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Mark's Market Blog

4-16-10: Fraud at Goldman

By Mark Lawrence

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The markets continued upwards this week until Friday, when mid-day it was announced that the SEC was charging Goldman Sachs with fraud. Bank stocks immediately dropped 4%, and the S&P dropped 2% on very heavy volume. Last week I wrote that I expected the market to make it from S&P 1955 to nearly 1230. We made it to 1212 before dropping today back to 1930 on news of Goldman. What's next? No clue. I can make a decent argument that the market will stagger around for a couple days, then return to going up. I can make an equally decent argument that this will prove the start of a 10% or so correction.


S&P 500 October 12 2009 to April 16 2010

On Friday, the SEC charged Goldman Sachs, the center of the Evil Empire, with fraud. The complaint alleges that Goldman collaborated with hedge fund Paulson & Co to design mortgage-backed securities to fail. These securities were then marketed and sold to Goldman customers, while at the same time Paulson took out insurance against the bonds failing. Goldman's marketing materials indicated that Paulson invested over $200M in the bonds, while in fact and to Goldman's knowledge Paulson had not invested in the bonds at all and was heavily invested in their failure. These bonds subsequently collapsed, costing Goldman customers over $1B, while Paulson's firm made over $1B. Goldman was paid $15M by Paulson for their help. John Paulson is the man who made the "Greatest Trade Ever" by betting against the mortgage market. His firm earned $15 billion in 2007 alone. Paulson has not yet been charged. Several state retirement funds have been considering suing Wall Street firms over their losses in 2007-2009. I predict these SEC charges will be like blood in the water.

Consumer Reports has given the Lexus GX 460 SUV a rare "Don't Buy" warning, saying a problem that occurred during routine handling tests could lead to a rollover accident in real-world driving. Toyota immediately stopped selling the GX, and is re-testing all their SUVs for roll over potential. This is another software problem. The GX has the stability control systems necessary to deal with this, but it didn't work for some reason. Last month Toyota ran a huge ad campaign along with 0% financing and raised their sales by 40% year on year. I don't know what they'll have to do next month to recover from this. Meanwhile, if you're looking for a car, I recommend Honda or Ford.

A volcano blew up in Iceland. Dust blanked much of Europe, resulting in two-thirds of European airports being shut down for two days, and warnings to Europeans to stay indoors. The last time this volcano went off, in 1821, it kept it up for a year. In 1783 a different Icelandic volcano went off, and the resulting dust cloud is held responsible for tens of thousand of European deaths.

The National Federation of Independent Business said its monthly index of small business optimism fell 1.2 points in March to 86.8 and below 90 for the 18th consecutive month. Small businesses normally account for the bulk of new jobs, making them an important part of the recovery. Obama has proposed tax breaks to encourage hiring and special lending programs to try to boost hiring. Only nine percent of firms reported unfilled job openings on a seasonally adjusted basis, down two points from February and historically low. That showed little hope for a lower unemployment rate, the group said.

We hear with great regularity about the trade deficit. Where does this money go? Generally we're told it's going to China. Not exactly. We do run a trade deficit with China, but for the last three decades the main story of US trade deficits has been about oil. Who runs deficits and who runs surpluses? That's mostly about oil too.


US Trade Deficits 1960 to 2010


Per Capita Trade Surpluses / Deficits by Country

Arizona lawmakers on Tuesday approved the toughest measure in the country against illegal immigrants, directing local police to determine whether people are in the country legally. The bill cements the position of Arizona, whose border with Mexico is the most popular point of entry for illegal immigrants into this country, as the state most aggressively using its own laws to fight illegal immigration. In 2006 the state passed a law that would dissolve companies with a pattern of hiring illegal immigrants. Last year Arizona made it a crime for a government worker to give improper benefits to an illegal immigrant.

Just 49 percent of people now approve of the job Obama's doing overall, and less than 44 percent like the way he's handled health care and the economy. For the first time this year, about as many Americans approve of congressional Republicans as Democrats - 38 percent to 41 percent - and neither has an edge when it comes to the party voters want controlling Congress. Democrats also have lost their advantage on the economy; people now trust both parties equally on that, another first in 2010. Roughly half want to fire their own congressman. Adding to Democratic woes, people have grown increasingly opposed to the health care overhaul in the weeks since it became law; 50 percent now oppose it, the most negative measure all year. And it could get worse for Democrats: One-third of those surveyed consider themselves tea party supporters.

Iran has succeeded in producing its first significant batch of highly enriched uranium. So far they have produced 11 pounds of 20% enriched uranium, with a plan to make another 3 pounds a month. As we've seen, the jump from 20% to bomb grade is relatively easy, Iran has already done the hard part. About 250 pounds of 20% enriched uranium are needed to make a bomb. This makes it sound like Iran is still many years away from making a bomb, but Iran has recently announced a 3rd generation centrifuge that's much larger and faster than what they already have. I advise you to take that long-postponed trip to Israel soon, while there still is an Israel.

The personal income tax is an administrative and economic burden. 7.6 billion hours will be spent this year doing taxes at a cost of $28 billion, and 1 million accountants will be hired to help. The US has 98,000 troupes waging war in Afghanistan and 101,000 IRS employees waging war in the US. Economists believe a simpler tax code would eliminate such burdens, not to mention the burdens to the economy created by various kinds of tax-sheltering behavior that would make little economic sense with a simpler tax code. But these burdens have an overlooked and potentially beneficial side effect.

As President Obamaís head of the National Economic Council, Lawrence Summers, once wrote, "A better tax system may lead to more wasteful spending." Compared with the income tax, the Social Security / Medicare payroll tax is quite simple, and readily confirms the claims that a simple tax is a tax that will be used as a government revenue machine. The payroll tax has absolutely no deductions - not for charitable contributions, mortgage interest, college tuition and the dozens of other activities favored by the income tax - and collects almost as much revenue as the personal income tax, despite the fact that the payroll tax rate is less than 15 percent. For this reason, while 47% of people filing taxes this year paid nothing in income taxes, pretty much everyone paid some payroll taxes.

For years, taxpayers have been frustrated by the personal income tax, and politicians from John F. Kennedy to Ronald Reagan to George W. Bush tried to pacify them with cuts in the personal income tax rates. But the payroll tax generates much less complaining, and itís no accident that the payroll tax rate has been increased 20 times and cut exactly zero times. There is no real political fervor for cutting the payroll tax, or energetically resisting payroll tax increases. So we could eliminate some of your perennial mid-April frustration by replacing the income tax with a simpler and more efficient tax code, but in that case be prepared to send a greater fraction of your income to the United States Treasury.

Oil prices have gone back above $85 as a result of the resolution of the Greek situation and a weakening dollar. Positive data out of China showing higher demand for crude oil is also having an impact. Oil may have more serious long term problems though, with a U.S. military report revealing fears that extra capacity for oil production could cease to exist by 2012, with a 10 million barrel shortfall in oil predicted for 2015. Analysis by Arab economists indicate that $3.30 per gallon gasoline is a breaking point; above this level US drivers cut back on driving and switch to more fuel efficient cars. So they would like to keep oil prices below this level, about $95 per barrel.

A record number of U.S. homes were lost to foreclosure in the first three months of this year. Banks are starting to wade through the backlog of troubled home loans at a faster pace. RealtyTrac Inc. said Thursday that the number of U.S. homes taken over by banks jumped 35 percent in the first quarter from a year ago. In addition, households facing foreclosure grew 16 percent in the same period and 7 percent from the last three months of 2009. More homes were taken over by banks and scheduled for a foreclosure sale than in any quarter going back to at least January 2005, when RealtyTrac began reporting the data, the firm said. "We're right now on pace to see more than 1 million bank repossessions this year," said Rick Sharga, a RealtyTrac senior vice president.

This sudden jump in foreclosures was expected. In my 7-25-09 blog, I wrote: This financial crisis we're in got started when a bunch of "sub-prime" mortgages went bad. Since then it's widely believed that the sub-prime crisis has mostly worked itself out; about half of these mortgages have now gone into foreclosure, and that's likely to be by far the worst of it. However, the deteriorating economy and job market is now calling other mortgages into question. First will be the Option-ARMs, the Adjustable Rate Mortgages with unrealistically low initial teaser rates and payments. A large number of these ARMs will have their interest rates and payments reset in the next 18 months. After that moat is breached, the crisis will spread in an unknown amount to the prime mortgages. The chart below has become very popular on Wall Street in the last two weeks. 2009 is the eye of the mortgage crisis.

JP Morgan Chase, Wells Fargo, and Bank of America have been hit hard this week, with news that the three will need to protect themselves from a potential $30 billion home-equity loan loss. This amount is near equal to the anticipated profit at the three banks this year, according to Bloomberg.

China's economy grew at a 12% annualized rate in the 1st quarter. Real estate flipping is becoming very popular in China, with some people in some areas doubling their money in just a few months. We've seen that before. Singapore's economy grew at a 32% annualized rate in the 1st quarter (yes, that number is correct). Fears of an Asian bubble are growing. Thursday the Chinese State Council said anyone buying a second home would need to put up a 50% deposit, up from 40%, while the mortgage rate for second homes was also increased. The down payment for first homes bigger than 1000 sq.ft. was set at a minimum of 30 per cent.

Nine months ago, Bill Gross's Total Return Fund was 50% in US Treasuries. Now it's only 30%, the lowest percentage in the 23 year history of the fund. Why is Gross dumping Treasuries? Two primary concerns: inflation, and expected future borrowing to fund the deficit. Gross believes that while interest rates have now generally been declining for more than 25 years, we're now moving to an era in which rates will rise for an extended period. When rates rise people who own treasury bonds lose money.

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