The "Hows" of Moneymaking

On G+2 (Goldman plus 2), the best stock market managed to inch ahead once again. For the second day in a row, most of the non-Goldman part of the stock market produced modest gains...even though Goldman, itself, slipped more than 2%.

It was a very strange day for the immensely successful and widely despised financial firm. Before the market opened for trading, Goldman reported a dazzling earnings result for the first quarter - the second best quarterly result in the firm's 141-year history. And Goldman generated this result in classic Goldman fashion - a smattering of profits from traditional business lines like investment banking, along with a mountain of profits from proprietary trading.

But investors did not cheer the earnings result; they were still too busy booing Goldman's fraudulent conduct...and the grim consequences that might ensue. The various investigations and lawsuits that Goldman will soon endure is bad news. The possibility that disgruntled clients might jump ship is worse. How, for example, could Goldman possibly produce its proprietary trading profits if there were no stooges around to take the other side of its trades?

Goldman needs those stooges...er, clients...to grease the wheels of its profit machine.

Goldman's top brass insists the firm has done no wrong. But many are the critics who insist the firm has done little right...for its clients, that is. This firm knows all about making money. No one doubts that. But the "hows" of that moneymaking are becoming a topic of national interest...and disgust.

One faithful Daily Reckoning reader, who also happens to be a former attorney, provided the following insight:

Goldman Sachs is in a lot of trouble.

It is in far more trouble than most financial commentators seem to realize, for reasons that are deeply embedded in the American system of justice. Since Colonial times, American courts have required witnesses to take a specific oath. This oath has become a part of American folklore. From Perry Mason to Boston Legal, every witness who takes the stand must swear, "to tell the truth, the whole truth and nothing but the truth."

It is the "whole truth" portion of this oath that puts Goldman in such trouble. The law recognizes that you can deceive people without ever saying anything false, just by omitting critical truths.

A real estate ad that said, "This home is in a beautiful neighborhood, is immaculately designed and was at one time owned by a famous celebrity," might be 100% truthful. But it would also be 100% deceptive if the sales agent failed to mention the additional truth that "the walls are insulated with asbestos."

Omitting important truths is a crime...especially in the financial industry. This concept is literally written into the definition of securities fraud. The most important expression of that definition is SEC Rule 10b-5 : Employment of Manipulative and Deceptive Practices.

This rule states that in connection with the selling of securities, it is unaawful for anyone to "make any untrue statement of material fact, or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading."

In other words, you can't just tell someone the truth about the portfolio of collateralized mortgage obligations you are trying to sell, you have to tell them the whole truth.

And this is why Goldman Sachs is in such deep trouble. When Goldman was attempting to sell the portfolio of mortgage obligations to various parties, it never told them:

"We want you to know that we built this portfolio for a hedge fund manager who wants to short the collateralized mortgage market because he believes it is overpriced and may collapse. He could be wrong, of course, but he can't take a short position unless someone else buys the actual securities we have created. Would you like to buy those securities?"

Call me naïve, but I expect that most ordinary Americans, which is to say, people who sit on juries, when they hear that testimony will be thinking to themselves, "Wow! I'm not sure I would have bought those securities if I had known the whole story."

Goldman is in deep trouble if it has to tell its story in a courtroom, where every single employee-witness will have to tell the whole truth - perhaps for the first time.

Here's our question: If Goldman Sachs is truly in trouble, isn't the best stock market in even deeper trouble?

Goldman is the largest player in the US stock market, and one of the most influential players in every other major financial market. Therefore, a discredited and enfeebled Goldman Sachs is probably not a bullish event for share prices.