SEC Lands a Solid Hit to Goldman

04/16/2010 3:50 pm EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

The Securities and Exchange Commission on Friday, April 16th, charged Goldman Sachs Group (NYSE: GS) with securities fraud. And the whole market has sold off. At 3:00 pm ET, the Dow Jones Industrial Average was down 124 points, or 1.1%. The Standard & Poor’s 500 Stock Index was off 1.6%. Goldman’s shares tumbled 13%.

What is the SEC charging and why is this such a big deal?

The allegations go to the heart of an alleged long-standing conflict of interest at Goldman in particular, but also at Wall Street’s big investment houses in general. And they threaten to put an end to Wall Street’s argument that the financial crisis in the United States was not their fault, but an act of God.

And they come just as investors were buying up bank stocks in the belief that the sector’s problems were over. (For more on the state of the banks as revealed in JPMorgan Chase’s recent earnings report, see this recent post.)

The SEC has charged that Goldman Sachs created a financial product called Abacus—a derivative based on subprime mortgages called a collateralized debt obligation (CDO)—that it allegedly sold to one client as a good investment while knowingly allowing another client, hedge fund giant Paulson & Co., to short the product and to influence what subprime mortgages went into this pool of mortgages.

Goldman, the SEC alleges, never informed the buyers of Abacus that Paulson & Co. had helped select the mortgages underlying the Abacus portfolio, and indeed represented that the mortgages had been selected by an independent third party, ACA Management.

Goldman further represented to ACA, the SEC charges, that Paulson & Co. had invested long in Abacus and thus its interests were aligned with other investors buying the Abacus product when, in fact, Paulson & Co. was betting that Abacus would go down in price. (You can see the official complaint here.)

The Abacus deal closed on April 26, 2007, and by October 24, 2007, according to the SEC, 83% of the mortgage-backed securities in its portfolio had been downgraded by ratings companies, while the other 17% were on negative credit watch. By January 29, 2008, the SEC says, 99% of the securities had been downgraded. The SEC alleges that investors in Abacus lost more than $1 billion.

"The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation," Goldman said in a statement.

The SEC’s complaint notes that Paulson & Co. paid Goldman $15 million to structure and market the Abacus CDO. Paulson doesn’t face charges in the case.

This is a big deal for Goldman Sachs. Because Goldman does so many deals for clients in often obscure corners of the financial markets, it frequently becomes the market, for all intents and purposes. Clients have long felt that Goldman uses its knowledge of these markets to trade for its own profit, even against the interest of its fee-paying clients. (This alleged conflict of interests became a big issue when Goldman’s chief executive officer, Lloyd Blankfein, appeared before Congress’ Financial Crisis Inquiry Commission in January.)

Because Goldman is so powerful, few companies have been willing to say this. But the complaint does occasionally surface. For example, in recent testimony, Kerry Killinger, the former CEO of former mortgage giant Washington Mutual, made it clear he didn’t trust Goldman enough to hire the firm when Washington Mutual’s cratering mortgage portfolio put the company at risk.

In one e-mail released as part of the Commission’s investigation of the financial crisis, he wrote of Goldman: “They were shorting mortgages big time even while they were giving CfC (Countryside Financial, another aggressive mortgage lender) advice.”

But it’s one thing to have clients grumbling or a former CEO complain about your business practices, and quite another to have the SEC file a case that seeks disgorgement of profits and financial penalties from Goldman and that charges specific Goldman executives—in this case, vice president Fabrice Tourre—with civil fraud.

But the worries about this case extend well beyond Goldman.

So far, Wall Street has been very successful in arguing that the financial crisis could not have been anticipated. To hear Wall Street CEOs—and their pals at regulatory bodies such as the Federal Reserve—tell it, you’d think the whole bust that almost took down the global financial system was an act of God. Nobody on Main Street really believes that, but until today, no agency or court with the power to do real harm to Wall Street’s profits has challenged that view.

In its charges against Goldman Sachs, the SEC says, quite plainly, that it just doesn’t buy the “act of God” defense. There was real fraud at work, it claims, and companies and individuals should pay the price.

Wall Street has been hoping its defense would hold. Even this week’s Congressional hearings, at which Killinger and other former WaMu executives detailed the extent of conscious mortgage fraud at that company, weren’t too big a problem. Congress could investigate all it wanted, but it didn’t have the guts to do anything that would really hurt Wall Street’s profits or go after some of the biggest names. Now it’s clear that the SEC does.

But most damaging is that the SEC’s complaint comes just as Wall Street is trying to fend off meaningful regulatory reform in Washington and to line up its regulatory buddies at the Federal Reserve and the US Treasury to fight against the tough international rules on capital proposed by the Basel Committee on Banking Supervision in what’s called Basel III.

The comment period for Basel III closes today—the same day the SEC filed its complaint. That sure makes it tougher for the Fed and Treasury to argue, publicly at least, that banks don’t need strict new rules.

Full disclosure: I don’t own shares of any company mentioned in this story.

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