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.”

The financial world is centered in China this week of November 16 as the IMF (International Monetary Fund) leaders meet with Chinese and other global financial leaders.  The discussion is centered on how to improve the world's financial stability by perhaps rebalancing the global currencies against each other.  It is time the Chinese Remnibi is strengthed versus the dollar and the practice of indexing the Chinese currencies against the US dollar to protect Chinese labor advantage is discontinued.  This will also mean increased domestic consumption by the Asian economies as the Western economies save to reduce debt.  CNBC reported the following late Sunday night, Central Standard Time: 
 

IMF Managing Director Dominique Strauss-Kahn said the countries at the heart of global imbalances needed to take various measures to ease them.

In the case of China, that means an increasing emphasis on domestic demand, especially private consumption, Strauss-Kahn said in remarks prepared for a financial conference in Beijing.

"A stronger currency is part of the package of necessary reforms," he said. "Allowing the renminbi (yuan) and other Asian currencies to rise would help increase the purchasing power of households, raise the labour share of income, and provide the right incentives to reorient investment."

His remarks come as U.S. President Barack Obama is in Shanghai on the first leg of a four-day visit that will grapple with economic imbalances and the future of the yuan.

Strauss-Kahn noted that Chinese authorities were already taking steps to boost household consumption, including health care reforms.

"But more can be done to secure a lasting, structural shift towards consumption, by expanding the scope of social policies, moving ahead on financial sector reform, and undertaking corporate governance reforms," he said.

Conversely, countries with large current account deficits need to increase savings, and for many of them, including the United States, fiscal consolidation must take priority for them, he said."
 

What does this shift imply for American based investors?  As the remnibi takes an increasingly important role in world trade and is gradually rebalanced to reflect the strength of the Chinese economy, it will cause investments in Asia to rise in value as the dollar declines against the Chinese currency with the resultant de-linking.  This trend will affect not only Chinese stocks, but also stocks trading in the markets of other major Chinese trading partners like Singapore, Taiwan, Indonesia, South Korea and of course, Hong Kong.  Those economies must rethink their own currency indexing strategies to maintain competitive trade parity and are very likely to emphasize indexing the remnibi as opposed to the US dollar.  Even Japan will probably see its currency strengthen versus the American currency as the Remnibi gains favor as an Asian trading currency.

Now is the time to acquire additional shares in Asian stocks, funds and ETFs.  Because of the recent runup in 2009, it will be better to average in a larger position over time rather than making a lump sum commitment.

A response to a post by my good blog friend, Nirav:

Nirav, this is the problem with professors having opinions. Some people may want to think those opinions are more meaningful or well-informed because a given professor happens to be employed by a school like Stanford, or NYU (Roubini). But, such professors opinions about the future are no better than yours or mine. Professors should teach, and not opine.

The first thing wrong with Taylor’s opinion is his lack of command of basic financial math. A 100% change in nominal GDP over 10 years (and the resultant 50% cut in debt to GNP ratio) does not require a 10% annual inflation, but a 7.2% inflation, according to the Rule of 72, something any college finance or economics professor should know. I fully expect a 6-7% inflation within 2 years and think the Fed and Treasury are actually trying to orchestrate that.

The second thing wrong with the Professor’s opinion is the statement that a “permanent 60% tax increase would be required” to balance the budget. That statement is inconsistent with the 10% inflation conclusion. I think taxes could be left unchanged, or only increased to the degree Obama proposes, along with spending decreases, and inflation will do the rest. Not only will inflation cheapen the debt over time, it also will increase the number of dollars in which the debt is paid off. Anyone who owned a home in the 1970s remembers what a good deal inflation was at that time, so long as the mortgage was fixed. You could buy a $40K home, watch it appreciate to $80K with inflation, but pay off the debt as though it were still $40K. To the degree the Feds fix our interest costs (by issuing 30 year bonds which they should be doing in a big way right now), we will all benefit from the repayment in debt with ever cheaper dollars.

Inflation is the only way out of this box. I think the 1970s scenario is not only likely to occur, but welcome. It helped us resolve our Johnson era “guns and butter” Great Society debt of the 1960s, which in its time, was every bit as problematic as where we are today.

I would go on to say that as a responsible investor, it is important to try and anticipate the future, and not wait for it to run you over.  If inflation is in our future, as I think it most surely is, then a prudent investment strategy will take that into account.  The way to not only beat, but prosper from inflation is to own hard (real) assets, or stocks thereof. 

Oil, natural gas, industrial metals, precious metals, timberland, ag commodities, all the equipment suppliers to those industries (Joy Global, Deere, Cat, Monsanto, Nabors, Transocean, Dow Chemical, Dupont), and even real estate or REITs in the near future (once RE stops deflating) will all benefit from a long period of moderate inflation.  The Fed has demonstrated in the past its ability to prevent hyper-inflation, so that should not be a great worry.  Ben Bernanke knows the economics playbook very well.  So, rather than nashing teeth over the course of easy money and tax deficits, instead, put those actions to your own advantage.

Here is his post:

How to Reduce a Trillion Dollar Deficit

Jim Cramer has started to promote Gold or the popular bullion ETF, GLD, as the best investment in this whacked market.  With this signal, I have pointed out to investor friends that they should sell gold (see: "Gold, Great for a Trade, Risky as an Investment" ). Cramer has proven to be the ultimate contrary indicator.

But the fact gold is going down just underscores the power of this deflationary environment. Gold does best during periods of inflation.   Deflations are inherently bad for hard assets of all kinds as fiat currencies increase in value (the definition of deflation).  Gold does not escape this effect, though for short periods of deflationary panic, like the past 2-3 months, gold may do well.

Deflationary spirals are self-feeding and there is little to stop them. People will spend less and less first through fear, and later because they are unemployed and have nothing left to spend. Unfortunately for this country, we just elected a president who does not get this (not that the previous one did either). Raising taxes into a depression is a VERY bad idea. It guarantees economic failure (see Hoover administration).  And don’t be fooled by the $200/250K promise to limit tax increases. It will be broken when revenues come in lower than expected because of the declining economy and the need to pay for expensive new entitlement programs.

I have harped here long and hard that the only way to fix a depression is to print money like crazy and “reflate” (see: Reflation Economics (or “The Minsky Solution” and Fixing a Deflation: A Most Intelligent Analysis).  I have even offered some ideas to both fix the housing market, and reflate at the same time, with little added debt to the economy: the 4%, 40 year fixed mortgage program for EVERYONE (not just the irresponsible few), and a no-interest, no-payment loan from the Feds for any balance above market value, repayable on home sale (forced and secured by a Federal lien to guarantee repayment).

These two programs, easy to implement and relatively cost effective (the Fed loan program would cost almost nothing compared to other current proposals like forced bankruptcy and all the court costs that go with that idea), would solve our housing AND banking crisis at the same time. Bank mortgage assets written down to 20 cents on the dollar would suddenly go back to almost 100 cents as even underwater mortgages were repaid in full to take advantage of the 4/40 and no interest loan programs.  The banks holding those "toxic mortgages" would see their balance sheets repaired and the capital ratios improved (every dollar of increased value in the loan portfolio goes directly to capital).  Bank stock prices would move up, dividends would increase and talk of nationalization of the banking industry would stop.  From there, we might be able to rebuild our economy as consumer confidence, and then business confidence would return.

Once we have a well functioning economy, THEN (and only then), if Obama wants to fund his social engineering programs, noble ambitions that they are, there would be a chance to break even on those programs without crushing the economy and everyone within it.   But as it now stands, he is impatient, suffering messianic impulses and not willing to wait for the economy to recover before he starts redistributing wealth.

How many ways is Obama wrong with his budget and spending plans?  Here are but a few:

1. Eliminating deductions for charitable contributions for the high income tax payers  that provide the bulk of non-profits' budgets will spell doom for many non-profits and needy chartiable organizations.  Those organizations already were hit by the blowup of hedge funds, including the biggest of them all, the Madoff Fund.  Now, when they need financial help most, how ironic  Obama's budget attacks his own natural constituency: non-profits and those that need charity.   He is eating his own children.
2. Eliminating the home mortgage deduction for higher income taxpayers does not help our housing crisis, it definitely hurts.  While this proposal might be defended in that it only hurts high income individuals who don't really need the deduction (sarcasm intended), we all know that the threshold for "high income" will be reduced over time.  Taking away deductions will reduce housing demand and continue the downward spiral in home prices.
3. Eliminates subsidy for student loans through private banks (the Sallie Mae program) which benefit the middle class students and instead redirects those funds to PELL Grants which are only available to low income students.  Obama has made a decision to deny higher education to many middle class students, who might have good high school grades and bright future prospects, and will instead bless the poor who may or may not be good students now or in the future.
4. His ten year budget projects increased deficits (above those of the last eight years) until the end of that period, 2019.  So much for fiscal responsibility and his promise to cut the deficit made just a couple months ago.
5. Increasing income taxes on businesses, capital gains and dividends will not encourage employment, in fact it will insure that the 4-5% unemployment levels we have enjoyed the past decade will be a thing of the past and much longed for in the future.
6. An Environmental inspired "Cap and Trade" system will be applied to businesses that pollute (putting further pressure on our greatly weakened manufacturing sector and the blue collar jobs that go with that sector) and will apply an additional $80 billion a year in new taxes.  A business will have the choice to either clean up emissions or spend money on eco credits to offset emissions.  This will kill many globally marginal "heavy-industry" businesses and cost tens or hundreds of thousands of decent paying jobs.
7. The budget projects increased tax revenues based on assumptions of higher than average economic growth:  an assumption that "the next 10 years of GDP growth will be better than the previous 10".  That is very hard to accept given the current near Depression circumstances and the anti-business, anti-growth leanings of the budget proposal
8. From this week's Barrons: "Debt held by the public as a share of current-dollar GDP will run 58.7% in 2009. Data since 1969 show that it never ran higher than 49.4%, and that was in 1993, when the incoming Clinton administration was concerned about taming the debt.  Yet, even based on the president's rosy (growth) scenarios, the outstanding debt is projected at 67.2% of current-dollar GDP by 2019."

Contrary to statements from his Administration, this is not an "Honest Budget".  There is much in it that is really as dishonest as anything we have seen from any recent President, as compared to the promises made during the campaign and after.

Any of you who would like, take my ideas and send them to your Congress persons. Republicans and Democrats alike. Only they can block the insanity of Obama’s proposals and save the economy (many Dem congresspeople are aghast at Obama’s tax and spend proposals).

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