New York: Goldman Sachs Group Inc was charged with fraud by the US Securities and Exchange Commission over its marketing of a debt product tied to subprime mortgages that was designed to fail.

The lawsuit is the biggest crisis in years for Goldman, which emerged from the global financial crisis as Wall Street’s most influential bank.

It is also a huge test for Chief Executive Lloyd Blankfein, who has faced a firestorm of criticism over the bank’s pay and business practices. It comes as lawmakers in Washington debate sweeping reform of financial industry regulation.

Goldman shares fell as much as 15.6% and broader stock markets fell after the news.

Graphic: Yogesh Kumar/Mint

Fabrice Tourre, a Goldman vice president who the SEC said was principally responsible for creating the product, was also charged with fraud. Paulson was not charged.

“The SEC has come out swinging," said Cary Leahey, senior managing director of Decision Economics in New York. “This will be a difficult case to prove. Even supposed experts on Wall Street with years of experience in this area are still scratching their heads trying to figure out who did what."

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Goldman defends itself

Goldman vowed to fight the SEC civil suit.

“The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation," it said.

Paulson and Tourre were not immediately available for comment.

It is a regulatory and public relations nightmare for Blankfein, who has spent 18 months fending off complaints that Goldman is an unfair beneficiary of taxpayer bailouts of Wall Street. He became CEO less than a year before the product challenged by the SEC was created.

“This could be the beginning of a period where you have a regulatory cloud over Goldman Sachs, and perhaps even the entire investment banking industry," said Hank Smith, chief investment officer at Haverford Trust Co in Philadelphia.

The lawsuit represents an aggressive expansion of regulatory efforts to hold people and companies responsible for activity that contributed to the nation’s financial crises.

Other investigations may be in the offing.

Janet Tavakoli, president of Tavakoli Structured Finance Inc in Chicago and author of a book on synthetic CDOs, said it may have been quite common on Wall Street for hedge funds to play major roles in picking mortgage-backed securities to be put into portfolios used in CDO transactions.

“Many investors were not aware of how disadvantaged they were by these CDO structures," she said.

Robert Khuzami, head of the SEC’s enforcement division, said John Paulson was not charged because it was Goldman that made misrepresentations to investors, not him.

It is unlikely that criminal charges will be brought, a source close to the matter said. Representatives for the Justice Department declined to comment.

In afternoon trading, Goldman shares sank $24.92, or 13.5%, to $159.35 on the New York Stock Exchange, after earlier falling to $155.57.

The news sent broader US stock indexes down more than 1%, and major bank indexes down more than 3%.

E-mail trail

In its lawsuit, the SEC alleged that Goldman structured and marketed a synthetic CDO, ABACUS, that hinged on the performance of subprime residential mortgage-backed securities.

It alleged that Goldman did not tell investors “vital information" about ABACUS, including that Paulson & Co was involved in choosing which securities would be part of the portfolio. It also alleged that Paulson took a short position against the CDO in a bet that its value would fall.

According to the SEC, the marketing materials for the CDO showed that a third party, ACA Management LLC, chose the securities underlying the CDO, without revealing Paulson’s involvement.

The complaint quotes extensively from internal emails and memos, noting that in early 2007 it had become difficult to market CDOs tied to mortgage-backed securities.

For example, the complaint quotes a 23 January 2007, email from Tourre to a friend sent in English and French and translated by the SEC, as saying: “The whole building is about to collapse anytime now ... Only potential survivor, the fabulous Fab ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!"

Another email to Tourre from the head of Goldman’s structured product correlation trading desk complained: “The cdo biz is dead we don’t have a lot of time left."

Other communications detail the importance of hiring ACA for independent portfolio selection. “We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering," a 12 March e-mail said.

Paulson & Co paid Goldman $15 million to structure and market the ABACUS CDO, which closed on April 26, 2007, the SEC said. Little more than nine months later, 99% of the portfolio had been downgraded, the SEC said.

“In sum," the complaint said, “Goldman Sachs arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors ... Paulson’s role in the portfolio selection process or its adverse economic interests."


The SEC charges are expected to fuel anti-Wall Street sentiment on Capitol Hill, where sweeping financial industry reforms are expected to soon arrive on the Senate floor for a vote.

A Democratic bill, strongly supported by President Barack Obama, would slap new restraints on major banks, likely curtailing their opportunities for profit and revenue growth.

Similar legislation was approved in the House of Representatives in December. Analysts believe a bill could be signed into law by Obama by mid-year.

The SEC lawsuit was assigned to US District Judge Barbara Jones, who was appointed to the bench by President Bill Clinton. She presided over the 2005 criminal trial of former WorldCom Inc chief executive Bernard Ebbers over an $11 billion accounting fraud at the phone company.

The case is SEC v. Goldman Sachs & Co et al, US District Court, Southern District of New York, No. 10-03229.