What’s the Oracle of Omaha Thinking?

Is Goldman Sachs Truly a Value Investment?

You've probably heard that the man considered to be the best investor on the planet, Warren Buffett, has decided to invest $5 billion in Goldman Sachs Group Inc (NYSE: GS) in the form of preferred stock and also warrants to buy another $5 billion in common stock.

If he exercises those warrants he would own as much as 10% of the company. So is this another of his renowned shrewd investments? After all, the "Oracle of Omaha" is legendary for being the chairman and CEO of Berkshire Hathaway (NYSE: BRK.A, NYSE: BRK.B), a conglomerate holding company headquartered in Omaha, Nebraska which has returned more than 21% annually to its shareholders for the last 42 years.

Berkshire Hathaway's core business is insurance, including property and casualty insurance, reinsurance and specialty nonstandard insurance but it also has interests in candy production, retail, home furnishings, encyclopedias, vacuum cleaners, jewelry sales, newspaper publishing, uniform manufacturing and distribution, footwear manufacturing, importing and distribution and also several regional electric and gas utilities.

Berkshire's Class A shares are the highest-priced shares on the NYSE partly because they have never been split due to Buffet's interest in attracting only long-term investors. You can see for yourself how well he’s outperformed the market:

Given Buffett's track record, it seems he finds value in Goldman despite a well-publicized 2003 warning that mortgage-backed derivatives were "financial weapons of mass destruction" and that "there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives" and therefore rampant derivatives could destroy the national economy.

So is Goldman really safe? Either Buffett's changed his mind on derivatives or Goldman has managed its risk to the point where he feels comfortable with their portfolio. If so, is this purchase going to become as legendary as his 1988 purchase of 7% of the Coca-Cola Company for $1.02 billion?

Or maybe there’s something else at work … perhaps a sacrificial gesture to try and shore up a situation so desperate that he feels even a 'bad' investment is worth the risk if it helps prevent the market from a wholesale collapse?

A Quick Look At Goldman

Buffett may also be thinking that Goldman is a highly beneficial investment at this time due to the company's extremely influential political connections. (Treasury Secretary Henry Paulson previously served as the Chairman and Chief Executive Officer of Goldman Sachs, as did Robert Rubin. Mark Carney, current Governor of the Bank of Canada, is also a Goldman alumni).

Right now Goldman needs all the political influence it can get as there is nothing particularly bullish in this weekly chart:

Historically, Goldman earned $4 billion from the collapse in subprime mortgage bonds in summer 2007 by short-selling subprime mortgage-backed securities to offset the losses in their own non-prime securitized loans portfolio Alternative Mortgage Products (known as GSAMP for short).

GSAMP was the 15th biggest issuer of subprime-backed bonds in 2006 but by the start of the third quarter this year those securities were being downgraded by the credit ratings agencies faster than any other subprime lender. One in every six of the 8,274 mortgages bundled together in GSAMP Trust 2006-S3 was already in default 18 months later.

What's more, only last week Goldman sought to change its status from broker to "Bank holding" to ensure its eligibility for liquidity from the Federal Reserve Board in consideration for higher regulation concerning its activities.

So is this what Buffett is hoping to tap into? Political influence and Federal Reserve liquidity? It’s certainly very “interesting” that Paulson didn’t roll out his $700 billion rescue plan until it looked like Goldman Sachs might collapse after dropping 30% almost overnight. 

But Is This Truly a Crisis For The Taxpayer?

"The alternative is complete financial Armageddon and a great depression," said a former Federal Reserve official. "Where do they go after this? Well, the U.S. government could nationalize the banking system outright."

Right now, the people that Paulson represents are very desperate, and with their political and media influence they are making very strident demands for hundreds of billions of dollars and unlimited power. It seems to us that this is very much a 'just give us the money, no one needs to get hurt' moment.

Lawmakers have already — and rightly — raised doubts about what would be the largest government bailout in American history. In a previous newsletter, we have already expressed our opinion that this bailout would be highly inflationary and absolutely destructive for the US dollar. Paulson clearly isn't thinking long term here.

We would venture to suggest that this bailout is purely for his investment banking friends who would be 'taken care of' even if the mega-plan ultimately fails to accomplish its public purpose: staving off a major economic collapse.

And that's what really scares people. What if this costly plan is not only expensive, but also ineffective?

The $700 billion in assets purchased from private holders on Wall Street would help banks stabilize their balance sheets, and in theory provide an incentive for banks to re-extend credit and ensure liquidity amongst themselves again.

But what if they don't do so?

After all, the banks could very well decide to circle their own wagons while the rest of the nation burns. It's not like they could be obligated to help anyone else once they have their balance sheets cleaned up — after all, the very act of them successfully receiving $700 billion would clearly indicate that they're the ones in charge and that the government and its regulators are too spineless to stand up to them.

Where Does It All End?

If – and only if – everything goes smoothly, it is possible that taxpayers could profit from the proposed deal in the long run. If the underlying assets accumulate value over the coming years and the government is able to ultimately sell them back into the market at higher prices then taxpayers would no longer on the hook.

However, that's asking a lot for a government that apparently can't even regulate its way out of a paper bag, as far as the markets are concerned. Given this track record of epic failure, how on earth can our politicians – “advised” by the shysters now screaming desperately for emergency funding, no doubt — realistically think they're going to actually beat the market and secure a profit?

There’s only one easy, fail-safe answer as far as the Treasury and the Fed are concerned – print enough cash to cover any problem. It won’t take long before U.S. financial authorities and their advisors decide that the best way to ‘help’ the average citizen with his mortgage and other debt – not to mention their own debt to domestic and foreign investors – is to inflate it away.

It would be reckless to print money like it’s going out of style, of course. Foreigners would stop buying U.S. government bonds and the dollar would collapse. But the people – and here’s what “they” will bet on – will be too ignorant and short-sighted to realize that such a move will steal their future by eating away whatever savings they manage to store away. Not to mention destroying their purchasing power to the point where securing any savings in the first place would be a minor miracle.

If you don’t want to be one of the sheep, we strongly recommend you take a look at gold:

Good investing,

Nick Thomas
Analyst, Charts of the Week