Beauty is Truth, Part II

Simplicity and honesty are essential investment attributes. Complexity and deception are fatal.

Most publicly traded financial firms, for example, reside at the complex and deceptive end of the investment spectrum. They are complicated and highly leveraged…which means the chances of a costly deception (whether intentional or accidental) are very high. The corporate histories of Countrywide Financial, Washington Mutual, Lehman Bros. and Bear Stearns illustrate the point.

But we do not gather here today to mourn the dead; rather to scorn the living. In this case, Goldman Sachs.

Once upon a time, Goldman Sachs was a revered moneymaker – the can-do golden child of Wall Street. During the 1990s, Goldman was the American financial firm nonpareil. Its over-the-top success epitomized the feel-good vibe of the market. Accordingly, Robert Rubin, the former CEO of Goldman Sachs joined the Clinton Administration to become one of the most admired Treasury Secretaries of all time.

But then things changed. The stock market slumped, the housing market tanked and the economy stumbled. Through it all, Goldman Sachs made money. Lots of it.

This one fact angered politicians and average Americans alike. “How dare Goldman Sachs make so much money by betting against the housing market, while so many average Americans were losing their homes!” the hoi polloi exclaimed.

But making money is no crime…unless you are committing crimes to make money, which is exactly what the SEC’s suit against Goldman Sachs alleges. According to the SEC’s complaint, Goldman failed to disclose material information about a security it sold to clients. The SEC calls that “fraud” – always has, always will.

Berkshire Hathaway’s Warren Buffett, along with other Goldman cheerleaders, assert that the company did no wrong. “Goldman is in the business of buying and selling securities for profit,” the cheerleaders declare. “It has a duty to its shareholders.”

This argument misses the point. The only point that matters is this: Beauty is truth; truth beauty. It’s true that Goldman Sachs not only possesses the right, but the obligation, to make money for its shareholders. But it’s also true that this obligation is subordinate to Goldman’s fiduciary obligation to its clients. In other words, clients first; shareholders (and options-laden management) second.

As one of America’s largest purveyors of toxic collateralized debt obligations (CDOs), Golden played the role of financial cigarette salesman. Nothing wrong with that…so far. But this particular cigarette salesman took out insurance policies on its biggest customers. Okay, so maybe that’s a bit morally ambiguous, but it is still perfectly legal…as long as the cigarette salesman didn’t lie to his customers about the potential consequences of smoking cigarettes.

But Goldman did lie. To continue our metaphor, Goldman not only “whited out” the Surgeon General’s warning on every pack it sold, it also substituted its own warning that read something like: “These cigarettes are full of sugar and spice and everything nice, just like little girls.”

Goldman informed its clients that John Paulson – the guy who secretly helped construct the Abacus CDO that is at the heart of the SEC’s complaint – was a large buyer of this security, when in fact he was a large short-seller of the security. That was a lie. Importantly therefore, Paulson did not utilize his legendary expertise of the CDO market to select the securities that would succeed, he used his expertise to select the securities that would fail.

Goldman’s failure to disclose this very material fact was a fraud…big time. If Goldman had merely informed its customers that the “cigarettes” it sold were full of “frogs and snails and puppy dog tails” and/or that the guy who helped select the securities comprising this particular CBO was selling it short, Goldman could have purchased life insurance on its customers all day long in full compliance with every applicable securities law.

Every seasoned investment advisor and securities lawyer – or investment bank – understands that the SEC’s Everest of regulations and no-action letters would boil down to three words: “Disclose, disclose, disclose.”

Disclosure is the key component of almost every statute. And it would be impossible to be in a position of power and influence on Wall Street without understanding this fact.

A failure to disclose is the essence of the SEC’s complaint against Goldman Sachs. And if, as your editor suspects, additional SEC charges emerge, “Failure to disclose” will likely play a key role in those as well. No one is exempt from this obligation – least of all the only financial firm that is a major market maker in all of America’s largest financial markets.

The “remedy” to this problem is not complex. Enforce the laws that exist. Insist on disclosure. Prosecute those who don’t disclose. The financial markets do not need “more regulation,” they need the same old regulation they’ve already got…rigorously and blindly enforced.

Justice possesses too much eyesight. She needs to put her blindfold back on – and ditch her “Goldman” golf cap – and let a dispassionate analysis of the facts lead wherever it may.

Whatever the outcome of the Goldman prosecution/inquisition, we investors must insist on truth or stay away. The best investments are those that are easy to understand…and trustworthy. Both Goldman and Greece would fail this simple test. Our advice: stay away from both of them.

“Sell risk, buy caution. Sell complexity, buy simplicity,” your editor advised in a July 2008 presentation to the Vancouver Investment Symposium. “The Era of Peak Greed is over; the Era of Caution is upon us. That’s not such a bad thing. Caution sounds boring, but it’s not nearly as boring as it sounds. In fact, I think being cautious is kind of an uncelebrated virtue. It’s a little bit like being free of venereal disease. You can’t really brag about it at a cocktail party, but it’s still a pretty darn good thing at the end of the day.”

Two months after this presentation, Lehman Brothers came crashing down, and the entire investment world learned to its chagrin about all the mortgage-backed detritus the nation’s banks had been squirreling away on their balance sheets. Lots of risk; lots of complexity…amplified by lots of leverage.

Share prices have improved dramatically since the lows of one year ago, but many of the deceptive structures that created the financial crisis remain in place. The financial sector remains a minefield of complexity, leverage and questionable pricing of balance sheet assets. In other words, the risks remain because the deceptions remain.

Therefore, sell risk, buy caution. Sell complexity, buy simplicity. Place your hard-earned investment capital in the hands of individuals who will respect and reward it; not in the hands of individuals who will abuse it.

Eric J. Fry
for The Daily Reckoning