American Investment Services, Inc.

Disciplined, Diversified, & Cost Effective

Apr. 2010 – Government versus Goldman

The SEC has charged Goldman Sachs with fraud related to products that track the performance of mortgage-backed securities. Specifically, the SEC alleges that Goldman failed to inform customers that the product for which it was making a market had been created with the assistance of hedge fund Paulson & Co., and that Paulson was at the same time betting that those securities would fail. Goldman has vehemently denied the charges, explaining that their customer (ACA Management LLC) was the “portfolio selection agent” and was never misled.

Some say Goldman is a scapegoat. The SEC’s actions are comparable, arguably, to a suit brought against a casino in which one individual bet black and another bet red. Should the croupier be arrested when a gambler bets everything and loses? ACA after all is a sophisticated investor and apparently was familiar with all the securities to which it had exposure.

Economists tend to interpret events in light of the incentives of those involved. There are in fact many players acting in their own self interest. Goldman, Paulson and ACA were seeking profits. Paulson was betting that the product would fail, while ACA was taking the opposite view. The SEC is a regulatory body which thrives by finding activities to regulate. Politicians seek to assure voters they are protecting everyone from villainy.

Unfortunately these events have unfolded amidst a political tempest. The charges were levied just as a contentious financial regulatory reform bill was emerging in Congress. Goldman executives were immediately paraded before Congress, where Senators took turns criticizing them for having profited during the collapse of the housing market.

The hypocrisy on display was astonishing even by Washington standards. While there is plenty of blame to go around, we have little doubt that the sub-prime crisis would never have materialized had not the federal government, through various means, set the stage. The Fed held interest rates extremely low for an extended period, which enabled leveraged investing. Fannie Mae and Freddie Mac, abetted by Congressional cheer-leading, guaranteed highly questionable mortgages. Indeed Congress has for decades distorted incentives to promote home ownership and fostered “moral hazard” through policies ranging from the deductibility of home mortgage interest to industry bailouts.

It should be kept in mind that these policies were enacted after the Pecora Commission was formed during the 1930s, during which U.S. Senate Committee on Banking investigated the causes of the Wall Street crash of 1929, ostensibly to avoid a repeat performance. If history is a guide, it appears doubtful that well-reasoned and effective regulatory reform will emerge amidst the current environment of populist outrage and sensationalism.

This story is still unfolding, but these events have already provided important lessons for investors:

1. Understand the investment vehicle that you are buying. The securities we recommend, index-type mutual funds, ETFs and common stocks, are not mysterious.

2. Diversify. By owning all the securities in an empirically validated asset class you will avoid the uncompensated risk associated with a specific security or sector.

3. Capital markets provide access to risk factors that can be measured and tailored to meet your financial objectives. These are all the tools you need.

4. Do not rely on the SEC for protection. Regulators seek power and larger budgets, which may not necessarily serve the interests of investors. Regulators often act only after the fact, and tend to become “captured” by the entities they are charged with regulating.

Also in This Issue:

Quarterly Review of Investment Policy
The Back Page Explained
Court Maintains Status Quo on Mutual Fund Fees
The High-Yield Dow Investment Strategy
New Funds Recommended
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles