Why Goldman is a Screaming Buy

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The Securities and Exchange Commission shocked Wall Street today with its accusation, duly filed in Federal District Court in Manhattan, that Goldman Sachs ( GS ) engaged in fraud during the subprime debacle.

Shares have taken a dive, losing nearly -13% of their value on fantastic volume.  So the question arises: Is Goldman a good buy? Or is it lights out for the storied squid?

I wanted to find out. So I read the actual lawsuit. Not the news coverage of it, but the actual court filing. You should, too.  When you're done, I think you ought to respond to your first instinct.

First, stick with me as we break this down piece-by-piece.

It starts as a homebuyer gets a mortgage. Then the bank, for whatever reason, decides to sell the loan. This happens thousands of times a day. 

Those loans are combined into an entity called a "Residential Mortgage Backed Security." This is nothing more than a bond backed by mortgages. Each month, as borrowers make the house payment, a lot of interest is paid and a little debt is retired.

Those residential mortgage-backed securities can be packaged into yet another type of security called a collateralized debt obligation or "CDO." To make sure it's even more complicated, these are further divided into sections called "tranches" and are then risk-rated and sold. Now it's a big bond backed by a bunch of smaller bonds.

Let's be clear about who buys these.  These investments are only bought by major players who are looking for good returns and willing to take the risk to get them. "Qualified institutional buyers" are legally recognized as sophisticated, well informed investors who need less protection than individuals.

Now: Enter Goldman.

The investment bank was asked by a client to put together a CDO. So Goldman did. It loaded a lot of risky residential mortgage-backed securities into a new CDO and then sold pieces of it to investors. Just like it has done a thousand times before. Just like the other major investment banks do all the time. Goldman was paid a fee of $15 million to put the CDO together. For those of you keeping score at home, that's about 0.0003% of its annual revenue.

What happened? Well, as we all know, the housing market went south. As properties lost value, borrowers defaulted with insufficient collateral to cover the debt. The mortgages lost some if not all of their value and the over-arching CDOs basically became worthless because no one wanted to buy "toxic assets."

While millions of investors lost money and some institutions even failed, a few investors did manage to make money on the subprime collapse.

One who did: The client that asked Goldman to put together the CDO. It was a hedge fund called Paulson & Co. After the CDO it sought had hit the Street, Paulson bet against it by buying something called a credit-default swap.

Forgive the lingo, but there's no way around it. A "credit-default swap" is nothing more than a bet between rich dudes. One says something is going to happen and the other says it's not.  It's kind of like a private insurance policy.  Instead of going to, say, Geico, I pay a rich neighbor $1,000 to cover me for a year. If my car crashes, he buys me a new one. What's "swapped" is risk. I was taking it, then I paid someone else, my rich buddy, to shoulder the burden.

In the Goldman case, the something being bet on was the mortgages. In banker lingo, a "credit" is a loan. "Default" refers to the risk that a loan might go bad. So all a fancy "derivative" like a credit default swap really is is an insurance policy against a bunch of loans going bad.

And that is what Paulson bought. When the loans went bad, Paulson got paid. Not quite as complicated as it sounds in the papers, right?

Paulson made $1 billion on this deal, incidentally. That money came from the rich dudes who thought the mortgages wouldn't go bad. (And if they had, then they would have kept the premium, just like the insurance company keeps the premium even if you don't wreck your car.)

Paulson, for its part, is not being sued by the SEC.

Only Goldman. And a (now) 31-year-old kid who works there. He made the mistake of writing a couple of damning-sounding emails in which his ego-driven braggadocio far superceded his prudence and intelligence. He knew, as most did at the time, that the mortgage market was imploding and that CDOs were about to take a hit. He said so. That looks bad, as Goldman was still selling CDOs -- and institutions hungry for juicy returns were still buying them.

Remember: Every one of these CDOs, even, in some cases, with extremely poor credit ratings, were sold. Someone bought them. Someone read the details, took out his checkbook and said, "I will pay for that." And everyone who did was a qualified instutional buyer who knew exactly what was going on. Ignorance is no excuse. It's just ignorance.

The SEC contends that Goldman has some sort of duty to disclose that Paulson was betting against the CDO.

That's ridiculous.

Goldman should never tell anyone what one of its clients is doing. It doesn't and, I would guess, it hasn't. In other forms, exploiting or divulging clients' positions would be no different from front-running trades, which is and should be illegal.

Remember: Goldman is a broker/dealer. It arranges trades. A buyer wants something that a seller does not, Goldman puts the two parties together. It's not Goldman's role to talk a client out of buying something that it wants. Goldman's role, in this case, was to make a market. Provide the means for transaction between buyer and seller. It did that. It did nothing wrong.

Look at it this way: What if you called your broker and sold 100 shares of IBM ( IBM ) . Would you want your broker to tell the world that you no longer wanted to own Big Blue? And if you shorted the shares, does your broker have an obligation to tell the next customer that wants to buy IBM that you just bet against the company?

Of course not.

And, again, we're not talking about the individual investors that the SEC is supposed to protect. We're talking about sophisticated, well informed masters of finance who knew exactly what they were doing. It's ludicrous to suggest otherwise. That a lot of banks lost money on CDOs just means they were all equally stupid and willfully disregarded the risk.

I mean, c'mon: No one buys a debt instrument with a relatively high rate of default (as reflected in credit ratings and in the underlying fundamentals of the instrument, which are available in detail on any Bloomberg terminal) without understanding that somewhere someone might be betting against it. As rumors build against a company, investors short it -- betting it will implode. Others buy it, thinking it will make a comeback and they will make a killing.

There isn't any wrongdoing, even if both parties make their trades though the firm that underwrote the initial offering!

The broader context must be taken into account. Goldman Sachs is a great bank. Smart, admirable and decent people work there. They make good salaries, sure. But that just gives every Goldman employee all the more reason to play it straight.

Goldman does complicated stuff and makes a ton of money in ways that most people can't relate to or figure out. They hear words like "derivatives" and "credit default swap" and "collateralized debt obligation" and they're lost. Most people wonder how the housing bubble burst and how everything really went down, and in the end it's easy to blame an institution like Goldman or Skull & Bones or the Castro regime for things that otherwise defy an easy explanation. The same people who would be mad at Goldman for selling this security at the behest of a client are the same ones who thought the whole financial crisis would go away if we lowered a few CEO salaries. It is naive populism knee-jerking its way to judgment about something it clearly is ignorant of and has no frame of reference to understand.

This lawsuit is about redistributing wealth. It's about criminalizing financial sophistication and punishing size and success.

That's the bad news.

The good news is that the Goldman case will be tried in the most financially savvy court in the land. The truth will come out. Mark my words: Goldman will be fine.

So what's your first reaction?

If it's to buy Goldman shares at today's fire-sale price, then I'd agree. Goldman's a buy.


Andy Obermueller
Editor: Government-Driven Investing

Disclosure: Andy Obermueller does not own shares of any security mentioned in this article.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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This article appears in: Investing , Stocks

Referenced Stocks: GS , IBM

Andy Obermueller

Andy Obermueller

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