Goldman on Trial - Part 1

Get used to Goldman being in the news for the next little while. According to this NY Times article, Goldman Sachs is being sued for knowingly packaging poor quality mortgages and other loans into a large credit derivatives bundle, and then selling it to the market. More than likely, the lawsuit is sparked by the fact that Goldman has been profitable throughout the financial crisis and it's really pissing everyone off. News of this lawsuit has triggered banks from other nations to begin investigations to see if they have a similar case. Did Goldman sell them shitty mortgage-backed securities too?

Winning this case is going to be next to impossible. Yesterday, I pretended to be a Goldman Sachs attorney while my father, quite angry over the matter, represented the prosecution.

Dad: How is this different than selling me bad apples? You hid the rotten apples at the bottom of the basket, so I didn't find them until later on.

Me: Let's make it a carton of eggs. If you walk out of the store with a carton of eggs, and discover that one is broken, is it the store's fault for selling you a broken egg or your fault for not checking? Don't buyers have to perform their due diligence on something before buying?

Dad: No. You knowingly made it hard for me to find these bad apples. You tied bows on top and hid them in a place where I couldn't see them until much later. And we can prove you knew this, because not only did you sell these apples to me, but after selling them, you short-sold the very same assets, fully knowing they were total shit and that they were going to drop in value. So not only did you gain from not holding them anymore, you actually profited from me losing.

Me: First, I think you have to agree with me that in a free market, you have to at least squeeze the apples before you buy them, or accept the bad ones if you didn't bother to check.

Second, since when am I not allowed to change my opinion on how I view the markets? Initially, we were happy to hold all sorts of apples here at Goldman. We had a very optimistic view of the mortgage markets, just like everyone else. But in 2007, it became clear to us that we might be too optimistic. We had to shed our risk by selling some of our mortgage-related assets. But since we were still holding on to some, we wanted to hedge ourselves by taking further positions reflecting our new point of view, that mortgage markets were inflated. We had to protect ourselves from the risk that there was a mortgage bubble.

Dad: But you knew they were bad assets. What if I can prove that you knew that?

Me: Even if you can prove that we knew that, how can you possibly blame us for wanting to protect ourselves. Acting in our self interest is not illegal. You had access to the same information on mortgages, so did Lehman, so did AIG, yet all of you continued to take the position that housing prices would continue to rise.

If you had come to the same conclusions as us, we would not have been able to sell those assets the way we did, we would have had to sell them for much less. But in any market, a seller is supposed to get as much as he can, while a buyer is supposed to pay as little as he can. If the real estate markets continued to rise, we would have lost and you would have won. Should Goldman then be able to sue you for being right?

It was at this point that my father became aggravated with me, and I had to hold his hand and remind him that I wasn't really a Goldman lawyer, and that I hated what was going on as much as he did.

My point was this is a very difficult thing to prove in court. There are some famous cases in derivatives law against Banker's Trust (Proctor & Gamble and Gibson's Greetings being the victims). In the P&G case, for example, Banker's Trust was able to persuade the Treasurer at P&G into entering risky interest rate swaps. At the time, interest rates were low, and P&G bet that interest rates would remain low. The treasurer there was making a tidy profit each month, which of course translated into better performance results for him as the treasurer.

In the early 1990s, the Fed reserve raised interest rates by a hair, and it came to be known that P&G had made some massive bets against rising interest rates. All of a sudden, P&G found itself trying to explain to its shareholders how it had incurred massive losses that had nothing to do with operations. It was natural for P&G (and similar victims) to pursue legal action against Banker's Trust.

P&G accused Banker's Trust of selling them something that didn't meet their requirements. They were sold a product that was excessively risky and complex, when really P&G just needed a simple hedge against interest rates. Their case, by itself, probably would not have held water, but as it turned out, Banker's Trust had been sloppy.

One of the traders was caught on tape talking to his girlfriend on the phone about how he was passing off risk to the P&G treasurer, and that the treasurer was clueless. In addition to this, the traders were caught talking to each other about how this deal was a "wet dream." Not only could they sell the swaps and collect a huge transaction fee, but when it came time to settling the cash involved, the traders had learned that P&G didn't know how to determine the payment. So Banker's Trust would call P&G and say, "so we're going to pay out at $89,000," and the treasurer would agree that this number sounded reasonable. Then they would hang up and giggle to each other about how they really owed ten times that amount.

Banker's Trust ultimately settled. They had to because the behavior of the traders was not about to gather any sort of sympathy. We will see if there is evidence of Goldman acting in a similar fashion, and surely if there are phone calls to girlfriends, and emails about how stupid the rest of the world is, they too might start to scramble. Currently, their stance is to claim this entire lawsuit is completely unfounded.

When the entire financial system collapsed in 2008, when small banks were allowed to fail, we effectively destroyed trillions of dollars. That was our money. All of us. The US government should be looking for a way to permanently change the structure of the financial system instead of trying to recoup a tiny fraction of the losses.

Pursuing legal action against Goldman will not fix the problem that hit all of us in the face in the fall of 2008. I'm skeptical about their chances of success in the lawsuit, but the bigger issue is that this lawsuit isn't suddenly going to scare those with better information from taking advantage of the weaker players in the market. Unfortunately, the pursuit of justice will only serve to distract us from the real issue, which is that the financial system has become an uncontrollable monster that very few people understand, and that nobody can control.

China

Although China and the United States don’t always agree on everything, their recent dealings have suggested that they were meant to be together. After spending so many years courting China, trying to get the timid nation to open its doors to global trade and business, China eventually came around and the two nations have been riding a honeymoon high ever since.

But things have been a bit rocky recently. They are staring right into each other’s eyes, faces void of expression, suppressing contempt for all the annoying things the other one does, realizing that they don’t have very much in common, and trying to search through the haystack for reasons to stay together.

In January of this year, I posted a piece discussing how we are witnessing the decline of the US dollar as it slowly loses status as the world’s reserve currency.

The price of gold, which was the world’s original reserve currency for centuries, continues to rise, as Investors try to find a safe place to park their money. Greece is being bailed out as it would otherwise have defaulted on its sovereign debt. In the past, this would have been a time where investors blindly purchase the Treasury notes of the greatest nation on earth.

But institutional investors are hesitating as America’s balance sheet continues to accelerate towards insolvency. There is no plan in place to reverse this. Let’s not even bring up the fact that they will have to incur more debt to finance further stimulus in an attempt to end the recession (or what they like to call “jobless recovery”).

Until now, America’s saving grace has been its relationship with China. China is the largest lender to the US, and the main reason is trade. China’s explosive growth for the last two decades is completely attributable to their ability to export manufactured goods, and America is their largest consumer. However, the natural balance of trades when one nation (US) continues to import from another (China) is that China’s currency will rise in value versus the American Dollar. As this happens, it becomes more expensive for Americans to purchase the same goods. That isn’t good for production (China), or consumption (US).

To offset this natural movement in the foreign exchange rate, China lends money to the US by purchasing American Treasury bills. Because these amounts are so large, it pushes the value of the American dollar back up relative to the Yuan. America takes the money it receives from the proceeds of these T-bills, and subsequently lends it out to banks. Banks lend it out to the rest of the economy, and they continue to purchase goods from China. This relationship is what allowed China to experience an industrial revolution for the very first time.

I encountered these facts in one of my most recent readings, The Ascent of Money by Niall Ferguson. He continues by saying, “…the importance of net exports to Chinese growth has declined considerably in recent years.” This implies that making goods affordable for Americans is becoming less important to the Chinese economy.

That statement explains a recent move in the markets by the Chinese government. In this article, the Associated Press mentions how a $5.8 Billion sale of US T-bills by China can potentially raise the cost of borrowing for the US in the future.

The value of bonds is inversely related to interest rates, so such a market move would raise interest rates in the US economy. However, rising interest rates will have detrimental consequences for an economy mired in a recession, as it would contract the money supply and stifle growth.

To top it off, China is trying to have its cake and eat it too. It is in the unique position of centrally controlling its foreign exchange rate, which means as it slowly tip-toes away from being America’s biggest lender, it can simultaneously offset the natural rise of its own by setting its currency exchange rate too low in order to retain its export advantage. The Americans find this practice unfair, as a low Chinese currency means they are able to retain an export advantage over the US and other nations. Because the US is trying to spark production in its own economy, things are heating up.

So now it becomes a political exercise for America to have other countries continue to purchase their bonds and hold the value of the US dollar up. We used to call America the most powerful nation in the world, but that’s no longer true. Power comes from position – you can only have power if others are dependent on you.

I mention Ferguson’s book as he spends a chapter discussing what he calls the symbiotic relationship between the two nations. He makes a bold prediction that we should expect to see tensions between the two nations as China becomes less dependent on the US. He even goes as far as saying we shouldn’t be surprised if it comes to war. In this Newsweek piece, he elaborates on some of the ideas he introduced in the book.

As alarming as that sounds, it’s not an unreasonable conclusion given that every single war mankind has fought could easily be expressed as a battle for economic resources and prosperity. Sure, there are other reasons too. China’s policy on human rights, the questionable credibility of its economic data, currency manipulation…the list goes on. America happily swept most of this under the rug while times were good.

But I understand what America is going through. It hurts to think about China going off on her own, making new trade relationships. At G20 meetings, every nation is hovering around her, laughing at all her jokes even though she’s not that funny. It’s almost as if she used America’s ability to consume goods in order to develop her own manufacturing infrastructure. And now she thinks she’s all that? Does she honestly think she can do better? The natural economic response to a situation like this is that America has to get a much hotter trophy girlfriend instead of whining and complaining about how annoying China is.

We Are Hunted

Here's a new way to find music. Sure, it's just another list. But how they have compiled it is what intrigues me. In their own words:

We listen to what people are saying about artists and their music on blogs, social networks like Facebook and MySpace, message boards and forums, Twitter and P2P networks to chart the top songs online everyday.

You can listen to the entire song and buy it directly from the site. We are beginning to see very unique commercial uses of social networks like twitter and facebook. By organizing all of the clutter from our Twitter/Facebook pages and tracking popular songs, We Are Hunted is able to extract and compile a list we have never seen before.

This is similar to what I spoke about months ago in the use of Twitter for certain stock market traders. In this piece, market traders who believe that the herd will overvalue/undervalue stocks can use Twitter/Facebook/etc to harness the public market sentiment of a stock at a particular time. If they believe the herd is irrational, then they are trying to time their bets against the herd to profit from massive irrationality.

The technology is out there and it's working. If you can think of a particular piece of information to mine from the Twitter/Facebook data set that would have value to someone, it would appear that you're in business.

Taxi!

Torontonians are tolerant people, but ask them about taxi drivers and they will slap you in the face with their frustrations. I’m no different.



Just the other day, my sister and I were going to a house party and we got this: "Can you tell me where that is? I forgot my GPS at home." I shook my head and my sister rolled her eyes. We kind of smiled and stayed quiet, and then my sister asked him, “Maybe you should know where you're going before you start driving.” She actually knew where it was, but I think we were both in agreement that this guy would have to figure it out. Maybe it was the brash way he spoke to us, or the fact that he put us on hold rather than the person on the cell phone, but we enjoyed watching him struggle.



On our way home that night, we settled into a cab and told him our destination, at which point he conveniently remembered that he had to be somewhere else. No eye contact necessary for this one. “Why couldn’t you tell us this before we got in?” “Why is your light on in the first place?” As we were getting out of the cab, a lone girl was about to get in and we didn’t allow it. “Oh, he’s got to be somewhere else!” and when he tried to talk to the girl we cut him off and told him to turn his light off and go away. At this point, if he was going to get another fare, it wasn’t going to be on this block. We were more than happy to waste our time preventing passengers from getting into his cab.



I understand why he did this. He was trying to be efficient. They don’t want my $12 fare, because those 10 minutes might cost them a $75 fare to Mississauga. In other words, it’s better to sit idle and wait for that fare instead of taking us home.

The best fares are a combination of distance and speed. You only need few of those to have a good night. But in fact, it is illegal for a cab driver to refuse a fare in Toronto (unless the driver feels threatened, or if you’re destination is out of Toronto).

Our taxi force is mostly made up of immigrants that can't find work elsewhere and it's getting crowded. It takes a mere 17 days to get a license. I talk to enough cab drivers to know that driving a taxi is just a bridge until something better comes along (taxis and security are the best jobs to have when you are looking for other jobs). It’s a treat to find a cab driver that is actually interested in being a driver. It begs the question: is there another way?

When it comes to Taxis, there's the London way of doing things, and then there's everything else. To become a Black Cab driver in London, England, there is a rigorous examination process that takes applicants, on average, four years complete. "The Knowledge" requires you to learn about 320 routes covering around 25,000 streets and landmarks.

This means being a taxi driver in London isn’t just a job, it’s a career. Because the process weeds out people who aren’t really dedicated or interested, it secures a better lifestyle for cabbies in London. It protects their income because only they can do what they are doing.

It’s also better for the city overall in terms of productivity. London is moving people around faster, which is obviously tough to measure, but a true benefit in a city riddled with traffic congestion.

However, there are downsides to having talented taxicab crew. Have you ever stumbled out of the bars in London at five in the morning? You won't see any Black Cabs waiting. If you ask around, people will point you to the buses. Of course, you'll completely laugh at this idea. If you ask around a little more, people will tell you a secret.

Depending upon your luck, a stranger will pull up in a car and ask you if you need a ride. He will urge you to quickly get into the car so the police don’t see this happening. The secret is that people in London make extra money in the evenings because they moonlight as unlicensed cabbies. These drivers profit from the fares that content cabbies leave behind. But this leaves lonely passengers susceptible to strangers with cars, a dangerous proposition for a simple ride home.

The way Toronto's current system works is to let taxi drivers figure it out for themselves if they are making enough money to live. It is assumed that the ones that make the least amount of money will drop out. It's self-regulated, dog-eat-dog style.

I'm not suggesting a massive reform to copy London's system, but it can't hurt to make the standards a bit higher. We would be protecting the income of cab drivers that plan to do it for a living. We would improve the quality of drivers on the road as well as reduce congestion. We can also stop raising fares so frequently, because the remaining cab drivers would have more work available (freezing fares and reducing the number of drivers helps the remaining drivers but not the cab companies, but I don’t worry about the companies based on the way they treat new cabbies).

I've had a lot of great cabbies, but there is one I'll never forget. When I entered the cab, he asked my permission to avoid the highways because, as he put it, "I have to keep moving." I looked at the clock and figured we had enough time to pursue his neurotic experiment. Was he actually planning on taking backstreets all the way to Pearson airport from downtown Toronto in the thick of rush hour?

That's exactly what he did, and it took him less than 25 minutes. He drove like he was white-water rafting, recognizing the current and letting it take him, but only occasionally re-directing himself toward our destination.

When I asked for his card he said he didn't have one. This guy knew the magic tunnels to the city and I was never going to see him again. I want to meet more cabbies like him. Don’t you?

Oh Canada! Wooh!

There was no way I was going to watch this game at home. My friend Steve met me outside of Hooters about an hour before the game. They were full. We raced to every other bar we could and it was the same story. We finally hit the King St. West Gabby’s (full too) when they informed us that the King St. East Gabby’s had lots of space still. Steve was in disbelief that the bars could be so full, so early, and I said to him, “Dude, this is the biggest hockey game in the last…” and I paused when he finished my sentence for me, “in forever.”

I can remember childhood sleepovers at my cousin’s house where my Aunt made us go to the library to do some reading. It was a forced break in the non-stop street hockey playing action. However, we had found a loophole. We spent the entire time in the video section of the library, where we scoured through the collection to find a documentary on the 1972 Summit Series. We became obsessed with it.

The heavily favoured Canadians were up against what was an underestimated and mysterious opponent, the Soviet Union. The Russians took the Canadians by surprise with their unbelievable speed and lightning quick passing. Their goalie, Vladislav Tretiak, is now heralded as one of the greatest goaltenders of all time. Valeri Kharlamov was doing stuff like this which made Canadians nervous. I watched the Kharlamov highlights over and over again, almost breaking my Aunt’s VCR.

The series went to the eighth and final game in a dead heat (3W, 3L, 1T). I’m skipping over the part where Phil Esposito made an apology to all of Canada on National Television, promising the country that they would try harder. The Canadians had to win this game. And then, Paul Henderson scored the game winner, a moment simply known as "the goal," a highlight that would be replayed over and over again for decades to come.

Nothing will equate to the 1972 Summit Series. It was the first international professional hockey competition of its kind. The fact that our opponents were secretive and played an entirely different style in contrast with the NHL made for interesting hockey. And let’s not forget, it was during the Cold War, which made it even more symbolic (beat Communism!).

But Sunday's gold medal match against the United States will be an adored Canadian memory. The story had everything, including a picture perfect ending. We came in as favourites, the US surprised us in the tournament with a dominant goaltending performance by Miller. We had to brace ourselves for one last match against an undefeated US team. The Americans broke our hearts with only seconds remaining in the third period. And then, Crosby scored the goal.

Steve was dizzy from screaming so loud after the goal. I had never handed out so many high fives in my life. On our walk to Dundas Square, anytime Steve yelled “Woooh!” someone would echo back. People were playing street hockey downtown. Everywhere we went, we all sang our National Anthem in unison (unlike Auld Lang Syne and other similar songs often sung by drunk people in unison, I realized on this night that Oh Canada is the only one I can sing with passion and not feel weird about it).

I’m not normally much for spirit, but I couldn’t help but be engulfed. Because Canada is composed of so many different cultures, it’s hard to find a single uniting cause. Sunday night, I lost myself in it.

It was a perfect night. The hockey game climax rolled right into the closing ceremonies. By now we were at another bar, and they were showing highlights from the entire Olympics, including the goal by Crosby. The guy next to me said, “They should just play that goal over and over, eh?” I couldn’t agree more.

The Waiting Room

Every couple of years, I pay a visit to one of the shittiest places in Toronto: Rexdale. In the mid-1980s, my family was poor and the five of us lived snugly in a two bedroom apartment there.

I was too small to understand, but my father was in a deep hurry to move out of that area. Rexdale was (and still is) a hotbed for poor immigrant families just starting out. Success meant you could graduate to some place like Mississauga, much safer and quieter in comparison. My father's career had a habit of failing immediately after succeeding, and housing five people in a two bedroom cement block was how you got your bearings during the lows.

When we finally moved, we were proud to leave everything behind. So what draws us back to Rexdale every so often? We come back to get our eyes checked.

Now, I'm sure everyone thinks their optometrist is the best, but Dr. Snow is seriously the best. He caught a hole in my retina a few years back when there was no reason to be looking. He could have prescribed me glasses when I was a kid but didn't because I was a borderline case (this is honourable because he makes money from selling glasses). My sisters praise him too.

But he's not friendly or hospitable in anyway. To be honest, I still get nervous when he asks me questions, because he has absolutely no patience for vague answers. For example, here is something that happened in my last visit:

Snow: Does anyone in your family have Diabetes?
Umar: Well...um…do you mean my immediate family?
Snow: Okay, let me repeat. Does anyone in your family have Diabetes?
Umar: Yes. But nobody in my immediate family.
Snow: It would help if you told me who it was.
Umar: Right…um…
Snow: For example, it is your father's mother?
Umar: Yes, actually my father's mother had diabetes.
Snow: Thank you. Who else?
Umar: Uh...also my mother's brother.
Snow: You mean your uncle.
Umar: Yes, my uncle. Sorry.

I know by now not to mess with him when he's flipping lenses in order to determine my exact prescription. You only say that lens 1 is better than 2 when it's clearly better. Otherwise, just say that it's the same. It's okay if he's mildly annoyed that you can't spot the difference between the two lenses. He will just sigh deeply, and continue to repeat the same sequences over and over. What you want to avoid is saying something like, "um....I think the first one is better." He totally loses it if you say you “think” something. You need to assert yourself. Man, I love that guy.

But this isn't about Dr. Snow. It's actually about the hour I spent in the waiting room. I listened to two men who spoke to each other with excitement in an otherwise quiet room. They had been re-united. They had worked for the same company a while back, and had lost touch since that company folded.

As they ran through the missing details in each others' lives, I couldn't help but notice that it was the same story repeating itself: company failure. As it turned out, both of them had worked for several different Ontario manufacturing companies in the area since the 1970s. One was an engineer and the other was in sales.

Personally, I've only worked in the service sector and from what I’ve seen people have a tendency to skip from job to job. Not only is there no desire to stay at a company for a long time, but there are rarely consequences to flipping jobs every few years.

These men didn't do this by choice. They had to leave because their companies kept dying. They talked about it with such nonchalance; reciting the names of fallen companies as if they were reminiscing over their favourite films.

I managed to enter the dialogue by sneaking in a question about manufacturing and its future in Ontario. Everyone in the waiting room got involved at this point. Below are some snippets of what was said, which I found to be both frank and enlightening:

"What was it Lee Iacocca used to say? It's all a big circle, you see? If you don't have the people making the cars, you won't have the people buying the cars."

"The worst mistake management made was to open their books and show the unions the money. They never had control after that."

"Free Trade messed everything up for us. We couldn’t compete after free trade."

"The thing is none of these companies lasted long enough for me to get a proper pension. But I'll be okay. I work every other week designing basketball courts for schools in Ontario. But believe me, son, it's not like in the commercials. Freedom at 65 was it?

“Actually, It's 65 now. They used to say 55!”

We all laughed at this, but when I turned my head Dr. Snow was waiting for me with his arms folded.

A Falling Empire

There is nothing more symbolic of America's economic reign than the US Dollar. You can trace the power of the Dollar back to World War II, where America not only emerged as political and military leaders, but the Dollar supplanted the British Pound as the world's most reliable currency. Although there were ups and downs before, there is something very significant about the current US Dollar decline we are witnessing.

What followed the War was sheer economic domination by America. Sure, they had some ups and downs, but in the end you could always count on Maverick to come through in a dog fight against 18 Russian Migs. That’s right, America’s economic reign was exactly like Top Gun. They broke all the rules, relied on talent and guts, beat all the bad guys, got the girl, and finished everything off with an epic 80s guitar solo anthem.

Being the World’s measuring stick has a tremendous advantage. When asset prices collapse, like they did in late 2008 during the Financial Meltdown, the safe place to put your money was a reserve currency. When the housing bubble burst triggering the meltdown, trillions of dollars went into US Treasury notes, increasing the demand for the American Dollar. Warren Buffet said that we had all just witnessed a new bubble form, and he was right.

But Empires don’t fall overnight. I always look back to what America did in 2003 as their fiscal point of no return. They committed to the Iraq War (the War that gained them nothing in terms of National security) and the combination of expenditure without the means of raising funds internally relegated the nation to decades of deficits.

The White House Accountant, David Walker, tried to warn the administration that this was not only unsustainable, but dangerous. He was forced to resign soon after that. What followed was a completely reckless monetary and fiscal plan, justified by the idea that the US Dollar wouldn't face any consequences simply because everyone needed the Dollar. Their currency wasn't like gold - it was gold, and they had the ability to print as much gold as they wanted.

Fast forward to today, and at this point their situation is laughable. They just spent a ridiculous amount on stimulus, and it wasn't nearly enough because they are still entertaining double digit unemployment figures. Walker has gone on the record, stating that the United States is “underwater to the tune of $50 trillion” in long term obligations.

Let me be clear. If this was any other nation, the entire World would have been on the phone asking for their money back. All US T-Bills/Bonds would have been severely devalued because the nation has no reasonable plan or prospect to pay its debt back. Their credit rating would have been diminished, and American hedge funds and investment banks would have been shorting the currency itself (engaging in a variety of contracts to sell the currency both now and later), which would serve to exacerbate the problem even further.



And so, I give you the signs of a falling financial landmark:

When India moved a large sum of money into gold, that was not only a wise economic move, but it was interpreted as a signal that no longer are they going to blindly keep using the US Dollar as their reserve.



Think about this. They moved their money into a commodity that hasn't lost value in over thousands of years, and this is somehow considered a speculative move as compared with purchasing US Dollar notes, pieces of paper backed by a promise to pay by a nation with an exponentially growing debt and no real plan to repay it.



Before the recent financial crisis, there were only whispers among the other World leaders about establishing a new measuring stick. Now there is an open and frank dialogue, because basically nobody wants to rely on the greenback anymore. They are working on new global currency. It wouldn't be a national currency, it would be something synthetic, representing all the nations collectively (think of the Euro, but more widespread).



I've read several articles giving the recent drop in the US Dollar a positive spin. They will point out how we've seen declines like this before (70s oil crisis and late 90s as well we saw CAD/USD at par). When you study the charts, they will show you that the US Dollar will always climb back up.

But that’s irrelevant. I’m not saying the US Dollar won’t make some sort of recovery in value. I’m saying our entire concept of how we define that value is about to change, and all America can do is watch.