SEC Charges Goldman Sachs with Fraud

Federal regulators charged Goldman Sachs with fraud Friday, accusing the Wall Street firm of failing to disclose conflicts of interest relating to mortgage investments it created and sold — investments that were likely to fail.

The Securities and Exchange Commission alleges that Goldman Sachs created a mortgage investment, called Abacus 2007-AC-1, in February 2007 that contained mortgage bonds selected by a Goldman client, John Paulson, a top hedge fund manager. (Paulson is not named in the suit.) According to the civil charges, Paulson selected the bonds believing they would lose value if the housing market collapsed. By betting against them, he stood to gain rich rewards. Indeed, he is believed to have made several billion dollars betting against against the housing bubble in 2007.

The conflict of interest the SEC alleges stems from the fact that Goldman marketed and sold Abacus to its other clients as a good investment without revealing that its contents were handpicked by a client who believed those bonds would fail. According to the New York Times, Goldman told potential investors that “the bonds would be chosen by an independent manager.” According to the SEC, “[i]nvestors in the liabilities of ABACUS are alleged to have lost more than $1 billion.”

“[Goldman] told investors that a manager chose what was inside those securities, but they actually let the hedge fund of John Paulson, who was negative on the market, choose what was inside,” Louise Story, who is covering the story for The New York Times, told the NewsHour. “Investors were not told that, so that was misleading.”

“The product was new and complex but the deception and conflicts are old and simple,” said Robert Khuzami, director of the Division of Enforcement for the SEC. “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 civil suit names the firm and a vice president, Fabrice Tourre, who helped to create Abacus.

In response to the filing, Goldman released the following statement: “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”

Within an hour of the charges, Goldman Sachs shares dropped more than 10 percent.

The SEC’s suit directly targets the complex world of derivatives — which, as economics correspondent Paul Solman has written, are “financial instruments whose value is linked to something else.” The once-booming and largely unregulated market for derivatives is credited with bringing about the financial crisis, and earlier this week, President Obama said stronger oversight of derivatives must be brought under more oversight in any financial reform package under consideration in Congress.

Paul Solman, in his series on Goldman Sachs and how it made its money (Part I and Part II), recently explored how Goldman itself made bets against the products it sold to its customers, allowing it to reap handsome profits.

PAUL SOLMAN: How about the extravagantly profitable bets, for its own account, that “Goldmine Sachs,” as some call it, placed with insurer AIG, against the very products, mortgage-backed securities, that the firm was trading to customers?

McClatchy reporter Greg Gordon was the first to uncover the practice.

GREG GORDON, investigative reporter, McClatchy Newspapers: In 2006, Goldman began, in different ways, to make bets that the housing market would turn south. When you’re selling $40 billion in securities, U.S.-registered securities, to investors here and abroad in 2006 and 2007, and, at the same time, you’re secretly betting that these securities are going to go south, are going to lose value, well, that raises a big question.

In January, Lloyd Blankfein, CEO of Goldman Sachs, was questioned about that practice by the Financial Crisis Inquiry Commission.

LLOYD BLANKFEIN: What we do is risk management. Because we had this risk, because we were accumulating positions, which, by the way, we acquired from clients who want to sell them to us, we have to go out ourselves and provide and source the other side of the transactions, so that we can manage our risk. These are all exercises in risk management.

PHIL ANGELIDES, member of Financial Crisis Inquiry Commission: Well, I’m just going to be blunt with you. It sounds to me a little bit like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars, the pension funds who have the life savings of police officers, teachers.

LLOYD BLANKFEIN: These are the professional investors who want this exposure.