Goldman's 50-Year Bonds

Why Main Street should never trust Wall Street...

LAST WEEK, Goldman Sachs sold $1.3 billion of 50-year bonds with a 6.125% interest rate, writes Martin Hutchinson, contributing editor to the Money Morning email.

The issue was specially designed – with bonds in denominations as low as $25 – so the securities could be sold to small retail investors.

At last, Goldie's done something for the little guy...Or did it?

There are entities and currencies in which a 50-year bond at a suitably high interest rate might be a reasonable investment. Switzerland, for example. Maybe Singapore. Maybe even Canada, though there I'd be very worried about both inflation risk and Federation break-up risk.

The United States? Not so much, quite frankly.

Before I'm deluged with e-mails from outraged patriots, let me explain that I have only moderate concerns about a US default over the next 50 years. Yes, the Social Security trust fund runs out about 2040. And, yes, the long-term Medicare deficit is many times gross domestic product (GDP). But both those calculations assume nothing is done to improve the situation.

Medical costs, if allowed to go on increasing at the rate of the last few decades, would absorb the entire US GDP well before 2100. Since that can't happen, it won't. Most likely, a combination of delaying the age eligibility for Medicare and pushing the free market further into the medical system as lawyers are pushed out of it will solve the problem. Like US public-sector infrastructure projects, US hospitals are about four or five times as expensive as they are in other comparable countries. That problem is soluble, and is one that will eventually be solved.

But instead of default, the more dangerous problem with a 50-year bond paying 6% or so is inflation. It's not a problem over the entire 50-year window, since most current prospective buyers – middle-aged or even senior-citizen investors who are seeking income – won't be around to collect, anyway.

However, a burst of inflation over the next few years could easily send long-term interest rates up 3%, in which case that bond will trade at around 67. The investor seeking a safe investment will have lost a third of his money in only a few years.

There's a lesson here, and it's one that's well-worth heeding: Long-term bonds are very dangerous investments, indeed, when interest rates and inflation are close to their low point – just as they are great investments during such periods as 1981-82, when everybody's panicking about them.

However, the reason why this is a truly dreadful investment is the borrower. Goldman Sachs has traditionally lived by the ability of its traders to pull off trades with a maximum lifespan of a few days. These days, it also benefits from the ability of its computers to pull off trades that each have a lifespan measured in milliseconds.

Tell me, if you were a Mad Man living in 1960, would you have bought a 50-year bond of an investment bank?

Yes, with Goldman Sachs you would have been okay. But what if you had bought Glore, Forgan & Co. (bankrupt in 1974, losing Ross Perot $90 million)? Or Francis I. Du Pont & Co.? As the No. 3 US brokerage house, surely you'd have thought that name was solid. But it merged with Walston & Co. and Glore Forgan Staats Inc. before ending in the same bankruptcy (at one point in the 1970s, DuPont Walston Inc. was the second-largest brokerage house on Wall Street, giving the company a size and market presence that investors likely found reassuring).

How about McDonnell & Co...? It succumbed four years earlier to the back office crisis of 1970. Or, if you want something of a more-current vintage, how about the Bear Stearns Cos...? You'd have felt pretty confident of making it to the 50-year maturity with those bonds after holding them for 47 years – and you'd have been right, as it technically didn't go bust: Instead, it was bought out by J.P.Morgan Chase & Co. in March 2008.

Goldman Sachs bonds today are in the same situation as Glore, Forgan bonds in 1960. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 provides for an orderly liquidation of Goldman, should its derivative games blow up.

But the law also provides that long-term creditors should lose money in that event. And that "long-term creditors" includes bondholders.

If you look at what's happened in the financial markets in just the past two or three years, do you really want to bet that all of Goldman's schemes will go on working until 2060? That's not a bet I would take – and that's nothing personal against Goldman, compared to anyone else in that line of business.

There were other groups that seemed to be conspicuously absent in the publicity about the Goldman Sachs bond issue – Goldman Sachs partners, billionaires and hedge funds.

Oh, I have no doubt some of them bought a bond or two, but the issue was not aimed at folks or institutions of that ilk for one very simple reason: It was not a good enough investment. They are the people who get invited into the "private equity" deals for which Goldman Sachs has an inside track, and into which only wealthy investors are allowed to invest.

These preferred (or "qualified" investors, as defined by the US Security and Exchange Commission's Rule 144A) clients get the very best deals. For instance, they may get to invest in a particularly attractive emerging market stock that Goldman has discovered. If the price rises far enough, for a long-enough period, that stock may one day be listed on the New York Stock Exchange. Only then will "ordinary" investors have a chance to invest. Goldman and its Wall Street ilk deal in superb investments, ordinary investments, and not-so-hot investments – and it always seems the not-so-hot investments are the ones that Wall Street reserves for the retail crowd that makes up Main Street.

Face it. As a retail investor, you're never going to get an even break out of the big Wall Street investment houses. In fact, you're much better advised to have nothing to do with them. And that includes their bonds.

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