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Weekend Edition

Secrets from our Goldman Sachs "prop" trading insider
Saturday, July 2, 2011

Last April, the Securities and Exchange Commission (SEC) targeted Goldman Sachs in a civil fraud case. The lawsuit alleged Goldman sold investors a synthetic collateralized debt obligation (CDO) linked to the performance of certain mortgages without disclosing that John Paulson's hedge fund, Paulson & Co., helped design the CDO (named Abacus) and was shorting it. As mortgage prices collapsed, the buyers of Abacus – including ACA Financial and German bank IKB – lost nearly $1 billion.
 
On July 15, 2010, Goldman settled with the SEC for $500 million. The bank neither admitted nor denied the allegations. It said the marketing materials for Abacus contained "incomplete" information.
 
The point of today's essay is not the ethics of that case, but rather a prediction we made regarding the abundance of mortgage fraud leading up to the crisis and the subsequent lawsuits we would see.
 
The Goldman lawsuit involved synthetic CDOs. The investors weren't buying actual mortgage securities. They were agreeing to assume the risk of insuring mortgage bonds in exchange for annual insurance premiums. By definition, a synthetic CDO must have someone on the long and short side... Otherwise, it can't exist. Therefore, the buyers must have known another investor wanted to short the mortgages.
 
We referred to the Goldman lawsuit as "a warm-up." The "real fireworks," we proposed, would come when the SEC started investigating fraud surrounding actual mortgages (in particular the huge amount of fraud in mortgage underwriting between 2004 and 2007). Defrauding a German bank is one thing, but defrauding the U.S. government (in the form of Fannie Mae and Freddie Mac) is quite another. On July 16, 2010, we wrote...
 
These vehicles [mortgage backed securities] were completely riddled with fraud and insider dealing. Then, almost half of them were sold to Fannie and Freddie, now owned by Uncle Sam. When you defraud the sovereign, watch out. We think the fines are going to get a lot bigger... S&A Digest, July 16, 2010.
 
On Wednesday, Bank of America announced it would pay $8.5 billion to settle claims from investors who lost money on mortgage-backed securities they purchased before the crash. The dispute began last fall when a group of investors – including giants like BlackRock, MetLife, and PIMCO – alleged mortgages they purchased before the crisis from Countrywide Financial (which BOA bought in 2008 for $4 billion) were stuffed with loans that didn't meet the stated standards of quality of the borrower or the collateral. The investors also alleged Countrywide didn't keep accurate records of the loans. The settlement covers 530 separate mortgage securities with an original face value of $424 billion.
 
The $8.5 billion is more than Bank of America has earned since the crisis began in 2008. And BOA is taking another $7.5 billion charge on its books in the second quarter ($14 billion in total charges) to account for future liabilities from Fannie and Freddie.
 
The fines are getting a lot bigger (as we predicted)... And we bet there are more to come.
 
Compared to BOA's fine (which amounts to three years of earnings), Goldman's  settlement was a pittance – a mere 14 days of trading profits.
 
You may wonder how Goldman makes so much money with its proprietary trading. Despite using 20 times leverage and trading in huge volumes, the bank manages to make money nearly every day – literally, the bank will go entire quarters without a daily trading loss.
 
For one, Goldman doesn't trade like you and me... The bank does pairs trades (buying one security and selling another). It sells options instead of buying them. It buys low-risk bonds near maturity. And Goldman has incredibly accurate options-pricing models that give it a wide margin of safety on trades. Goldman doesn't try to make double-digit returns on its trades. Instead, the bank wants small (1%) gains with almost zero risk.
 
How do we know so much about Goldman's "prop" trading? Well, we hired a guy who used to work on its trading desk. Dr. David Eifrig was one of the most successful traders on the Street in the late 1980s and early 1990s. He worked for Goldman Sachs in New York and London. Then he worked for Chase, and later Yamaichi – a top Japanese bank.
 
Eifrig tired of Wall Street's dubious ethics and traded in the glamour of Wall Street for a career in medicine. But his love of the markets and his desire to share the trading secrets he learned with others brought him to us. As Porter tells the story...
 
As Doc explained these strategies to me, I realized how perfect they were for people who are retired. A retired person needs income to live on. A short-term trading system that can produce small gains, quickly and safely, would be perfect for our audience, which is filled with retired investors. The more Doc and I talked over the years, the more excited he became about sharing his secrets with more people – especially folks like him, who are retired.
 
Those conversations quickly turned into Doc's newsletter, Retirement Trader. He focuses on super-safe trades that will produce steady and consistent gains. Has Doc delivered on his promise? Since launching his advisory in April 2010, Doc has closed 21 positions – all winners. And the average annualized gain is 33.5%.
 
Let me repeat that... Doc is 21 for 21 with his closed trades over the past year and a half. And he's produced an average 33.5% annualized return with little risk. The performance is astounding.
 
Even if you haven't imagined yourself as a trader, I'd urge you to give Doc's Retirement Trader a try. No other analyst on our staff is capable of producing such large, consistent, and safe returns. You can learn more about Retirement Trader here...
 
Regards,
 
Sean Goldsmith




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