Federal regulators today charged investment bank Goldman Sachs with fraud over the sale of risky subprime mortgage securities that were secretly designed to fail, costing investors $1 billion.
In a civil suit filed Friday, the Securities and Exchange Commission alleged that Goldman Sachs didn't tell investors that a massive hedge fund -- Paulson & Co. -- had hand-picked the subprime mortgages that went into the securities in question, all with an eye toward picking those most likely to go bust. The securities were then bundled up and sold to investors, who were told the mortgages had been picked by an independent third party.
Today's civil fraud suit against Goldman is a "massive, a watershed event," said Sean Egan of Egan Jones. "It's directly addressing the fundamental problem in the market that has been at the root of the financial crisis. The SEC's action's have underscored the basic problem that has existed and continues to exist in the financial market whereby investors don't have sufficient information to make judgment independently. Something like this had to happen. There had to be some action that puts this fundamental market problem into focus, and this is the event."
"It took a lot of guts to take this action," Egan said of the SEC. "You are likely to see some significant changes in how business is done."
Shares of Goldman Sachs, which rebutted the SEC charges, fell 10 percent in trading today, touching off a triple-digit decline in the Dow Jones Industrial Average and a sell-off in financial stocks.
The SEC alleges that Goldman Sachs was peddling an investment that was secretly set up to fail. And according to internal Goldman Sachs e-mails, the company vice president included in the SEC's charges, 31-year old Fabrice Tourre, did not fully understand the complex deals he was making.
According to the SEC complaint, Tourre wrote in an e-mail to a friend in January 2008, "More and more leverage in the system, the whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab…standing the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!"
Ultimately investors in the deal lost more than $1 billion, the SEC said, while Paulson & Co. raked in a $1 billion profit from its short position. Goldman Sachs received $15 million for brokering the transaction. Within nine months of the transaction creating ABACUS 2007-AC1, 99 percent of the mortgages in the portfolio had been downgraded -- an almost perfect failure rate.
Some critics say that it's about time the SEC started looking at the fallout from the kinds of investments -- collateralized debt obligations, also known as CDOs -- that Goldman is facing heat over.
"I think they have been absent without leave," said Bill Bartmann, the president of investment advisory firm Bartmann Enterprises in Tulsa, Okla.
Bartmann and others fault the SEC for failing to regulate CDOs from the start.
"They should have put checks and balances in place to prevent the catastrophe that ultimately occurred," he said. "The SEC seemingly was asleep on the switch or looked the other way and sometimes you can't tell which one it is."