The Securities and Exchange Commission (SEC) on Friday charged Goldman Sachs Group, Inc. (NYSE: GS) with securities fraud in a civil suit, claiming the financial giant defrauded investors with a mortgage-related investment that was intended to fail.
The SEC accused Goldman Sachs of failing to disclose vital information on a synthetic collateralized debt obligation (CDO) that was peddled to clients while the bank bet against its success, knowing the bank was likely to come out the winner. The SEC says Goldman used hedge fund Paulson & Co. to pick particularly risky securities for the product with a higher chance of collapsing.
The whole financial sector slid after the SEC's announcement. Goldman's stock fell over 12% Friday to close at $160.70 a share.
The product in question is Abacus 2007-AC1, one of many synthetic CDOs Goldman sold before the housing market bubble burst. Goldman did not tell clients the role that Paulson & Co. played in choosing the portfolio and that it had taken a short position against the CDO. Goldman's Abacus marketing materials listed ACA Management as making the portfolio selections, leading investors to believe the assets were safer than they actually were.
Goldman sold $10.9 billion of the bundled products to pension funds, insurance companies and foreign banks that eventually saw billions in losses.
Paulson & Co., led by John Paulson, made $15 billion in 2007, largely from betting against the housing market. The SEC did not charge Paulson because it was Goldman that distributed the misleading marketing materials.
The suit also names Goldman vice president Fabrice Tourre, who was responsible for creating and marketing Abacus.
"Tourre structured the transaction, prepared the marketing materials, and communicated directly with investors," the SEC said in its release. He also "allegedly knew of Paulson & Co.'s undisclosed short interest and role in collateral selection process."
This is the first time the SEC has taken action against a Wall Street firm that capitalized on losses during the housing market collapse after much speculation that firms engaged in manipulative practices by betting against the investments it sold to clients.
Wall Street firms like Deutsche Bank AG (NYSE: DB) and Morgan Stanley (NYSE: MS) defend synthetic CDOs as ways to hedge against other investments and limit losses. Goldman expressed innocence in its CDO activity in a letter published in its annual report, released last week.
"We certainly did not know the future of the residential housing market in the first half of 2007 anymore than we can predict the future of markets today," Goldman wrote. "We also did not know whether the value of the instruments we sold would increase or decrease."
But many economists and analysts see synthetic CDOs as risky business, resulting in conflicts of interest between a firm and its clients.
"The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen," Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York, told The New York Times. "When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else's house and then committing arson."
Goldman's Behavior Raises Eyebrows
The lawsuit piles on to recent news that has tarnished Goldman's already bruised reputation – something the firm knew could hurt business.
Goldman listed in an annual SEC filing bad publicity and regulatory scrutiny as risk factors that could "have a negative impact on our reputation and on the morale and performance of our employees, which could adversely affect our businesses and results of operations."
In an e-mail released by investigators this week, Washington Mutual Inc.'s former CEO Kerry Killinger wrote that doing business with Goldman would be like "swimming with the sharks."
"[W]e always need to worry a little about Goldman because we need them more than they need us and the firm is run by traders," wrote Todd Baker, WaMu executive vice president for corporate strategy and development, in an email exchange with Killinger.
Goldman is one of the biggest opponents to financial reform, joining JPMorgan Chase & Co. (NYSE: JPM) CEO Jamie Dimon in speaking out against tightened financial regulation. Goldman president Gary Cohn set up a fundraiser for Senate Majority Leader Harry Reid, D-NV that turned into a verbal attack on the senator for his anti-Wall Street position.
Goldman execs criticized Reid – as he "sat dumbfounded" – and the Democratic Party for having no qualms about accepting campaign funds from the firms, but then turning around and painting them as greedy and unethical to win public support. Goldman was the second largest campaign contributor to President Barack Obama, who has referred to Wall Street execs as "fat cats."
Goldman also came under scrutiny for its contribution to insurance giant American International Group Inc.'s (NYSE: AIG) demise. Money Morning Contributing Editor Shah Gilani urged readers in February to ask the questions, "Did Goldman drive down the value of securities to collect cash, demand to be made whole and at the same time buy credit-default-swap insurance on AIG, which they were helping to sink?" and "Why are so many Goldman Sachs people in so many powerful government positions?"
In a statement released on its Web site Friday, Goldman Sachs said the SEC's charges "are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation."
News and Related Story Links:
- The Wall Street Journal:
Goldman Is Charged With Subprime Fraud
- The New York Times:
U.S. Accuses Goldman Sachs of Fraud in Mortgage Deal
- The New York Times:
Banks Bundled Bad Debt, Bet Against It and Won
- Fox Business:
Goldman Sachs to Harry Reid: Back Off
- Business Week:
Lehman May Have Grounds to Sue Goldman, Barclays, CME Group
- Securities and Exchange Commission:
Complaint Against Goldman Sachs, Tourre
- Goldman Sachs: 2009 Annual Report
- Money Morning:
How to Profit From the "Evil Genius" of Goldman Sachs