Eric Fry

Deception in the financial markets is not always costly, but it is rarely remunerative. Investors cannot afford to ignore this tendency.

Recent disclosures from the Federal Reserve reveal that honesty was one of the earliest casualties of the 2008 financial crisis. These disclosures contain a number of juicy tidbits, like the fact that Goldman Sachs received tens of billions of dollars in direct and indirect succor from the Fed.

Thanks to these spectacularly large taxpayer-funded bailouts, Goldman was able to continue “doing God’s Work” – as CEO Lloyd Blankfein infamously remarked – like the work of producing billion-dollar trading profits without ever suffering a single day of losses.

Thanks to the Fed’s massive, undisclosed assistance, Goldman Sachs managed to project an image of financial well-being, even while accessing tens of billions of dollars of direct assistance from the Federal Reserve.

By repaying its TARP loan, for example, Goldman wriggled out from under the nettlesome compensation limits imposed by TARP, while also conveying an image of financial strength. But this “strength” was illusory. Goldman repaid the TARP loans with funds it procured days earlier from the Federal Reserve. Then, over the ensuing months, Goldman recapitalized its balance sheet by selling tens of billions of dollars of mortgage-backed securities to the Fed.

And the public never knew anything about these activities until two weeks ago, when the Fed was forced to reveal them.

In a free-market economy, certain precepts seem fundamental…and essential:

1) Taxpayers have a right to know who’s spending their money.
2) Dollar-holders have a right to know who’s debasing their money.
3) Investors have a right to know who’s cheating them out of their money…by hiding the truth.

All three camps have a very large and legitimate bone to pick with the Fed’s secret bailouts of 2008 and 2009. But let’s consider only the case of the deceived investor…

Secret bailouts do not merely benefit recipients; they also deceive investors into mistaking fantasy for fact. Such deceptions often punish honest investors, like the honest investors who sold short the shares of insolvent financial institutions early in 2009.

Some of these investors had done enough homework to understand that no private-market remedy could ride to the rescue of certain financial firms. Therefore, these investors sold short the shares of certain ailing institutions and waited for nature to take its course. But the course that nature would take would be shockingly unnatural. We now know why. The Federal Reserve altered the course of nature, and did so without telling anyone.

Many of the investors who sold short ailing financial firms in 2009 were alert to the possibility that bailouts by the Federal Reserve could change the calculus. In other words, the Fed could make the bearish case less bearish…at least temporarily. Therefore, many of these investors studied the Federal Reserve’s disclosures, as well as corporate press releases, in order to quantify the Fed’s influence.

Based on all available public disclosures, the story remained fairly grim into the spring of 2009. Accordingly, the short interest – i.e., number of shares sold short – on Goldman Sachs common stock hit a record 16.3 million shares on May 15, 2009 – about 3.3% of the public float. But over the ensuing six months, Goldman’s stock soared more than 30% – producing roughly $500 million in losses for those investors who had sold short its stock. Not surprisingly, the total short interest during that timeframe plummeted to less than 6 million shares, as short-sellers closed out their losing positions.

Was it just bad luck? Or was something more nefarious at work here?

Let the reader decide. But before deciding, let the reader carefully examine the chart below, while also carefully considering a selection of public announcements from Goldman Sachs during this timeframe.

Goldman Sachs Borrowing and MBS Sales to the Fed

Based upon contemporaneous public disclosures, Goldman Sachs was “forced” by the Federal Reserve to accept a $10 billion loan from the TARP facility in October 2008. But Goldman’s top officers repeatedly – and very publically – bristled under the compensation limits the TARP loan imposed.

Therefore, as early as February 5, 2009, Goldman’s chief financial officer, David Viniar, remarked, “Operating our business without the government capital would be an easier thing to do. We’d be under less scrutiny…” And on February 11, 2009, CEO Blankfein magnanimously remarked, “We look forward to paying back the government’s investment so that money can be used elsewhere to support our economy.”

But at that exact moment, we now know, Goldman was operating its business with at least $25 billion of undisclosed “government capital.”

In April, 2009, The Wall Street Journal observed, “Goldman Sachs group Inc., frustrated at federally mandated pay caps, has been plotting for months to get out from under the government’s thumb… Goldman’s managers have a big incentive to escape the state’s clutches. Last year, 953 Goldman employees – nearly one in 30 – were paid in excess of $1 million apiece… But tight federal restrictions connected to the financial-sector bailout have severely crimp the Wall Street firm’s ability to offer such lavish pay this year.”

On May 7, 2009, a Goldman press release states: “We are pleased that the Federal Reserve’s Supervisory Capital Assessment Program has been completed… With respect to Goldman Sachs, the tests determined that the firm does not require further capital… We will soon repay the government’s investment from the TARP’s Capital Purchase Program.”

On June 17, 2009, Goldman finally got its wish, thanks to some timely, undisclosed assistance from the Federal Reserve. Goldman repaid its $10 billion TARP loan. But just six days before this announcement, Goldman sold $11 billion of MBS to the Fed. In other words, Goldman “repaid” the Treasury by secretly selling illiquid assets to the Fed.

One month later, Goldman’s CEO Lloyd Blankfein beamed, “We are grateful for the government efforts and are pleased that [the monies we repaid] can be used by the government to revitalize the economy, a priority in which we all have a common stake.”

As it turns out, the government continued to “revitalize” that small sliver of the economy known as Goldman Sachs. During the three months following Goldman’s re-payment of its $10 billion TARP loan, the Fed purchased $27 billion of MBS from Goldman. In all, the Fed would purchase more than $100 billion of MBS from Goldman during the 12 months that followed Goldman’s TARP re-payment.

Did private investors not have the right to know that the Federal Reserve was secretly recapitalizing Goldman’s balance sheet during this period? Did they not deserve to know that the Fed’s MBS buying was producing Goldman’s “perfect” trading record during this timeframe?

Yes, would seem to be the obvious answer.

“There’s a saying in poker: If you don’t know who the patsy is at the table, it’s you,” observes Henry Blodget, the once and again stock market analyst, “Next time you feel like bellying up to the Wall Street poker table, therefore, ask yourself again who the sucker is.”

To be continued…

Regards,

Eric Fry
for The Daily Reckoning

Eric Fry

Eric J. Fry, Agora Financial's Editorial Director, has been a specialist in international equities for nearly two decades. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short-selling.  Following his successes in professional money management, Mr. Fry joined the Wall Street-based publishing operations of James Grant, editor of the prestigious Grant's Interest Rate Observer. Working alongside Grant, Mr. Fry produced Grant's International and Apogee Research, institutional research products dedicated to international investment opportunities and short selling. 

Mr. Fry subsequently joined Agora Inc., as Editorial Director. In this role, Mr. Fry  supervises the editorial and research processes of numerous investment letters and services. Mr. Fry also publishes investment insights and commentary under his own byline as Editor of The Daily Reckoning. Mr. Fry authored the first comprehensive guide to investing internationally with American Depository Receipts.  His views and investment insights have appeared in numerous publications including Time, Barron's, Wall Street Journal, International Herald Tribune, Business Week, USA Today, Los Angeles Times and Money.

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