By Zachary A. Goldfarb
Washington Post Staff Writer
Saturday, April 17, 2010; A01
The Securities and Exchange Commission filed fraud charges against Goldman Sachs on Friday, alleging that the famously successful but vilified Wall Street bank sold investors a subprime-mortgage investment that was secretly designed to lose value.
In filing the civil suit, the agency targets one of the few banks that, with the help of taxpayer bailouts, emerged from the financial crisis stronger than before. The case strikes at a main cause of the financial crisis: the creation of investments derived from home loans made to borrowers who couldn't afford the houses they were buying.
But the suit, which alleges that Goldman Sachs misled its clients, goes beyond, raising the possibility that the bankers who devised these investments knew they were selling toxic financial products that could endanger the financial system but were concerned only with the fees they would earn by doing so.
The SEC suit comes against the backdrop of a escalating battle on Capitol Hill over how best to overhaul the regulation of financial firms and prevent the kind of abusive practices that contributed to the worst financial crisis in decades.
Months before the mortgage investment was marketed, a senior Goldman Sachs executive recognized in an e-mail that the implosion of the housing market was imminent. "The whole building is about to collapse anytime now," concluded Goldman Sachs vice president Fabrice Tourre, who allegedly created the investment at the core of the case.
The SEC suit also drags into a legal maelstrom the legendary hedge fund manager John Paulson, who personally earned billions of dollars as his firm Paulson & Co. bet against the housing market as it went bust. The fund was a central actor in the alleged fraud, but officials say Paulson did nothing wrong.
Goldman Sachs denied the SEC's allegations. "The SEC's charges are completely unfounded in law and fact, and we will vigorously contest them and defend the firm and its reputation," the bank said in a statement.
An attorney for Tourre, who also faces civil charges, did not respond to requests for comment.
A Paulson spokesman said his firm did nothing improper. He "is not the subject of this complaint, made no misrepresentations and is not the subject of any charges," according to the statement.
In its case, the SEC alleges that Goldman Sachs created and marketed a financial product known as a collateralized debt obligation, often referred to as a CDO, whose value was linked to that of home loans. The agency claims that Goldman Sachs didn't tell investors that Paulson & Co. helped the bank assemble the CDO while the hedge fund at the same time placed bets that it would lose value.
"The product was new and complex, but the deception and conflicts are old and simple," SEC enforcement director Robert Khuzami said in a statement. "Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."
The suit, filed in federal court in the Southern District of New York, alleges that Paulson & Co. paid Goldman Sachs to create a product that would allow the firm to bet against subprime mortgage securities it believed would lose value. According to the SEC, Paulson & Co. helped assemble the CDO by encouraging the inclusion of subprime mortgages that would probably go bad. At the same time, Paulson & Co. in essence bought insurance that would pay out if the CDO lost value.
Without disclosing the hedge fund's role, Goldman Sachs began to market the CDO, which was known as ABACUS 2007-AC1, to investors who wanted to bet that the housing and subprime mortgage markets would continue to boom, according to the SEC.
The CDO was created April 26, 2007, just as the housing market began to falter, the SEC said. Paulson & Co. paid Goldman Sachs $15 million for structuring and marketing the CDO. Investors in the CDO lost more than $1 billion, according to the agency.
Both Goldman Sachs and Tourre, who is still employed by the firm, could face penalties including fines, repayment of ill-gotten gains and limits on the business they can do. The SEC does not have criminal authority and would not comment on whether the Justice Department is conducting a criminal probe.
Goldman Sachs shares tottered on the news Friday, dropping nearly 13 percent to $160.70.
The case is the latest instance of bad publicity for Goldman Sachs, which has faced widespread criticism that it has unfairly benefited from close ties to both Democratic and Republican administrations.
The firm did not make many of the risky bets its competitors did, and therefore largely escaped the carnage that the crisis wrought on Wall Street. But the company, like other banks, was helped to survive by the federal government. Critics, for instance, have pointed to the government's rescue of American International Group, which was a top trading partner of Goldman Sachs. Last year, Goldman Sachs agreed to a $60 million settlement in Massachusetts for its role in underwriting subprime-backed mortgages.
Goldman and the SEC could settle the case filed Friday. But the bank's tone suggested it might be ready for a courtroom battle.
If the conduct alleged by the SEC went beyond this specific instance and was common on Wall Street, this disclosure could upend a popular notion about the causes of the financial crisis. It could mean that bankers may have been intentionally creating toxic assets, looking only to generate fees for their employers and bonuses for themselves without worrying whether it would cost investors or clients or pose a risk to the nation's financial markets.
The prevailing view has been that Wall Street's biggest banks, perhaps ignoring common sense, bought into the widespread notion that housing prices would continue to rise for the foreseeable future, and that these firms were as surprised as anyone by the sudden collapse in the housing market.
Khuzami told reporters on Friday that the SEC is trying to find out whether other banks did what Goldman Sachs is alleged to have done.
"We are looking very closely at these products and transaction. Obviously we have found a transaction with certain characteristics that we believe operated as a fraud upon investors," Khuzami said. "If we see that same profile repeated elsewhere, we'll look at it very closely."