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Timothy Morton-Smith: Who Has Your Money?

Large financial institutions lose their way by focusing only on corporate profits

Wall Street has recently come under great scrutiny for failing to put the interests of its private clients ahead of its own proprietary trading operations.

In a recent New York Times article, Andrew Sorkin discusses a letter Goldman Sachs sent to its private clients to address the conflict-of-interest policy of the firm. Such conflicts include Goldman Sachs’ involvement in creating and selling bundles of collateralized debt obligations (CDOs), a product similar to collateralized mortgage obligations (CMOs).

Most Wall Street firms sold CMOs, an all-too-familiar term to some, as a safe investment. As we have now learned, in reality, these products contained significant risk that contributed to the financial crisis of 2008.

Of even greater concern, as Goldman Sachs was recommending and selling these investments to its clients, it was simultaneously selling them short in its own portfolio, meaning it would profit when CDOs declined in value. In essence, Goldman Sachs was profiting from selling its clients products that internally it was betting against.

Unfortunately, Goldman Sachs’ involvement doesn’t stop there. As it was getting ready to bring these bonds to the market and sell them short, it was actively lobbying the ratings agencies to increase its ratings on these same products. This would, artificially, increase the price it could sell them for to their clients and increase the price at which it could establish its short position.

This is just one example of a large financial institution that highlights a concerning trend — the deterioration of ethics in large financial institutions. In Goldman Sachs’ aforementioned letter to clients, it said the following in addressing these issues:

“We may trade, and may have existing positions, based on trading ideas before we have discussed those trading ideas with you.”

“We prepare trading ideas based upon information that we believe to be reliable, but we make no representation or warranty that such information is accurate, complete or up to date and accept no liability, other than for fraudulent misrepresentation, if it is not.”

Its justification doesn’t make its actions acceptable, and again is a disappointing example of how these firms that are so focused on corporate profits have lost their way.

At Pacific Pointe, we have one clear objective: to always act in the very best interests of each of our clients above all other obligations or duties. As such, we have built Pacific Pointe to turn the notion that bigger is better on its head, and revert investment management back to what it once was — a respectable profession where our clients’ interests are our only concern.

U.S. Equity Markets — Investment Outlook

It seems after the volatile moves of 2008 and 2009 that investors have been left completely disoriented. Those who haven’t put money back into the market are wondering whether there’s still a possibility of a correction, and those fully invested have seen their investments rise significantly and are wondering whether it’s time to take some money off the table.

A key tenant of our investment approach is to select managers who are unconstrained, can raise cash if they feel it’s appropriate and are not required to mange their portfolios to a specific mandate. Hiring managers who have this type of flexibility has provided our clients with outstanding investment results in times of economic prosperity and severe market declines. As we embark on a new year, it’s this approach that we think will help us navigate through an economic landscape that still is in recovery mode.

An important characteristic of our managers is their disciplined research process, which has been successful over time in identifying great companies with solid fundamentals. Inversely, if they don’t find attractive opportunities to buy these companies,they have the freedom to hold cash as a valuable and strategic position in the portfolio.

In 2008, this played right into their hands, as many of our managers held large cash positions, which caused them to be down in the low teens, as opposed to those fully exposed to the markets, which were down close to 40 percent. Having the flexibility to hold these large cash positions also allowed our managers to have funds available to invest as valuations became more attractive in the first quarter of 2009.

While you would think the rally off the march lows would decrease opportunities, the rally was in low-quality stocks such as banks, financials and highly levered companies and the large, fundamentally sound companies were ignored. One of our highly toted managers referred to the most recent rally as a “dash to trash.” While the market has risen significantly, we still see tremendous opportunities in the high-quality names that have benefited our clients for years.

There are wide ranges of possible outcomes for the markets in 2010; however, there seems to be consensus among our managers that a highly probable outcome will be a sideways moving market with some correction or decline at some point this year.

Our growing cash holdings will provide our managers a phenomenal opportunity to put that money back to work at attractive valuations for high-quality stocks. Although we remain cautious, and believe there are head winds in front of us as we approach 2010, we are also encouraged by the opportunities that our managers will have to buy great companies at a discount. As Warren Buffett once said, “Time is the friend of the wonderful company, the enemy of the mediocre.”

Penny for Your Thoughts

We want to leave our readers with a piece of data or research to ponder, and hope you will reach out to us to discuss. In the past two years, the U.S. government has issued more than $3 trillion in debt to prop up the economy through this economic downturn. One of the primary uses of the money has been to stabilize the housing market. The government now owns 43 percent of the outstanding mortgages and recently announced it is halting any further purchases.

The next logical step would be to resell those mortgages back to the market, and the manner and speed at which it does so could have a large impact on the economy. Penny for your thoughts.

— Timothy Morton-Smith is a partner with Pacific Pointe Advisors.

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