Since the latest news regarding the SEC allegedly charging Goldman Sachs (NYSE:GS) for defrauding its clients, we have come to the conclusion that there will be more to come.
What is interesting is that this particular scenario was well laid out in Gregory Zuckerman’s book The Greatest Trade Ever. In the book, Zuckerman describes in detail how Paulson’s team formed its opinions on the current status of the mortgage market and figured out how to profit from their views.
Because the mortgage securitization market was still relatively new, there were not many ways to profit from the demise of real estate or the defaulting of loans other than taking long positions in Credit Default Swaps (which are essentially an insurance product in which a participant can pay a premium in advance to secure full coverage over a pool of assets, in this case mortgages).
The book also describes how in order to increase the size of their bearish position, Paulson and his team approached larger investment banks to ask for their cooperation on packaging pools of mortgages they believed would be the first to fall as soon as the real estate bubble burst. Based on their research they believed mortgages with the latter vintage years of 2005 & 2006 were the most likely to fail. By essentially hand picking each of these types of mortgages and encouraging investment banks to package them and sell the CDO’s to clients, Paulson & Co. was then able to take the other side of the trade and buy the Credit Default Swap(Insurance) on that specific pool.
So far Goldman Sachs (GS) is the only investment bank accused of “defrauding investors”, because they did not disclose to clients who purchased these CDO’s that other parties took part in creating the CDO’s: specifically parties that were betting against what they had a hand in creating.
Our view is that Goldman Sachs (GS) was not the only bank participating in this sort of practice. Investment banks are set to receive boatloads in commissions when facilitating these types of transactions, and if others noticed Goldman Sachs (GS) making money off of it, they too would participate.
Because the SEC has been so late to the party throughout the course of this financial meltdown, they are very likely to drag this out and attempt to make a name for themselves. European regulators are likely to do the same in the coming weeks, as they begin to learn that their investment banks may have very well participated in this process. We believe a series of events related to this topic could become a catalyst for pessimism/fear to enter the marketplace and will set the stage for a long needed correction.
We continue to be bearish on the S&P 500 and Deutsche Bank (NYSE:DB) in the near term. After a healthy correction, we will begin to build positions in companies whose valuations have come back to reality and futures look poised for growth.