Last Updated: May 5, 2008: 2:50 PM EDT
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Goldman makes the short list

Is the Wall Street giant 'playing with fire' by recommending short sales of struggling financials like Washington Mutual?

By Roddy Boyd, writer

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NEW YORK (Fortune) -- Goldman Sachs recently provided a glimpse of one of the rarest occurrences on Wall Street: an analyst recommended that clients bet against a company by selling its shares short. In this case, the company was struggling Seattle thrift Washington Mutual (WM, Fortune 500), which happens to be a Goldman client.

Goldman's short call last Friday made headlines in part because Goldman had just earned millions of dollars in fees for arranging a costly $7 billion recapitalization of WaMu. Five years ago, Goldman and other major investment banks paid over $1.4 billion to settle charges brought by then New York Attorney General Eliot Spitzer that they tainted their research to curry favor investment banking clients. The settlement has yielded a mixed bag: the most egregious conflicts of interest have waned, but aggressive calls to sell a stock are still uncommon.

While Goldman scored points for not letting its WaMu banking business influence its research on the bank, the firm's bold call also pointed to the declining clout - and revenues - of Wall Street's research operations.

The business of research "is increasingly irrelevant and the analysts are going to have an increasingly harder time getting paid," says Andy Kessler, a former portfolio manager who once was a well-regarded research analyst at Morgan Stanley. "Hence the 'louder' calls."

Indeed, while sell calls are still quite rare - Thomson Financial says just 5.7% of the existing research opinions on 5,500 publicly traded U.S. stocks are sell or its equivalent - they're not nearly as rare as calls to sell a stock short. Thomson doesn't even track those and major investment banks don't list them as a grade or ranking in their research recommendations. The only other recent short-sale call that comes to mind is Goldman's Feb. 25 recommendation to short shares of mortgage lenders Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500).

Wall Street traders made a real distinction between a standard sell call and a short recommendation. According to traders, a "sell" or "avoid" rating implies that the company's stock is sharply overvalued or is facing some bad news for a prolonged stretch. But advising clients to short a stock is, in the words of one hedge fund trader, like "Yelling at the world: 'There is a major problem here - get out!'"

"It's definitely an oddity," agrees David Hendler of independent research boutique CreditSights. Hedge fund manager Whitney Tilson is more blunt: Putting a sell call on a company, he says, is a "CLM - a career limiting move - for an analyst. It's much easier to put a 'hold' on it and quietly tell your best clients it's a toxic piece of dung."

Kessler, the former Morgan Stanley analyst, notes that Goldman Sachs has more freedom than other Wall Street firms to take such an aggressive stance. The WaMu recommendation by Goldman's mortgage finance specialist, James Fotheringham, he notes, was also "a statement about the fact that his clients are hedge funds, as opposed to mutual funds." Hedge funds almost always seek to be long one asset and short a similar one against it - and Fotheringham last week advised clients to buy WaMu debt while shorting its stock.

That's a call that wouldn't make sense for investment banks with large retail investor client bases, such as UBS (UBS), Merrill Lynch (MER, Fortune 500) and Citi (C, Fortune 500). These banks are no doubt leery of advising individuals to adopt short-selling as a strategy because of its high risk and the upfront cash required. An investor who purchases a stock based on a buy rating can lose only the purchase price, but a short-sale gone wrong can have limitless losses - as there is no ceiling on a stock's price.

Brokerage firms also must be wary of the legal headaches associated with short-sale recommendations. Publicly traded companies like drug distributor Biovail (BVF) and insurer Fairfax Financial (FFH) have sued sell-side analysts in recent years, accusing them of participating in wide-range conspiracies designed to benefit short-sellers.

What's more, despite Spitzer's years-old crusade against conflicts of interest on Wall Street, brokerage firms still don't want to rock the boat with their corporate clients by issuing negative calls against them.

A Goldman spokesman declined to comment for this story, but the report that Goldman issued last week on WaMu makes explains the reasons for the firm's call. The report argued that the thrift was likely staring at an additional $17 billion to $23 billion in credit losses in coming months. But Goldman's recommendation that clients buy WaMu's bonds - along with Goldman's role in arranging for the firm's capital-raising with investors led by private equity firm TPG - may have soothed hurt feelings at WaMu's executive offices.

Goldman - which made billions of dollars last year by shorting the subprime mortgage bonds that its bankers were pumping out in volume - seems to have timed its latest calls right. Both the WaMu and Fannie-Freddie short calls have made investors money, as shares in all three companies have since fallen.

Even so, one hedge fund portfolio manager who spoke on condition of anonymity, describes the practice of recommending that clients short sell a stock as "playing with fire." Leave it to Goldman to do so without getting burned - at least not yet. To top of page

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