Goldman Sachs Indicted for Fraud

Mayor McKae’s Blog
April 16, 2010

Goldman Sachs Indicted for Fraud

Just when you thought things were getting back to normal. This pops up, or was it the comment a spouse makes to another, “honey maybe we should put another $100,000 in the market”? GOD FORBID!

The next 8-10 years you will see an enactment of the 1974 to 1983 years. 1974 was then the worst recession since the Great Depression. More money was lost out in the stock and bond markets than in the Great Depression. Well it happened again.

I have written this before, but it is highly improbable you will see back-to-back 40% returns on the stock market and a similar bull market in Bonds. From a probability and statistical standpoint the chance of a 40% standard deviation in the stock market is less than 10%, it happened last year. Two years in a row very slim.

Sooner or later investors will find the returns on Money Market funds to low and the stock and bond market too risky. Private investment in Hedge Funds, are you kidding me Mr. Madoff?

Where will they go? I look at the past and I say it is real estate. The real estate market is coming to life; REIT’s are being bought by other REIT’s, median home prices are going up. Foreclosures and short sales are becoming a smaller piece of the home sale market as higher end homes are pushing up median prices. Silicon Valley is hiring and confidence is being restored in Silicon Valley.

Timing was auspicious for the SEC to announce the indictment of Goldman Sachs. The Senate is deadlocked on a finance regulation bill, Obama’s Boys are upset, banks are not lending and pay is outrageously high for Wall Street. Look at the fellow who has lost his job and has stopped looking. He reads that the average pay on Wall Street is at record highs. Are you not surprised the Tea Party is growing across the country?

Let me tell you why I think interest rates will move up. It is called the “Carry Market” among traders. Let’s take a bank-trading department. The bank management must review risk and capital against loan applications. On one hand the bank has their capital invested in Treasury Bonds and Treasury Bills. Let us say this bank has their excess capital in 10-year Treasury Bonds. 10-year Treasury Bonds most mimic mortgages. The Bank has the bonds at par, for example $1,000,000. The coupon is 3.83%, example only as this is the last quoted yield. The Bank does not put up $1,000,000. The Bank is allowed to use leverage. They put up $100,000, actually much less. But I will use this as an example. The banks borrow money from the Federal Reserve System at ¾%.
$100,000 invested
$38,300 annual interest
$6,750 interest expense ($900,000 times .75%)
$31,550 net returns per year
31.6% annual return on invested capital

Alternative is Home Buyer with 20% down 700 credit rating and 4 to 1 ratio of income to mortgage payment including property taxes. The interest rate on a jumbo 30-year mortgage is 5.9% with 1 point.

Do you think there is an incentive for the bank to lend money to the homebuyer when they replace a 31.6% return on capital? Why should they?

Prior to March 31, 2010 the bank had a field day, the FED was buying, 90% of the mortgages ended up in US Government hands. The banks acted as intermediaries and servicing agents and they received double-digit returns on their capital. Why should there be a surprise when banks announce record earnings and trader’s earn record earnings. The traders made it, not the old-line bankers.

Do you understand why the examinations on Capitol Hill are over the bank using the trading desk for their own benefit rather than providing loans to businesses and home buyers. The banks are using taxpayer money to line their pocket with leveraged trades. All they are today are Hedge Funds insured by the US Government. That is why the Finance Index has out performed all other indexes and averages. That I why the Tea Party is getting stronger as they see tax payers are lining the pockets of bank traders at the expense of tax payers.

Now, I am not a Tea Party member, but I do know history. If you go back again in time and read Teddy Roosevelt life story, you will see a similarity of the Robber Baron of the late 19th Century and TR work as a Progressive to change and stop the abuses that were going on at the time.

What stops this? The FED raises short-term rates, the Discount Rate; a rate that does not affect the Average American. It only affects banks and brokers. When this happens bond prices drop as yields move up and the bank losses money on the bonds and their cost of money increases. If the FED raises rates by ¼ of a point or .25% to 1%, what is the effect?

$100,000 invested
$38,300 interest income
$9,000 cost of money

$61,274.51 loss on value of 3.83% bonds in a market where bond yield is now 3.83% - .25% or 4.08%
-$31,974.51 loss on investment.

When that happens the game is over and the banks are now back to where they should be lending money to qualified borrowers and helping the economy grow and employing the fellow who stopped looking for a job.

From Yahoo Finance this is the rate market as it was at 4PM Friday April 16, 2010:

30 Year Fixed
Today: 5.19% Last Week: 5.23%

15 Year Fixed
Today: 4.38% Last Week: 4.48%

1 Year ARM
Today: 3.37% Last Week: 3.89%

30 Year Fixed Jumbo
Today: 5.90% Last Week: 5.95%

5/1 ARM
Today: 3.94% Last Week: 3.97%

3/1 ARM
Today: 4.33% Last Week:4.40%

Study the history books and see why I am saying interest move up and why median home prices will move up.

Gary McKae