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Goldman Sachs Plans to Redeem Berkshire Hathaway’s Investment March 18, 2011

“Goldman Sachs has the right to call our preferred on 30 days notice, but has been held back by the Federal Reserve (bless it!), which unfortunately will likely give Goldman the green light before long.”

— Warren Buffett, 2010 Letter to shareholders dated February 26, 2011

Goldman Sachs has announced that the Federal Reserve has granted approval for the company to redeem Berkshire Hathaway’s $5 billion investment in Goldman’s 10% cumulative perpetual preferred stock.  The investment was made on October 1, 2008 at the height of the financial crisis.

Goldman Sachs will have to pay Berkshire a 10% premium and is required to provide 30 days notice of its intent to redeem.  As a result, the redemption will take place on April 18, 2011.  Berkshire Hathaway will retain the Goldman Sachs warrants that were issued as part of the deal. Berkshire has the right to purchase 43,478,260 shares of Goldman Sachs at $115 per share.  The warrants expire on October 1, 2013.  Based on Goldman’s closing price of $159.96 today, Berkshire would hypothetically earn a profit of nearly $2 billion if the warrants were exercised today and the shares sold at the closing price.

In Mr. Buffett’s recent letter to shareholders, he predicted that both Goldman Sachs and General Electric would redeem the preferred stock investments Berkshire made during the darkest days of the financial crisis.  General Electric is contractually prevented from initiating the redemption until October 2011.  Berkshire’s highly successful investment in Swiss Re was recently redeemed.  Mr. Buffett warned that it would be difficult for Berkshire to replace the lucrative income streams from these investments which were made on very favorable terms during the financial crisis.

Mr. Buffett has stated that he is on the hunt for acquisitions due to the need to allocate Berkshire’s large cash position as well as the cash that will be coming in due to repayment of the financial crisis era investments.  On Monday, March 14, Berkshire Hathaway announced plans to acquire Lubrizol in a deal worth $9.7 billion.

The Rational Walk’s recently published report, Berkshire Hathaway:  In Search of the “Buffett Premium” contains a section that covers Berkshire’s financial crisis investments in more detail.  That section of the report is included as part of the free sample which may be downloaded in PDF format or viewed in Scribd format through the viewer the appears below.  RSS Feed readers may view the file on Scribd by clicking on the link.

In Search of the “Buffett Premium” — Free Sample

Disclosure: Long Berkshire Hathaway

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Goldman’s Problems Continue with Threat of FCIC Derivatives Audit July 26, 2010

Despite paying the largest penalty ever assessed against a financial firm by the Securities and Exchange Commission, Goldman Sachs is still an attractive target for government panels investigating the financial crisis. Goldman agreed to pay a $550 million settlement on July 15 in connection with the Abacus case in which the SEC alleged that Goldman failed to disclose key information regarding the portfolio selection process.  Today, the Financial Times reported that Goldman is facing a separate inquiry by the Financial Crisis Inquiry Commission (FCIC) regarding the company’s use of derivatives.

FCIC Chairman Phil Angelides believes that Goldman Sachs is not being honest regarding the manner in which the company tracks revenues generated from derivatives trading.  At a recent hearing, two Goldman executives told the FCIC panel that the bank does not break out trading revenue generated strictly from derivatives:

They maintained that such information would give little insight into the bank’s trading risks as many trades involving a derivative contract also include an offsetting cash security. For instance, Goldman might buy a credit default swap to hedge against the possible default of a company where the bank also has a position in its debt. Tracking the revenue of one slice of a trade would ignore whatever gains or losses were booked on the other side, the bank said.

This seems entirely reasonable given the manner in which derivatives are used by large financial institutions.  The FCIC is threatening to send auditors to examine the raw data at Goldman and it is possible that programmers could extract only derivatives trades from the vast databases that the firm keeps to track trading activity.  However, without looking at such trades in the overall context of what they were intended to accomplish, the exercise would appear to be more likely to confuse the issue than to provide any insight for investigators.

It is unclear whether the FCIC understands how financial institutions use derivatives in modern markets:

Mr Angelides said he remained skeptical that Goldman did not have the derivatives information, given the bank’s reputation for risk management and its discipline in marking the value of every position daily. “It’s not credible that that’s a black hole,” Mr Angelides said. “It defies logic that these institutions have no clue of how much money they are making or losing from these derivatives.”

Goldman Sachs is known for risk management and it would in fact “defy logic” if the bank had no mechanisms in place to measure risk.  However, looking at a part of a transaction made up of a derivatives position while failing to examine offsetting transactions does not constitute “risk management”.  Rather, it seems to be a political exercise meant to vilify a financial instrument rather than a credible attempt to examine the overall risks being taken by financial institutions in a more holistic manner.

It is unclear whether government officials understand the nature of how derivatives are actually used and what risks emanate from such use, or if they do understand the issues but are attempting to make some political point by falsely isolating the impact of derivatives books from broader transactions.  In either case, loud announcements threatening audits will not help reassure markets regarding the stability of the financial system.

Disclosure:  The author has no direct position in Goldman Sachs but owns shares of Berkshire Hathaway, a large investor in Goldman Sachs securities.

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Buffett Gives Goldman Sachs Another Vote of Confidence April 23, 2010

Goldman Sachs and Warren Buffett

Berkshire Hathaway’s investment in Goldman Sachs at the height of the financial crisis represented a major vote of confidence that enabled Goldman to raise additional equity from investors.  The September 2008 deal involved $5 billion in Goldman Sachs perpetual preferred stock along with five year warrants to purchase approximately 43.5 million shares of Goldman common stock at $115 per share.  The preferred stock carries a dividend rate of 10% and is callable at any time at a 10% premium.  Despite the recent drop in Goldman Sachs common stock, Berkshire’s warrants remain in the money. While Goldman could almost surely refinance Berkshire’s $5 billion preferred stock investment at a lower rate, having Warren Buffett’s endorsement in the current environment may be priceless.

Confidence Unshaken

In an interview with Bloomberg, Berkshire Hathaway Director Thomas Murphy states that Mr. Buffett is “not concerned with the investment at all” and continues to have great confidence in Goldman.  Mr. Murphy spoke to Mr. Buffett after the SEC charges against Goldman were announced on April 16.  This follows an interview with Berkshire Hathaway Director Ron Olson last week prior to the SEC charges in which Mr. Olson stated that Berkshire’s investment was a bet on Goldman’s integrity.

Goldman’s Response to SEC Complaint

Over the past week, Goldman’s response to the SEC charges has  more clearly taken shape.  Last week, we provided a summary of the SEC charges and recommended that Goldman take quick action to address the charges and to hold individual employees accountable.  The most serious charge involves the claim that Goldman led ACA to believe that the Paulson & Co. hedge fund was taking a long position on the synthetic CDO deal known as Abacus.  The SEC did not charge Paulson with any wrongdoing.

Earlier this week, The Wall Street Journal reported that Paolo Pellegrini, one of the top executives at Paulson & Co., told SEC investigators that he personally informed ACA that Paulson had a bearish outlook for the CDO.  The SEC complaint made no mention of Mr. Pellegrini’s statement.  The SEC has indicated that a full accounting of the investigation will occur “at the appropriate time”.

Fraud or Poor Judgment?

Whether the charges against Goldman amount to fraud largely rests on the charge that the firm misrepresented the nature of Paulson’s role in the transaction.  As Mr. Murphy stated in the Bloomberg interview, all of the major players involved in the transaction were very sophisticated buyers and sellers.  ACA obviously knew about Paulson’s involvement in selecting the collateral for the CDO.  If Goldman did not lead ACA to believe that Paulson was long, as the SEC complaint alleges, the government’s case will be much weaker.

The conduct of Fabrice Tourre, including several embarrassing emails, indicates the poor judgment and immaturity of a junior level employee who apparently had a major role in the transaction.  In a session sure to produce some political fireworks, Mr. Tourre is scheduled to testify before Congress next week along with Goldman CEO Lloyd Blankfein and others from the firm.

It is likely that Mr. Buffett has been briefed on the situation by Goldman’s management.  While Berkshire has an obvious economic stake in the outcome of the investigation, the potential impact to Berkshire’s reputation would be more significant if Mr. Buffett’s support ends up being misplaced.  Berkshire shareholders should have some confidence that the situation is not as dire as indicated by the SEC charges if Mr. Buffett is willing to publicly support Goldman’s management at this time.

Disclosure:  The author owns shares of Berkshire Hathaway.  No position in Goldman Sachs.

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Goldman Sachs Fraud Charges Require Quick Action April 17, 2010

Goldman Sachs

Goldman Sachs has served as a political piñata for so long that many observers may be tempted into believing that Friday’s fraud charges brought by the Securities and Exchange Commission should be viewed as just another part of the political process.  This would be a grave mistake.  While much of the rhetoric regarding the company remains overheated, the complaint brings forward several charges that point to serious ethical breaches.  Goldman Sachs relies on its reputation for client service to justify much of its economic goodwill.  Billions of dollars of goodwill could evaporate if the situation is not skillfully handled.

Summary of SEC Charges

There are many media reports available that provide detail and analysis regarding the charges including The Wall Street Journal’s coverage today.  The SEC complaint itself makes for some fascinating reading for a document put together by lawyers. Here is a brief summary of the key points covered in the complaint:

  1. A hedge fund managed by Paulson & Co. approached Goldman Sachs in order to discuss transactions in which counterparties for its desired short positions on subprime housing could be found.  Paulson discussed creating a CDO constructed with its input and then effectively shorting the portfolio by purchasing credit default swaps (CDS) to obtain protection against specific tranches of the CDO capital structure.
  2. Fabrice Tourre, a Goldman Sachs Vice President on the structured products correlation trading desk, was the main coordinator behind the development of a series of synthetic CDOs known as Abacus, whose performance was tied to residential mortgage backed securities (RMBS).  Mr. Tourre was the main interface for Goldman in dealings with Paulson.
  3. Mr. Tourre believed that it would be difficult to market the CDO if investors knew that Paulson had a role in selecting the securities and then took a short position directly opposite to the economic interests of the investors.  Therefore, Goldman Sachs brought in ACA Management, a firm with background in analyzing credit risks of RMBS, to officially “construct” the portfolio.  However, Paulson still had a major role in selecting the securities.
  4. The SEC alleges that Mr. Tourre deceived ACA into believing that Paulson would be taking a long position in the CDO knowing that ACA would not put its reputation behind the process if it believed that Paulson intended to take a short position.
  5. The SEC alleges that Goldman Sachs marketed Abacus to investors by falsely representing that ACA selected the portfolio and made no mention of Paulson’s involvement.

A review of the SEC complaint shows that there are many direct quotes taken from email conversations that heavily implicate Mr. Tourre and cast serious doubt on the ethics behind the overall process.  In addition, the complaint states that unnamed senior level managers at Goldman Sachs approved of the structure of Abacus.  The complaint does not charge the Paulson hedge fund or John Paulson with any wrongdoing.

Political Rhetoric vs. Real Misconduct

Many commentators and politicians seem to believe that the mere involvement of Goldman Sachs in structuring such instruments was inherently wrong or that taking positions opposite to its customers automatically signaled ethical breaches.  This makes little sense given that it is the business of firms like Goldman to facilitate financial transactions between players that can hardly be considered naive or unsophisticated.

The broader questions being considered in financial regulatory reform, particularly related to the “too big to fail” problem, legitimately consider issues such as the aggregate exposure of institutions like Goldman and the prospect of systemic risk caused by a firm’s collapse.  However, this is a different debate.

The question in this case is whether Goldman Sachs intentionally deceived its clients regarding the true nature of the CDO it created and marketed.  It seems quite clear that allowing clients to believe that collateral was selected in some independent manner by an unbiased third party would be highly deceptive.  Clearly Mr. Tourre knew the reality of market conditions and understood Paulson’s intentions when it came to collateral selection and the adverse impact withholding such information from ACA and investors would have:

“More and more leverage in the system, The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab[rice Tourre]…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!” – SEC Complaint page 7

Take Buffett’s Approach

So far, Goldman Sachs has only released a brief press release denying the charges.  However, regardless of the legal rights the firm may have and the ultimate defense lawyers come up with, it seems clear from the direct quotes in the SEC complaint that Mr. Tourre acted in a manner that would be very regrettable to anyone concerned with ethical practices in business.  Mr. Tourre’s statements clearly bring shame to Goldman Sachs.

When Warren Buffett had to step in to rescue Salomon Brothers from imminent ruin during the treasury bond scandal in the early 1990s, he said the following in a meeting with company employees:

“If you lose money for the firm, I will be understanding. Lose a shred of reputation for the firm, and I will be ruthless.”

Much has been made of the $1 billion loss in market value on Berkshire’s holdings of Goldman Sachs warrants based on Friday’s fall in Goldman’s stock price.  However, the real question is whether the intrinsic value of Goldman Sachs has been impaired by this scandal.  To the extent that a large portion of the value of Goldman Sachs is based on economic goodwill generated by a reputation for client service, an impairment in intrinsic value is indeed a possibility.  The firm can mitigate the impact by quickly coming forward to admit any wrongdoing and terminating the employment of the individuals responsible.

Disclosure:  No position in Goldman Sachs, Long Berkshire Hathaway.

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Goldman Sachs Board Member Bill George Comments on Financial Reforms January 6, 2010

Yesterday, we discussed a  number of lessons that must be learned from the financial crisis.  In a “Tea with The Economist” interview shown below, a Goldman Sachs board member provides his insights regarding leadership during a crisis and financial reforms that are needed to stabilize the overall system. Bill George also comments on a variety of other topics regarding politics, business, and leadership.  Mr. George is the author of Seven Lessons For Leading in a Crisis.

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