Cohan tries to prove that Freeman was the victim of a prosecutorial “witch hunt.” Is he also trying to say that public opinion is also tarring GS unfairly now? Hard to say, but why else would anyone bring up Freeman of all people, twenty years after the fact?

No one doubts that Rudolph Giuliani, then a crusading US Attorney, played hardball and made some crucial errors in going after white collar crime on Wall Street. Nevertheless, Freeman admitted to breaking the law on insider trading, and the case seemed pretty clear.

Therefore I don’t see how Cohan can call Freeman’s prosecution a “witch hunt.” The more accurate metaphor would be a “fishing expedition” that expanded perhaps too far afield from its central targets: uber risk arbitrageur Ivan Boesky and Michael Milken, the wildly successful junk bond promoter at Drexel Burnham Lambert. Freeman proved to be unlucky but not exactly innocent. A guilty bystander, as it were.

Here are the facts that matter, whether Cohan likes it or not:

As Cohan states, risk arbs in those days did a great deal of research on the phone, trying to ascertain the latest news, the small details, the so called “color” of the deal related stocks they were trading. New color could cause a significant move in the stock, and sometimes provided clues that researchers could assemble into a mosaic of intelligence on whether deals would close.  On the other hand, arbs could take things only so far: SEC rule 10b-5, forbids trading on “material, non public information.”

In the case that ended his GS career, Freeman bought shares of Beatrice Foods, which Kohlberg, Kravis, Roberts (KKR) was in process of taking private in 1986. After Freeman bought, rumors leaked that the deal was not working out. So Freeman did his job and hit the phones to learn what he could. He spoke with Bernard “Bunny” Lasker, a former NYSE chairman, who suspected the rumors were true. Freeman cut his stake in Beatrice. Then Freeman talked to Marty Siegel, an investment banker who represented KKR. (Siegel eventually went to jail for selling inside information to Boesky.)

Siegel confirmed that the Beatrice deal was in trouble, with the now classic line, “Your Bunny has a good nose.” At which point, Freeman sold his Beatrice call options (and some more of his stock, too depending on which account you read), in clear violation of the law. When KKR announced it was reducing the cash portion of its offer for Beatrice, the share price fell. Freeman may have had reason to fear for the option position: if the calls were short dated and near or out of the money, they might have gone worthless on the news.

Wall Street firms have elaborate controls to prevent trading on inside information when they have it. I suspect GS procedure would have required Freeman to tell the firm’s lawyers about his chat with Siegel, at which point GS would likely have considered itself to be “restricted” in its trading of Beatrice shares until the information became public. (If any readers worked at GS then you are welcome to weigh in about this.)

Furthermore, key court precedents established that trading on inside information is forbidden when that information was obtained in a “breach of duty.” That’s common knowledge among Wall Street professionals.  In this case, Siegel, a banker who represented KKR, betrayed KKR’s confidence by passing privileged information to Freeman. As clear a case of a breach as you can find. And yes, Cohan omits this issue from his article.

What Freeman did was illegal and really, really stupid. Yet notwithstanding all this, Cohan says that Freeman deserves a presidential pardon. Yeah, right.

One of Cohan’s whoppers – and this one destroys the credibility of his whole article – has to do with his treatment of Marty Siegel – and by extension, Giuliani. Cohan insinuates that Siegel was an entirely unreliable witness and that Giuliani went out and arrested all the subjects of his insider trading investigations, including Freeman, based on Siegel’s say-so, without corroboration.  Was Giuliani really that foolish? Well, no, not really.

Along with Drexel banker Dennis Levine, Siegel turned state’s evidence on Ivan Boesky, who was certainly dirty. Boesky in turn helped finger Milken (a prosecution that leaves me uncomfortable to this day) and many others. The Boesky and Milken cases were among the biggest white collar prosecutions of the decade, front page news that went far beyond the world of finance. After winning these cases Giuliani ran for Mayor of New York and won. Incredibly, Cohan omitted any mention of Boesky or Milken.

In other words, Cohan failed to tell his readers that Siegel had hit pure gold for Giuliani. Giuliani had every reason to take Siegel seriously.

Having said that, Cohan correctly judged that Giuliani overreached. Giuliani blundered badly by failing to corroborate Siegel’s assertions sufficiently before arresting Tim Tabor and Richard Wigton, both of Kidder Peabody, and then Freeman. Neither Tabor nor Wigton went to trial – the cases fell apart before that – but neither man worked on Wall Street again. Giuliani had ruined them.

So Cohan may well be right when he says that  Giuliani did everything he could to nail Freeman once the Tabor and Wigton cases proved weak. A contemporaneous Times editorial concurred, saying that Freeman was “abused.” But odious as these facts are, they don’t erase what Freeman did.

Cohan also tries to dance around Freeman’s guilt by saying that Freeman got caught only because his subordinate was given immunity in exchange for testifying against Freeman. But that’s standard procedure in any investigation: prosecutors threaten little fish with stiff sentences to get evidence against big fish. More cogently Cohan notes that several other allegations against Freeman proved false. Which may be why even the judge who sentenced Freeman termed him, “basically decent.”

Here’s an intriguing nugget Cohan noted but didn’t pursue. Apparently Freeman’s position limit was $50 million. Yes, quaint as it looks now GS partners really cared about sums that size back then, especially when all of them were potentially liable for the firm’s mistakes. Yet Freeman risked $66 million on Beatrice including his stock and options positions. Did Freeman’s partners know of the limit violation before the investigation?

If not, one could understand how Freeman might have been driven to sell Beatrice options before the bad news hit the wires: fear that his partners would see that Freeman’s excessive risk taking brought with it excessive losses, which is exactly what position limits are designed to prevent. Or maybe Freeman got prior permission to exceed the limit, but wanted to avoid embarrassment when his big bet went bad. Either way, the risk of an insider trading scandal was greater than that of a trading loss, but even very smart traders make mistakes under pressure.

GS lawyers defended Freeman, but then, according to Cohan, Freeman copped his plea to avoid further anguish for his family when Giuliani threatened to bring racketeering charges. So Freeman served only four months; Judge Pierre Leval suspended the rest of the one year sentence and fine him $1 million. The Times actually approved of that sentence when it came down, saying that Freeman deserved “a taste of prison” but also citing Giuliani’s “outrageous tactics.” My sentiments exactly, but that was back in the day when the Times was more able to call things as it saw them.

As for Goldman, it came up smelling like a rose. Giuliani never brought charges against the firm, and so it was spared the fate Giuliani had visited on Drexel Burnham. But in hindsight it would likely not have gone any other way.

GS management committee member Robert Rubin, also Freeman’s boss and mentor, moved up to vice chairman in 1987 during the Freeman investigation (in 1990 he became the firm’s co-head) and Rubin never paid for any of the things that went wrong on his watch. These would include the insider trading at GS, the financial deregulation Rubin championed as Treasury Secretary,  and the de facto bankruptcy at Citigroup (C) where Rubin was vice chairman. Just a thought.

The Citizens United decision allows corporate (and union) donors to pay for ads that will run within 30 days of a Presidential primary or 60 days of a general election. Previously such spending was barred by the McCain-Feingold campaign finance reform law.

As political spending increases, its recipients in old media will benefit. I’ll tell you which companies are best positioned, but it’s too early to say just how much more they can make.

Some restrictions on campaign spending remain. Corporations cannot donate directly to candidates, though they can donate to issue oriented political action committees (PACs) that are at least nominally independent of candidates and their parties. Also, the sources of a PAC’s funding have to be disclosed.

A few numbers illustrate the new potential for political ad spending. A combined total of $5.3 billion was spent for the Congressional and Presidential elections of 2008. By way of contrast, Exxon (XOM) earned $45.2 billion in 2008 on that year’s record oil prices, and $13.2 billion for the first nine months of 2009. Goldman Sachs (GS) will pay out $16.2 billion for wages and salaries, or $498,000 per employee, and still record $13.4 billion in profit for 2009 after making these payouts. My point is, many major corporations can afford to break expenditure records on any given race if they care to.

And many of them have reason to care. For example, if  five votes on a congressional committee stand between you and, say, an arcane tax law change that would yield $40 million annually, what’s $15 million of campaign spending?  One heck of a good investment. Or, take environmental law. To pick an outsize but obvious hypothetical, even $100 million in campaign funds would be chump change for, say,  Chevron (CVX), if in return it got to extract a billion barrels of oil in the Alaska National Wildlife Refuge and earn profits, of, say, $10 per barrel.

But who needs hypotheticals? Last week the President proposed a tax on repurchase agreements, a form of collateralized lending used by large financial institutions. He also proposed bank size limits and talked about preventing banks from using federally insured deposits to finance speculative trading, the so called “Volcker rule.”

Citizens United gave banks new weapons to fight proposals like these. If, come election time, a tough bank regulation bill gets close to enactment (though it’s not likely to get too close, in my view), look for anti-regulatory commercials. They’ll be brought to you by PACs with names like “Depositors for a Sound Banking System.”

Having said all that there are two reasons why I could be wrong about the increase in campaign spending I expect. First,  interest groups already know how to exert influence while working within the pre Citizens United rules. Therefore, it’s possible that the new decision won’t change much.

Secondly, politicians understand the new, post Citizens United campaign economics and many of them will begin to censor themselves, even more than they already do. Expect even some of the bravest to pander to the money that talks on key issues, rather than face deep pocketed opposition. As former Treasury Secretary Paulson once said, “If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.”

So, how to play this? Ad agencies and broadcasters should expect a noticeable, recurring revenue increase during election cycles. I don’t know how anyone could predict exactly how large a bump they will get, and what effect that bump will have on earnings per share, because we are in new territory here. If this type of play interests you, look for pure media companies with heavy domestic exposure and put them on a watchlist.

CBS (ticker symbol, also CBS) would be an obvious beneficiary of this trend; the other networks are part of large conglomerates. Therefore new political ad revenue at those broadcasters might not have much effect on parent company net income. If you want to stretch a point, however, you might also look at News Corporation (NWS), since its Fox News division contributes a disproportionate share of profits to NWS.

Among ad agencies, billboard owner Lamar Advertising (LAMR) would seem to be among the purest domestic plays that could benefit from increased political ads, but be forewarned, it is losing money due to the recession and has a leveraged balance sheet. Two ad majors, Interpublic Group (IPG) and Omnicom (OMC) would seem to be safer bets, but both of them generate around half of their revenues from abroad. IPG has more domestic exposure than OMC.

The increases have been significant, and perhaps more so now than in 2008, in regards to the impact on discretionary consumer spending. Let’s look at recent moves in the past year. Oil, which bottomed at $35 in December of 2008, has now, without much fanfare from the administration or the talking heads on TV, climbed to over $80 per barrel. Crude oil imports averaged about 8.5 million barrels per day in the latter half of 2009.

The result has been that gas prices have made a huge move upward to nearly $2.20 per gallon wholesale in the past year from a low of $.82 a year ago. This is closing in on a 200% increase in just over a year. According to the EIA, we use about 380 million gallons/day in gasoline. Just in direct costs to the consumer, that’s a huge cost increase in the past year when many are already stressed financially. That’s $456,000,000 per day increase out of the US consumers pockets. That’s a lot of discretionary income up in smoke daily. This doesn’t include indirect costs for food products, transportation costs of products, electricity, etc.

Natural gas prices, which were the lone bright star in energy costs through the end of summer have spiked from a low of $2.65 in September to close at nearly $6 yesterday. Though at least our supply situation is much better in nat gas, as more users switch, primarily many of the utilities and recent winter weather, have caused a serious spike in prices in just the past 30 days. So when you factor in that many of the newer homes built in the past decade use natural gas for heating, that’s another hit to the consumer as well as those who use other forms.

Increasing energy prices are one of the most regressive taxes on consumers, affecting those who can least afford them the most significantly, yet not a peep out of anyone in the current administration, who have purposely pursued a weak dollar policy in order to cover our growing indebtedness. We’ve seen a definite move upwards in longer term interest rates the past 30 days which have a direct effect on mortgage rates.

So my question is, who and what is going to lead this economy out of recession, as unemployment remains high, foreclosure levels are at record highs and will probably continue, see here, and now a further squeeze as energy prices are once again seriously affecting consumers pocketbooks. Yet no one is even talking about the effect that these energy prices are actually having on the consumers. The Fed, led by Ben, says they’re keeping an eye out for inflation. I suggest they go to the grocery store and stop on the way home for a fill-up at their local gas station.

The graph shows cure rates, the percentage rate at which delinquent borrowers repay past due amounts so as to restore good credit standing on their mortgages. As recently as June 2007, 80% of borrowers who fell behind one payment were able to catch up. The graph also seems to show that as of September 2007, homeowners who counted on eager buyers to bail them out of overpriced homes began to have a tougher time of it.

In hindsight, the difficulties of borrowers who were two or more payments behind began to intensify a year earlier, in June 2006. One suspects that the graph captures the experience of the really junky mortgages whose borrowers went into early payment default (EPD).  EPDs happen when the borrower defaults within only a few months of taking the loan out.  If their lender sells the mortgage to another investor, that investor may have the right to put the mortgage back to the lender in the event of an EPD.

Thinly capitalized firms can’t survive too many EPDs. It was the epidemic of EPDs that forced a rash of undercapitalized mortgage bankers out of business.  Their bankruptcies helped mark the beginning of the housing crisis.

What does the graph tell us now? Most striking to me is that more than 90% the borrowers who miss two payments fail to catch up. As recently as March 2007, at least half of them succeeded in catching up. Data from the recent monthly Mortgage Bankers Association (MBA) survey and the quarterly FDIC banking industry profiles seem to bear this out. The MBA surveys show that about five million borrowers, or roughly 10%, are at least one payment behind on their mortgage.

The FDIC data show that the current delinquent population presages many more foreclosures to come. We know this because the aggregate amount owed by borrowers 90 days or more past due is in fact much larger than the amount owed by borrowers 30-89 days past due. That’s the reverse of what we expect during normal times.

The FDIC’s third quarter “profile” shows that 8.06% of the home mortgages held by FDIC insured institutions were “non-current,” 90 or more days past due as of September 30. FDIC institutions had $1.929 trillion in home mortgages outstanding then, so there were $155 billion in non-current loans. If we assume that the average borrower owes $200,000 on a mortgage, that would make for 777,000 non-current loans. (The FDIC data don’t count loans made by non-bank financial institutions that are also covered in the MBA survey.)

The FDIC numbers additionally show that 3.15% of the outstanding mortgages are 30-89 days past due. That would be $61 billion worth, and these borrowers correspond to the top two lines of the graph. White used data from MBA and the National Association of Realtors, so the correspondence is close but not exact.

Since the FDIC’s 90+ days late group owes more than twice as much as the 30-89 days group, it only makes sense to guess that lots of people in the 30-89 days late group, just stop paying their mortgage. By definition, everyone who is 90+ days late, was once 30-89 days late, and then fell further behind.

These FDIC data square well with White’s graph. The graph tells us that 30-59 days of delinquency indicate more borrower stress than they used to, and 60 days of delinquency is now a point of no return.

The MBA cites the job market as the culprit for this change in behavior. High levels of long-term joblessness (six months or more out of work) mean that that those who stop paying because they have lost their job, are less likely to find work again in time to catch up on their mortgage than in previous postwar recessions.

Our data have some important implications for the housing market and for housing related stocks. The data help show that there is a large “shadow” inventory of homes that will eventually come onto the market, or that owners would sell if they could. The number of homes officially listed for sale is only part of the supply that weighs on the market .  Clearly the homes that secure loans 60 or more days past due should be counted in shadow inventory, though they are only one part of it  (the Calculated Risk blog does a good job of explaining shadow inventory and all its components).  And a large shadow inventory means, new homes will have to compete with homes offered in distressed sales over the foreseeable future.

Obviously I don’t expect homebuilder earnings to rebound anytime soon. On the other hand, I wouldn’t short the major builders because the government has given them massive tax breaks and seems hell-bent on bailing them out. That’s why I am also reluctant to short banks that got TARP money. Investors who want to exploit this situation, need to short overvalued housing-related stocks that are not likely to benefit from government assistance.

We’re using Jing Pro to record short videos of actual called trades so that we can quickly post these on a much more frequent basis. Enjoy and please feel free to leave comments or suggestions that we may do to help you in your trading.

http://www.youtube.com/watch?v=RYuPZh0Eabk

The news I refer to came out of Saudi Arabia on Friday, November 6. The Saudis all but confirmed the accelerating decline of the Ghawar oil field. With an estimated production capacity of 5.2 million barrels per day (mmb/d), Ghawar accounts for about half the Saudis’ production, give or take, and is the most prolific field ever found. Many experts believe that when Ghawar’s production decline curve accelerates, worldwide oil production, which now runs about 85 mmb/d, will tip into decline as well.

The Saudis expressed their concern, not with an explicit press release, but by concluding a five year, integrated turnkey contract with Halliburton (HAL) to redevelop Ghawar. In other words, Saudi Aramco, which is among the more sophisticated national oil companies (NOCs), felt the need for some outside extra help to keep Ghawar’s oil flowing. The contract calls for HAL to do directional and horizontal oil drilling and to drill 153-185 oil and water injection wells, among other things.

When Ghawar oil production began back in 1951, it might not have been much of an exaggeration to say that all the reservoir managers had to do was stick wells in the ground and enjoy. As time went on, Aramco resorted to enhanced oil recovery (EOR) techniques such as injecting water or other substances into the field to force the oil towards well openings. Aramco also employs other EOR techniques such as horizontal and directional drilling, both of which can be used to angle the well so as to maximize the length of oil well pipe in contact with the “pay zone,” the layer of oil bearing rock.

EOR is standard procedure especially over the later history of many if not most oilfields. It’s natural to pump the easy oil first; as a field matures the rest gets harder to extract. Over time as the oilfield owner pumps out the crude, the pressure which drives oil to the well and up to the surface falls off. In addition, the early, higher quality product of crude oil and natural gas liquids, often gives way to a product increasingly mixed (or “cut”) with water, which must then be separated from the crude before refining takes place. With this background in mind, oil analyst Michael Lynch of GLG Group (h/t, theoildrum.com) has some choice words about the HAL contract.

“The contract makes no mention of Ain Dar, the most mature part of Ghawar…  Ain Dar has been under pressure maintenance by peripheral water injection for over 40 years. Ain Dar began producing salt water in the late 1970s and by 2005 the cut was 42%… Once water became a major problem, many existing vertical wells were converted to short lateral horizontals running along the top 10 feet of the Arab D zone, the main pay [zone for both Ain Dar and other parts of the Ghawar]…Today the entire field still contains a great deal of crude oil but it is much harder to get and the production rates continue to fall off. Halliburton’s mandate will be to deal with the higher and higher water cuts, utilize all known new technology to hold [production] rates as high as possible… It’s a good, long-term contract and a tall order for the company.”

As a side note, the Saudis objected fiercely in 2005, when Matthew Simmons stated in his book, Twilight in the Desert, that Ghawar was in decline and that the Saudis were making strenuous efforts to maintain production. Simmons also highlighted difficult geological problems that the Saudi petroleum engineers faced. The HAL contract would seem to confirm Simmons’s work.

If Ghawar were still in its early phase when oil flowed easily to the surface through highly productive wells, Aramco most likely would not need an EOR program like this. The need for this program is evidence that we may indeed be facing “twilight in the desert,” and that Saudi Arabia’s glory days as a leading oil exporter are winding down. Can “peak oil” be far behind?

Nonetheless, there is reason to be cautious about oil stocks in the short to intermediate term: demand for crude is down. US refineries processed 14.2 mmb/d of crude in October 2009, which is down about 200,000 b/d year on year and down 800,000 b/d from the October 2007 level. No surprise for a weak economy. Furthermore, both Sunoco (SUN) and Valero Energy (VLO) have in fact closed refineries recently. US crude oil inventories sit at about 24 days’ supply, 2 days above the year-earlier level. These numbers don’t indicate tight markets, and I have to wonder if current prices are sustainable.  I just don’t know how far they fall from here, and how long they stay down.