A financial professional works in the Goldman Sachs booth on the floor of… (Chris Hondros / Getty Images )
Federal regulators accused powerhouse Goldman, Sachs & Co. of fraud Friday for peddling tainted mortgage investments, a move that could lead to more lawsuits against major banks.
The civil complaint filed by the Securities and Exchange Commission against the investment bank sent shudders through Wall Street as investors also girded for heavier regulation under proposed legislation in Congress.
The suit bolsters the hand of the Obama administration, which has struggled to overcome Republican opposition to proposals for overhauling financial regulations. Among them are tough rules for complex investments known as derivatives that were the basis for the allegations against Goldman and a key factor that led to the worldwide financial crisis.
"We can't allow history to repeat itself," Obama said Friday in vowing to veto any bill that omits stringent oversight of derivatives.
The SEC's case against Goldman and one of its young vice presidents alleges that they created securities based on subprime mortgages that would probably collapse. Those securities were secretly selected by hedge fund Paulson & Co., which was separately betting that such mortgage-backed securities were going to fail.
Paulson & Co. paid Goldman a $15-million fee but made $1 billion, the SEC said, while investors who bought the mortgage-related securities lost $1 billion. Their losses were almost immediate. Less than a year after the securities were issued, 99% had been downgraded by credit-rating firms.
Goldman denied any wrongdoing, saying in a statement that it provided full disclosure to the sophisticated investors who bought the securities. Goldman claimed that it lost $90 million from its own investment in the security.
"We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact," the company said.
Paulson & Co. founder John Paulson, no relation to former Treasury Secretary Henry M. Paulson, said he had no role in choosing the mortgages.
The case goes to the heart of the complaints about the role that Wall Street, and particularly Goldman, played in fanning the excesses of the subprime mortgage era. Those transactions helped lead to the paralyzing recession during which the federal government gave billions of dollars in bailouts to Goldman and other Wall Street firms.
At its core, the SEC alleged that Goldman sold out some clients to score huge fees from a deep-pocketed hedge fund.
"This exposes the cynical, savage culture of Wall Street," said Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance financial research firm. "You have a basic conflict of telling one client to buy it and telling another client to [bet against] it."
Goldman, one of the most successful and envied firms on Wall Street, has been widely criticized for profiting from the financial crisis. Before Friday the firm had not faced any legal fallout, and it appeared that Goldman might emerge with only a damaged public reputation.
The suit involves only one financial device created by Goldman, but it signals the SEC's new willingness to take legal action against Wall Street firms for their behavior during the crisis.
"We are looking very closely at these products and transactions," said Robert Khuzami, the SEC's enforcement chief. "If we see that same profile repeated elsewhere, we will look at it very closely."
The SEC action also sparked frenzied selling of financial stocks, including a 13% drop in shares of Goldman Sachs Group Inc., the bank's parent.
"Goldman is such a prestigious company, and the allegations seem to indicate fairly flagrant violations," said Marc Flessner, a former federal prosecutor now at the Sonnenschein Nath & Rosenthal law firm. "If those allegations are sustained, it's obviously going to cause some fairly big problems."
The SEC built its case in part on e-mails in which a Goldman vice president, Fabrice Tourre, now 31, appears to gloat about the coming investor losses.
"The whole building is about to collapse any time now," Tourre wrote. "Only potential survivor, the fabulous Fab[rice] standing in the middle of all these complex, highly leveraged exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic]!!!"
The security in question -- known as a synthetic collateralized debt obligation and carrying the tongue-tripping name ABACUS 2007-AC1 -- was a complex financial creation whose value was based on a bundle of subprime mortgages.
Tourre put ABACUS together in April 2007, just as the mortgage market was collapsing, at Paulson's request, according to the SEC complaint. The agency alleged that Goldman allowed Paulson to select the securities but told investors they were chosen by an objective third party.
The case is a major blow to Goldman, which despite widespread public opprobrium has nonetheless reveled in its image on Wall Street as a prescient forecaster of financial market trends.
The company forecast the collapse of the housing market earlier than most industry analysts.
The worldwide financial crisis briefly appeared as though it might derail Goldman.
In late 2008, soon after the collapse of Lehman Bros. Holdings Inc., Goldman took $10 billion from the government's Troubled Asset Relief Program. But its recovery was so sweeping that it paid back the government by last summer, plus 23% interest.
Regardless of the outcome of the case, Goldman could be hurt immediately if clients flee.
"No client is likely comfortable with the idea that it could be the next sucker on the other side of a Goldman trade or product," Michael Wong, an analyst at Morningstar Inc. said in a note to clients.