Guest Post: How Should Traders and Investors Weight the Goldman Sachs Fraud Case for their Investment and Trading Decisions?

By John Bougearel, author of Riding the Storm Out and Director of Financial and Equity Research for Structural Logic

“The whole intellectual edifice collapsed.” ~ Alan Greenspan

“Blaming individuals [or a few institutions] is no substitute for acknowledging the failure of the whole system.” ~ ` BOE Mervyn King

~ Quotes excerpted from Yves Smith’s timely new title called “Econned.”

Investors and traders can overreact or underreact to the Goldman Sachs fraud case depending on the government’s intent and political will. If the government intent is simply to save face and improve its sorely lacking credibility with the public, this case will be limited to a few firms and a few individuals, and the rest of the world will go about their lives knowing nothing substantial has been done to insure the public against socializing future losses of these predatory institutions. The risk in this situation is that the tightly coupled too big to fail myth will fail miserably so yet again. The prescription for this situation is to simply ride the next wave of looting until the whole edifice is on the brink of another ginormous failure.

If however, the government were to acknowledge this looting has been a direct result of the failure of the whole system, then real change will occur. The risk for traders and investors in this situation will be a dramatic housecleaning. This may be painful for many investors in the short run, but the long term benefits would be substantial.

We must bear in mind one thing as we go forward, no one knows exactly how this will play out. We can make educated guesses, but the best course of action will be to keep an open mind to the potential ramifications. What we saw on Friday was an increase in volatility as new uncertainties entered the financial markets. A Pandora’s box of uncertainties abound as a result of the fraud case. Fraud, looting, predatory behaviors in the financial system is rampant and widespread throughout the financial system and has been a problem dating back to the days of Michael Milken and Drexel Burnham Lambert. Will the PR spinmeister’s and Goldman lawyers be able to ring-fence these widespread abuses to one GS VP, one hedge fund, and one CDO? Will the SEC be able to prove their case, or will Goldman falsely deny any wrong-doing and win their case?

Think back to the Michael Milken days for a moment. Milken was under nearly-constant scrutiny from the Securities and Exchange Commission from 1979 onward due to unethical and sometimes illegal behavior in the high-yield department. A former Drexel executive, Daniel Stone claimed in his book April Fools that Milken “viewed securities laws, rules and regulations with a degree of contempt, feeling they hindered the free flow of trade.”

Milken’s lawyer Harvey Silverglate contended that “Milken’s biggest problem was that some of his most ingenous but entirely lawful maneuvers were viewed by those who initially did not understand them, as felonious, precisely because they were novel – and often extremely profitable.”

The SEC never got beyond the investigation phase until 1986. For two years after initial charges of fraud, insider trading, and other violations, Drexel insisted that nothing illegal occurred even after the SEC formally sued Drexel in 1988. Drexel finally began plea bargaining talks after New York’s AG Rudy Guiliani considered adding racketeering to the charges, “concluding no financial institution could survive a RICO indictment.”

Milken was indicted in March 1989 for 98 counts of racketeering and fraud and tax evasion. On April 24, 1990 Milken pleaded guilty to six counts of securities and tax violations. Milken paid $200 million in fines and $900 million in restitution to investors hurt by his activities. Still today, Milken is 45th richest man in the world.

At Milken’s sentencing, Judge Kimba Wood told him:

You were willing to commit only crimes that were unlikely to be detected…. When a man of your power in the financial world… repeatedly conspires to violate, and violates, securities and tax business in order to achieve more power and wealth for himself… a significant prison term is required.

http://en.wikipedia.org/wiki/Michael_Milken

Time Magazine wrote a piece on Drexel Burnham titled Predator’s Fall on Feb 26 1990. They wrote The final plunge of the most powerful and dreaded firm on Wall Street in the Roaring Eighties came with astonishing speed. Like the abrupt fall of the Berlin Wall thousands of miles away, the collapse suddenly confirmed what everyone in the financial world could already feel in the wind: a new era had arrived.

http://www.time.com/time/magazine/article/0,9171,969468,00.html

That was twenty years ago, but Time magazine was wrong. A new era had not been ushered in at all. Other predatory firms rushed in to fill the predatory vacuum left by Drexel Burnham,

“There’s a lot of pent-up anger and disgust with behavior on Wall Street,” says Samuel Hayes, an investment-banking professor at the Harvard Business School.

“The era of extravagance and insanity has come to an end,” says economist Pierre Rinfret, who runs a Wall Street consulting firm. “This is a breath of fresh air. Drexel got what it deserved. These guys could destroy the country. There is no rhyme or reason for what has been going on.” As its legacy, Drexel [left] behind a battered junk-bond market and hundreds of corporations staggering under debt

But, other than a few prosecutions, the government did nothing constructive with the pent up anger directed at Wall Street. Rather than tighten regulations, they proceeded to further deregulate the financial industry over the course of the next decade making further looting and fraudulent activities all the more possible.

And history proved Pierre Rinfret wrong, the era of extravagance and insanity had not come to an end. In fact, the insanity was just warming up, which culminated in the volcanic disruptions of the financial destruction of Main Street in 2008-09. And nothing yet of substance has been done to safeguard against further volcanic eruptions, leaving most to assume there will be further volcanic eruptions to Main Street coming from Wall Street and Washington in the coming years.

But the Time magazine was spot on in its summation of Drexel Burnham’s fall from grace: “While Congress has been eager to investigate debacles like Drexel’s, it has shown little interest in enacting new laws to curb financial markets, even after the 1987 crash.” This is precisely where we stand now in 2010, eager to investigate but unwilling to enact any substantive financial reforms and straightjacketing of the financial industry.

To date, the history of predatory and looting financial system over the past thirty years has proved Yves Smith’s dictum in the final chapter of her book “that the more things change, the more things stay the same.”

Yes, some sort of financial reform is eventually going to pass, but in its present format, this will be a victory for the financial industry, not Main Street. This will virtually guarantee another financial crisis will coming to a theater near us in the not too distant future.

Now, think back to the financial markets in March 1989 when the SEC first charged Michael Milken, then Feb 1990 when Drexel fell and April 1990 when Milken pleaded guilty. As for the stock market, it took the SEC and NY AG charges against Milken and Drexel fairly well in stride.

Yes, on the announcement in March 1989 (assuming the news of the charges against Milken broke on Friday March 17 1989) the stock market SP500 flushed almost 3% in two days and 3% in 6 trading days. Notably, in that 6 day window, there was a one day bounce on third day.

On Friday April 16, 2010, the SP500 fell 23 points or roughly 2%. Note the news story broke on a Friday again folks. Also note that on Tuesday April 20, GS will report big profits on Tuesday morning and Apple presumably will post huge profits on Tuesday afternoon. The working hypothesis is that we get a one or two day bounce into Apple’s earnings on Tuesday April 20, 2010.

As I am looking at it now, Tuesday night or Wednesday morn should set the high for the week (this is subject to some minor revisions as I consider other inputs such as other earnings and other economic data to come out this week).

Investors and traders would do well to recall that the SP500 shook off the initial allegations in less than two weeks. As a market input, the initial allegations may not be as significant as when this actually goes to trial. Discovery may take a year to bring these allegations to trial (if the timetable surrounding the Milken charges are any indication).

In sum, I would suggest traders and investors remain concerned short term but underweight the ramifications surrounding the recent SEC allegations against GS about two weeks hence. As the case is brought to trial, and the trial gets underway, uncertainty will be significantly heightened, and I would suggest traders and investors once again, overweight the potential negative inputs of the fallout from the trial. Prior to the trial, the stock mkt may climb a wall of worry, particularly with another $500 billion of stimulus from the Obama administration in Q2 and Q3 2010.