Goldman Sachs' Misconduct... How to Play the Banking Sector's Latest Black Mark

by Karim Rahemtulla

Goldman Sachs' Misconduct... How to Play the Banking Sector's Latest Black Mark

by Karim Rahemtulla, Options Expert

Tuesday, April 20, 2010: Issue #1242

Down with Goldman Sachs (NYSE: GS), right?

After news broke late last week that the SEC has filed civil fraud charges against the investment bank, many onlookers have called for fury to be unleashed against Goldman and, in turn, its fellow banking behemoths.

But those calling for Goldman's breakup are being optimistic. Goldman has about as much chance of being put out of business as Philip Morris (NYSE: PM).

That's because, as reprehensible as Goldman's behavior is, the U.S. financial system is a cash cow for the government, much like tobacco companies are a cash cow for the government because of the taxes that Washington attaches to tobacco products.

And you don't kill cash cows.

As an investor, though, here's what you can do to play this latest black mark on the banking sector...

Goldman Sachs' Shenanagins

Let's briefly recap how this situation arose...

Basically, the SEC has caught Goldman with its pants down, based on a huge conflict of interest in the subprime mortgage market (yes, that old nemesis again). Turns out that Goldman was playing both sides of the market. The company allegedly created a product that it knew would benefit one side over another and stood to profit from the fees for creating it.

Specifically, it issued subprime mortgage CDOs (Collateralized Debt Obligations), while also playing the market's downside, knowing that the house would eventually cave in. Result: a massive profit.

As it stands, the SEC suit is a serious allegation... and more bad publicity for the banking sector. But this latest salvo across the bows of the financial sector is nothing short of a power grab by the government, which is struggling to push through the most radical agenda of reform since the introduction of the Glass-Steagall Act in 1933. Glass-Steagall came in the aftermath of the banking sector collapse when the government wanted to limit the activities of commercial banks to quell speculation. The Act was repealed in 1999.

Today, the government is again trying to curb what it considers speculative trading by commercial banks.

Now, you may agree that Goldman and the other big banks deserve their come-uppance, since the government bailed them all out.

But at what cost? Along with the bad comes the good. And it's not just a few billion or hundred billion dollars of losses at stake here... but financial product innovation.

The Wrong Scapegoat for the Financial Crisis

Those who blame the financial crisis on product innovation are wrong.

The crisis was the result of greed and dishonesty on the part of the banks, realtors, appraisers, a large number of homebuyers and sellers, plus the government. All were complicit.

What didn't cause the crisis was the market for CDOs. They're nothing but contracts, traded and rated by debt rating agencies. Those contracts failed because those who prepared them, used them, bought them and sold them did so with mal-intent. Blaming the innovation of CDOs for the financial crisis is merely using them as a scapegoat.

It's the innovation of financial products that allow millions of qualified homeowners, would-be car buyers and business owners, etc, to be able to buy, sell and go into business with relatively low barriers, compared to other countries.

Many parts of the world - China and India, for example - don't have a credit verification system, or accessible mortgage industry. Instead of 10% down, buyers must buy in cash or put 50% down. Prudent, maybe. But as history has shown, it's not the credit card that gets people in trouble, it's the people using the card.

So what's next for Goldman?

The Government Wants to Regulate... But it Can't Outlaw Innovation

Given the extent of the financial crisis, the public outcry and massive costs involved to prop up the system, it's not surprising that the government is now desperately trying to play catch-up and regulate the financial sector.

But Goldman is nothing more than a poster child for the government's attempt to over-regulate it.

It will succeed (and the SEC suit against Goldman may actually accelerate the process), but so will Goldman. That's because while the government might be able to write laws preventing this or that, there are no laws against financial innovation.

So at some point, I think Goldman shares might offer an excellent opportunity. It's understandable if you don't want to invest in such a company and there is certainly more headline risk to come, so buyers must beware. But there's a strategy that allows you to limit your losses and enjoy unlimited upside...

The Best Way to Play Uncertainty and Volatility

A "married put" is a simple trade to execute.

You simply buy shares of the company and buy put options against them.

In this case, if you were to buy Goldman shares, buying put options against them would give you the right to sell your shares at a certain price (the strike price).

  • If Goldman drops below that price, you'll be protected from the stock's further decline.
  • If Goldman shares move higher, your loss is the amount of money you spent for the put options. And even then, the rise in the share price should more than offset that loss.

The married put strategy is perfect to use during periods of volatility and uncertainty. It gives you insurance against a collapse, while leaving your upside unhedged.

Good investing,

Karim Rahemtulla

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