Downgrades Crush Goldman Sachs Stock On News of Criminal Investigation

Goldman Sachs Group, Inc (NYSE: GS) fell 9.39% Friday after being downgraded on news released Thursday that federal prosecutors started a criminal investigation into whether Goldman committed securities fraud.

Standard & Poor's Financial Services LLC downgraded Goldman to sell from hold and lowered its price target to $140 from $180.

"Though traditionally difficult to prove, we think the risk of a formal securities fraud charge, on top of the SEC fraud charge and pending legislation to reshape the financial industry, further muddies Goldman's outlook," S&P analysts wrote in a note to clients Friday morning.

Bank of America Merrill Lynch (NYSE: BAC) its rating on Goldman stock to neutral from buy and slashed its price estimate to $160 from $220 after the criminal investigation announcement.

The Wall Street Journal reported Thursday that the Manhattan U.S. Attorney's Office is conducting the investigation on a referral from the Securities and Exchange Commission, according to people familiar with the matter.

Goldman's stock has fallen more than 20% since the SEC's April 16 announcement that it was filing a civil lawsuit charging the bank and vice president Fabrice Tourre with fraud. The SEC accused Goldman of failing to disclose vital information to clients on a synthetic collateralized debt obligation (CDO) as the investment bank bet against the security's success, knowing that it was likely to emerge as the winner.

The product highlighted in the SEC case is Abacus 2007-AC1 - one of many synthetic CDOs Goldman sold before the housing market bubble burst. It is unclear if the criminal investigation involves the same Goldman deals.

The challenge facing prosecutors will be to find evidence that proves Goldman or its employees knowingly committed fraud. The burden of proof is higher in a criminal case than a civil one.

"In order to proceed criminally in a case, you need to have very clear evidence of lying, cheating and stealing," Douglas R. Jensen, an attorney with Park & Jensen LLP, told Bloomberg

Goldman in an 11-hour Senate subcommittee hearing this week maintained that its investors were sophisticated and aware of the information related to the Abacus product they purchased.

"It is my belief that nothing unethical and nothing illegal has happened but I will tell you if I discovered something like this or any senior person at Goldman Sachs discovered illegal or unethical behavior, we would eliminate that from the firm," Chief Executive Officer Lloyd Blankfein told CBS News this week.

Money Morning Contributing Editor Martin Hutchinson wrote on April 19 that the SEC lawyers' discovery process, where they access Goldman files and e-mails, could procure enough evidence to bring about criminal charges.Hutchinson believes Goldman's existence would be in danger if the criminal investigation led to formal charges.

"If the FBI files serious criminal charges against Goldman on a deal central to their business (as the Abacus deal was), I think it would be very difficult for them to survive. Clients would desert them, counterparties would worry about their credit risk and sharks in the credit-default-swap (CDS) market (and to a lesser extent in the stock market) would try to batter the stock price down and the CDS price up, forcing the market into panic. That's essentially what happened to Lehman Brothers Holdings Inc. We are very close to a tipping point at which Goldman goes bust, its top management go to jail and Wall Street changes forever," said Hutchinson.

Hutchinson says Goldman clients will be tempted to take their business to fellow Wall Street powerhouse JPMorgan Chase & Co. (NYSE: JPM), which he calls "probably the only major Wall Street house managed by a grown-up, Jamie Dimon."

"Grown-ups are sophisticated, and have a strong sense of when a deal or set of deals shouldn't happen because it risks the long-term health of the franchisem," he said "Traders can't run things."

The Goldman saga continues as financial reform is batted around the Senate floor. Republicans finally agreed this week to start talks with Senate Democrats. President Barack Obama has been citing the Goldman case to gain public support for a financial system overhaul, but Hutchinson is skeptical of how much it will prompt drastic change in legislation.

"I think the lack of understanding in Congress is such that they will not pass meaningful reform, because anything that worked would meet screaming hostility from the lobbyists and Congress would be scared to move in case they caused unexpected damage. However the case itself could force change where Congress can't."

The change Hutchinson sees occurring is an alteration in how big banks conduct business - and how much their clients approve of the business model of sharing banking and trading activities.

"This whole business is getting chief financial officers to think about questions they should have been thinking about all along - like do they want to give a deal to someone whose proprietary trading desk may short it for their own account?" says Hutchinson. "Clients will eventually come to realize they shouldn't trust piranhas with their delicate corporate information," "The mega-bank model is badly flawed, and this may kill it off."

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