Here is a really interesting article from our broker in Chicago, Craig Turner. Craig writes the ‘Turner’s Take’ newsletter. Trial details at bottom of article.

On Friday the SEC announced they are charging Goldman Sachs with civil fraud. As many of you know, I got my start professional right out of college with Goldman Sachs (New Associate class of 2000), they paid for my MBA (NYU Stern School of Business 2004), and I am a member of the Goldman Alumni Association. I thought I should just get that out for full disclosure.

The Goldman fraud announcement sent the markets into a near panic as the stock market and commodities declined materially. As usual in these cases, the US Dollar, US Treasuries and Japanese Yen all gained against the overall market, as they are seen as the top 3 “flight to safety” assets during heightened periods of uncertainty.

When uncertainly reigns, investors tend to sell riskier assets and move them in to less riskier assets. That is why the US Dollar, Treasuries and Yen always seem to gain on days like Friday. For those that need further proof of this, take a look at the rallies in the US Dollar, Treasuries and Yen when the S&P was on its way from 1300 to 675 from October of 2008 to March of 2009. You will see major rallies in the US Dollar, Treasuries and Yen.

We received a lot of inquiries from clients and subscribers on Friday and during the weekend about what the Goldman civil fraud case means. While the facts of the case are still coming out, we know a lot more than we did on Friday afternoon.

First, it is important to note that Civil Fraud differs from Criminal Fraud, in that Civil Fraud starts out as unintentional while Criminal Fraud is intentional from the start. This means that the US Government thinks that Goldman never meant to defraud anyone but along the way some type of fraud occurred. If the Federal Attorney General or a State Attorney General decides to get involved too, that would most likely be for Criminal Fraud.

At the center of the allegations is a CDO (Collateralized Debt Obligation), called ABACUS, which is a portfolio of subprime residential mortgage-backed securities (RMBS). The buyer (and eventual loser) of ABACUS was ACA Management, an insurer specializing in RMBS, that actually picked out the securities that ABACUS was made of.

ACA Management was long subprime mortgages and the US housing market in general. To take the short side of investment like subprime residential mortgage-backed securities, investors can purchase Credit Default Swaps (CDS). Credit Default Swaps are bets against the RMBS. A hedge fund called Paulson & Co asked Goldman to put together a CDS of the ABACUS subprime residential mortgage-backed securities. In other words, hedge fund Paulson & Co wanted to be bet against ABACUS

Here is where the potential issues come in:

  1. ACA Management, the buyer of ABACUS, did not know Paulson & Co hedge fund were taking the opposite side of the trade. Paulson & Co actually met with ACA Management to talk about ABACUS before ACA got into the deal to get their thoughts on the RMBS. Did Goldman have a responsibility to disclose that information?
  2. Should Goldman be on both sides of this trade as the Broker? This is a tough question because there is no exchange for these products like the NYSE or CME. If these products were cleared through exchanges, then most likely one broker would be representing ACA and another would be representing Paulson. However, since these complex and unique financial products are just between the banks and the client, this becomes a very gray area.
  3. Should Goldman and other investment banks both be brokers and proprietary traders? It may come out that one side of Goldman (proprietary investments) was short the Housing Industry while another side of Goldman (structured finance) was brokering deals, matching buyers and sellers of mortgage backed securities.

What does it all mean for Market Regulation?

We will most likely see Financial Reform passed in the House, Senate and signed by the President. Derivatives need more regulation and transparency. Creating a central exchange for complex financial derivatives would be a good start. Setting limits on how much leverage you can take on (like the Futures Exchanges presently enforce) would also be a good start.

Mortgage Backed Securities and Credit Default Swaps have their place in our Financial Community, but with no transparency or risk control, they can be hazardous to the system. Let’s hope this is the kind of regulation the government wants to bring about.

We may also see regulation that brings back aspects of the Glass-Steagall Act. This would include separating the traditional services of Investment and Commercial Banking. It also could include regulations on banks and their role in proprietary trading.

What does it all mean for Turner’s Take?

The markets were down on Friday, and we expect the uncertainty to work its way out of the market this week. Due to the insecurity in the market and how it will react to the Goldman Fraud case, we will not be entering any new positions until the dust settles; however, we will be looking for exits on trades where we have profit and positions we were considering liquidating before the Goldman news. For now, we will just review our positions, watch the market closely, and look for the next opportunity.


Right now we are long the mini Russell 2000 and short the Emini S&P 500. This position is a great example of what Turner’s Take is all about. We were bullish the stock market, but didn’t want to just get long the S&P 500 because it exposes us to so much systematic risk (just look at what happened to the stock market after the Goldman announcement). We are big believers of hedging systematic risk whenever possible.

Instead of getting long the Emini S&P at 1183.50, we sold the Emini S&P at 1183.50 and bought the mini Russell 2000 at 692.50. Why would we do this? A few reasons:

  1. In a bull market, we know that small cap stocks generally grow at faster rates than large cap stocks. In times of economic recovery or expansion, it is easier for smaller companies to grow than larger companies. Small companies can easily double their growth in a year or two, while it is much more difficult of for a large cap to grow that fast. Therefore, a small cap index should outperform a large cap index in a bull market (also note the small cap index should underperform the large cap index in a bear market).
  2. Index spreads have reduced margins. The margin on the S&P is $5625 to hold overnight. The margin on the Russell is $4000 to hold overnight. But if you have a 1:1 spread between the two there is a 70% spread credit. $5625 + $4000 = $9625. $9625 X .3 = $2887.50. The margin needed to be long the mini Russell 2000 and short the Emini S&P 500 is only $2887.50. Why are the margins reduced? Because spread trading related products helps reduce systematic risk.
  3. If we had just been long the Emini S&P (which is what most traders do when they are bullish on the stock market), we would be long from 1183.50. The Emini S&P 500 closed on Friday at 1190.25, up 6.75 pts or $337.50. Consider we had an intraweek high of about 1210.00 in the Emini S&P; we would have given back $1000 of a $1300 move. While giving back profits is unavoidable in successful trading, we want to limit it as much as possible.
  4. If we were just long the mini Russell 2000, we would be up about 21.30 pt, or $2130, based on our 692.50 entry and Friday’s close of 713.80. However, the volatility of that position has been significant. If you were only long the mini Russell 2000, there would have been almost a $2000 swing in P&L from Thursday to the close on Friday. That kind of volatility can be difficult to handle when the markets are going against you. It makes position and portfolio management extremely difficult.
  5. The spread “long Russell and short S&P” did not change a whole lot in terms of overall value from Thursday to Friday. It stayed between +$1500 to +$1800 during the entire session of trading on Friday. Obviously the market is either still bullish on the economy or everything just got sold together. The latter is the best explanation, which is usually the case in panics (big and small). That is why we try to spread our trading ideas whenever possible. It prevents us from getting knocked out of a position because of a major news event. The spread allows us to step back, re-evaluate the market, and not have to make a rash decision heading into the close on a Friday.

Right now we are still bullish on equities, but we are certainly interested how trading will go on Monday and Tuesday. If the spread starts to weaken because small caps are being sold more than large cap stocks, that is a sign of bearish market conditions and we will consider exiting the spread. If we do exit, it will be primarily to get flat and let the dust settle after the Goldman news.

One thing to note is the Emini S&P chart below. We are testing the recent uptrend. If we break this uptrend, it will most likely be best to get flat and take our profits off the table. However, the break could just be a result of the knee-jerk reaction to the Goldman news on Friday. Monday’s trading should give us a better read on the market.

Emini S&P 500 Chart:

Mini Russell 2000 Chart:


The USD and JPY rallied on Friday for two reasons. The first is the Goldman Fraud news and the “flight to safety” knee-jerk reaction. The second reason was China announcing they are raising mortgage rates for home buyers. This is leading investors to think China will be raising interest rates soon. When this happens, the JPY and USD both tend to rise.

We are still bearish on the EUR and JPY while bullish CAD and AUD. However, with the current volatility we are considering adjusting the currency basket to better reflect global market conditions going forward. As for the GBP, we would rather be short the EUR than the GBP at this point. The charts are mixed as well as the fundamentals. The elections in May will have a new parliament and possibly a new Prime Minister. We will be looking to get out of the GBP sooner rather than later.

We feel it is only a matter of time before the EUR sells off again and trades through 1.34, than 1.33 and finally down to 1.30. Europe’s recovery is lagging behind the US, Asia and other major economic regions. When you add in the debt problems Greece is going through and the potential debt problems for Spain, Portugal, Italy and Ireland, the EUR is the most bearish of all currencies. The EUR/JPY will most likely go in JPY’s favour, which is another reason why we will be looking to reduce exposure to JPY and increase our exposure to short EUR.

EUR Chart: The most recent Greek Bailout news broke the recent downtrend line on the weekly charts. Now that the market realizes the Greek bailout is temporary and the Eurozone is still going to have economic difficulty, the EUR is coming back down. Major resistance is at 1.3800 while support is 1.3400 and than 1.3000.

JPY Chart: A month ago the JPY broke its multiyear uptrend that started during the early days of the US subprime crisis in 2007. Now that the subprime crisis is over and we are slowly on our way to recovery, we have been waiting for the JPY to make its way back down to 1.0000 and eventually to 0.9000. While the uptrend has been broken, “flight to safety” buying will most likely be the biggest risks this trade has.

CAD Chart: The Canadian Dollar sold off this week when the stock market sold off. The recent uptrend from April 2009 is still intact on the Weekly Charts. We feel the CAD should break through 1.000 and beyond, as Canada’s economy is recovering faster than the United States.

AUD Chart: Like the Canadian Dollar, the uptrend on the weekly charts is still intact. We like the Australian Dollar for the same reasons we like the Canadian. The Australian economy is improving faster than the US; Australia and Canada do not have the same banking issues in their home residency and mortgage sector as the US; and Australia and Canada are “Commodity Currencies,” meaning that they benefit when commodities are in demand, like during economic recoveries.

Craig Turner is a Senior Broker at Daniels Trading in Chicago. He writes the Turner’s Take newsletter. Trial it here: