 hours long, but I know it has a happy ending". What a positive point of view. More of us should share that perspective.

I am piggy-backing on many of Buffett's trades since late 2008 owning: GE, WFC, USB and GS.   These are all global franchises that for the most part, came through the crash without much damage (GE is much healthier than its stock price suggests and is a raging bargain).

Regarding the housing crisis and home building, Buffett makes the point that the housing crisis precipitated our economic crisis (but he did not lay the blame properly at the feet of a laissez faire Congress that eliminated the regulatory protections needed and cheerled the mortgage industry into the ground).  His medicine: don't build any more houses; a little simplistic, but maybe tongue in cheek.  We need to work off the inventory we already have. I think that is pretty obvious and goes without saying. But he said it by way of making the case that excess housing is the root of our problems and our economy won't truly mend until housing inventories are once again in balance.

Without saying any more, here is the interview: