MarketView for April 16

 

 

 

Summary 

 

Wall Street took a major hit to the solar plexus on Friday as fraud charges against Goldman Sachs and disappointing earnings sent the Street running for cover in what was the heaviest trading day this year and one that dramatically ended Wall Street's six-day winning streak.

 

Goldman fell 13 percent to $160.89 in its worst one-day drop since January 2009 on a volume of more than 100 million shares after the Securities and Exchange Commission charged the Wall Street firm with fraud over its handling of a debt product tied to subprime mortgages.

 

Other major financial firms saw their shares hit the skids as investors worried about a potential crackdown on other companies, with rival investment bank Morgan Stanley losing 4.7 percent to $29.42. Meanwhile, the CBOE Volatility index .VIX, Wall Street's favorite measure of investor fear, surged 16 percent.

 

Financial stocks were certainly not the only ones pounded on Friday.  Google, Bank of America and General Electric all took a hit after they reported quarterly results that fell short of heightened expectations. Bank of America reported higher-than-expected earnings but said loan demand was low, while GE posted weak first-quarter revenue. BofA fell 5.5 percent to $18.41 and was the top percentage loser on the Dow. GE, another Dow component, sank 2.7 percent to $18.97. Google lost 7.6 percent to $550.15 a day after it posted a 23 percent jump in quarterly revenue, but the Street had hoped for even better results.

 

On the upside, Mattel posted a surprise first-quarter profit, sending its shares up 0.4 percent to $23.84. Gannett posted abetter-than-expected first-quarter earnings, but its shares fell 0.6 percent to $18.04.

 

The Goldman news also had an impact on commodities, with crude oil futures dropping 3 percent to $82.95 per barrel.

 

In economic news, the Thomson Reuters/University of Michigan's Surveys of Consumers showed consumer sentiment took a surprising negative turn in early April due to a grim outlook on income and jobs. Housing starts rose more than expected in March, while permits to build new homes scaled a 17-month high, according to the Commerce Department.

 

Goldman Charged By SEC

 

Goldman Sachs was charged with fraud by the Securities and Exchange Commission over its marketing of a subprime mortgage product, igniting a battle between Wall Street's most powerful bank and the nation's top securities regulator. The civil lawsuit is the largest crisis in years for a company that faced criticism over its pay and business practices after emerging from the global financial meltdown as Wall Street's most influential bank.

 

It may also make it more difficult for the industry to beat back calls for reform as lawmakers in Washington debate an overhaul of financial regulations.

 

Goldman called the lawsuit "completely unfounded," adding, "We did not structure a portfolio that was designed to lose money."

 

The lawsuit puts Goldman Chief Executive Lloyd Blankfein further on the defensive after he told the federal Financial Crisis Inquiry Commission in January that the bank packaged complex debt, while also betting against the debt, because clients had the appetite. "We are not a fiduciary," he said.

 

The case also involves John Paulson, a hedge fund investor whose firm Paulson & Co made billions of dollars by betting the nation's housing market would crash. This included an estimated $1 billion from the transaction detailed in the lawsuit, which the SEC said cost other investors more than $1 billion. Paulson was not charged.

 

Fabrice Tourre, a Goldman vice president whom the SEC said was mainly responsible for creating the questionable mortgage product, known as ABACUS, was charged with fraud.

 

The SEC lawsuit announced on Friday concerns ABACUS, a synthetic collateralized debt obligation that hinged on the performance of subprime residential mortgage-backed securities, and which the regulator said Goldman structured and marketed.According to the SEC, Goldman did not tell investors "vital information" about ABACUS, including that Paulson & Co was involved in choosing which securities would be part of the portfolio.

 

The SEC also alleged that Paulson took a short position against the CDO in a bet that its value would fall. In a statement, Paulson & Co said it did buy credit protection from Goldman on securities issued in the ABACUS program, but did not market the product.

 

Goldman had not disclosed that the SEC was considering a lawsuit but had known charges were possible and had urged the SEC not to file them, people familiar with the situation said on Friday. The sources requested anonymity because the probe was not public.

 

To better understand CDOs, the SEC in 2008 approached some hedge funds, including Paulson & Co’s Paulo Pellegrini was among those to talk with the regulator. By betting against subprime mortgage-related debt, Pellegrini helped Paulson's firm earn an estimated $15 billion in 2007. Pellegrini last year left to start his own firm.

 

The lawsuit is a regulatory and public relations nightmare for Blankfein, who has spent 18 months fending off complaints that Goldman has been an unfair beneficiary of taxpayer bailouts of Wall Street. Blankfein became chief executive less than a year before the product challenged by the SEC was created.

 

The SEC lawsuit represents an aggressive expansion of regulatory efforts to hold people and companies responsible for the nation's financial crises. It could help the regulator rehabilitate its reputation after missing other high-profile cases, including Bernard Madoff's Ponzi scheme.

 

Robert Khuzami, head of the SEC's enforcement division, said John Paulson was not charged because it was Goldman that made misrepresentations to investors, not Paulson. Still, Khuzami called Paulson's firm "a hedge fund that had a particular interest in the securities performing poorly."

 

According to the SEC, Goldman marketing materials showed that a third party, ACA Management LLC, chose the securities underlying ABACUS, without revealing Paulson's involvement. The SEC complaint quotes extensively from internal e-mails and memos, noting that in early 2007 it had become difficult to market CDOs tied to mortgage-backed securities.

 

It quoted a January 23, 2007, e-mail from Tourre to a friend as saying: "The whole building is about to collapse anytime now ... Only potential survivor, the fabulous Fab ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!" Another e-mail, to Tourre from the head of Goldman's structured product correlation trading desk, complained: "The CDO biz is dead we don't have a lot of time left."

 

Other communications detail the importance of hiring ACA. The SEC said Goldman reached out to German bank IKB to buy securities that Paulson was selling, knowing it would buy only securities selected by an independent asset manager.

 

"We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering," a March 12, 2007, Goldman e-mail said.

 

IKB ultimately took on exposure to ABACUS, as did the Dutch bank ABN Amro Holding NV. The German government ultimately bailed out IKB in the summer of 2007, in part because of the bank's investments, while lenders that eventually bought much of ABN Amro were also subjected to their own government bailouts.

 

In a statement after U.S. markets closed, Goldman said it lost more than $90 million on the transaction, six times the $15 million fee it received, and provided "extensive disclosure" on the securities involved.

 

It also said it never represented to ACA Capital Management, which invested $951 million in the transaction that Paulson was going to be a "long" investor, meaning that Paulson was betting the securities would gain in value.

 

Paulson & Co paid Goldman $15 million to structure and market the ABACUS CDO, which closed on April 26, 2007, the SEC said. Little more than nine months later, 99 percent of the portfolio had been downgraded, the SEC said. The charges are expected to fuel anti-Wall Street sentiment on Capitol Hill where sweeping financial industry reforms are expected to soon arrive on the Senate floor for a vote.

 

A Democratic bill, strongly supported by President Barack Obama, would slap new restraints on major banks, likely curtailing their opportunities for profit and revenue growth. Similar legislation was approved in the House of Representatives in December. Analysts believe a bill could be signed into law by Obama by mid-year.

 

Goldman in 2008 won a $5 billion investment from Warren Buffett's Berkshire Hathaway. Last month, Buffett praised Goldman as a "very, very strong, well-run business," and said of Blankfein, "You cannot find a better manager." Buffett had no immediate comment, his assistant Carrie Kizer said.

 

New Home Permits Rise, While Sentiment Falls

 

New home permits rose in March to a 17-month peak and construction activity was the most vigorous in more than a year, providing fresh evidence that economic prospects are brightening. However, a surprising slump in consumer confidence this month indicated that average Americans remain frustrated at the slow pace of recovery, which is not generating strong jobs growth.

 

Data such as retail sales, trade and orders for long-lasting manufactured goods have indicated the economic recovery is gaining muscle and filtering to other sectors. Payrolls resumed growth in March. Building permits, an indicator of future activity, jumped 7.5 percent to a 685,000-unit-a-year pace last month, the Commerce Department said on Friday. Markets had expected a 630,000 unit pace. New home construction hit its highest level since November 2008 but most of it was in the volatile multifamily segment.

 

Yet, the Thomson Reuters/University of Michigan's Surveys of Consumers index of consumer sentiment slipped to a five-month low of 69.5 in early April from 73.6 at the end of March. That was below market expectations for 75.0. Boosting consumer spending, which fuels 70 percent of total production of goods and services, is critical to get a self-sustaining recovery on track.

 

The drop in consumer confidence, a proxy for spending, is at odds with the rise in retail sales seen in recent months. Retail sales have risen even as the unemployment rate has remained elevated at 9.7 percent and income growth has been sluggish.

 

Despite frustration with the pace of the economic recovery, consumers invested in new residential property last month. House starts rose 1.6 percent to a higher than expected seasonally adjusted annual rate of 626,000 units. February's housing starts were revised up to show a 1.1 percent increase, which was previously reported as a 5.9 percent drop.

 

The rise was probably due to a combination of consumers rushing to take advantage of a homebuyer tax credit and a snap back from February's snowstorms which had held back activity. Prospective homeowners have to sign contracts by the end of this month and close them by end of June to take advantage of the tax break.

 

Starts for the volatile multifamily segment jumped 18.8 percent jump in March, while groundbreaking for single-family homes slipped 0.9 percent. The data was a welcome relief after the housing market recovery appeared to have stalled in recent months and sales dropped following strong gains in the second half of 2009.

 

A National Association of Home Builders survey on Thursday showed home-builder sentiment rose to a seven-month high in April. New building permits increased across both segments of the housing market and were up 34.1 percent from March 2009, Friday's Commerce Department data showed, the largest year-on-year gain since February 1992.

 

Kansas City Fed President Wants MBS off Fed Balance Sheet

 

Federal Reserve Bank of Kansas City President Thomas Hoenig said on Friday he would not want to disrupt markets by selling too quickly the assets the central bank acquired during the financial crisis. However, he also made it clear that he would like to keep the option open for selling the mortgage-backed securities bought as part of additional steps to get the economy going, rather than just letting them roll off the Fed's balance sheet.

 

"My view is we should exit as deliberately as possible," Hoenig said. "I don't want to disrupt the market by quick sales but I want to leave the option open for taking them off the balance sheet through more than just amortization."

 

The Fed bought during the crisis longer-term assets including $1.25 trillion of mortgage-backed securities. That more than doubled the central bank's balance sheet to over $2 trillion. Hoenig said he would eventually want to see it back below $1 trillion.

 

Hoenig, a voter on the Fed's policy-setting Federal Open Market Committee this year, dissented at the past two policy meetings because he did not feel comfortable with the Fed's pledge to keep rates ultra-low for an extended period.

 

Asked about whether the Fed should raise reserve requirements for banks, Hoenig said even discussing using this tool would cause unwanted uncertainty in markets at this point. He also said the topic should be revisited later.

 

He reiterated his view that big banks should be broken up, and said he was a "very strong supporter" of the Volcker rule to ban commercial banks from engaging in trades not done on behalf of their customers.

 

"The country would be well served by more smaller banks," Hoenig said, adding he supported "clear, firm" leverage limits for banks.

 

Hoenig said he has concerns that regulatory reform being discussed in Congress doesn't adequately address the problem of banks that are "too big to fail". Hoenig said any law should require large insolvent firms to be placed into receivership, like smaller banks.

 

The Kansas City Fed chief also criticized the Senate proposal to strip the Fed of supervision of thousands of smaller banks. He said that would lead to the Fed being marginalized outside of Wall Street and Washington.