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.
SEC Also at Fault?
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."
SEC Charges Goldman With Defrauding Investors
The SEC "charged that Goldman failed to make adequate disclosures on the role that Paulson & Co. played in selecting the portfolio," the SEC's enforcement director Robert Khuzami said on a conference call with reporters this morning. Paulson & Co. wasn't charged because the hedge fund did not make representations to investors, the SEC said.
This afternoon, Paulson & Co. issued a statement, saying that "we were not involved in the marketing of any ABACUS products to any third parties. ... Paulson did not sponsor or initiate Goldman's ABACUS program, which involved at least 20 transactions other than that described in the SEC's complaint.
For its part, Goldman Sachs adamantly rebutted the SEC charges.
"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 company said in a statement.
Goldman Sachs said that it too, lost money on the deal -- more than $90 million.
"The transaction was not created as a way for Goldman Sachs to short the subprime market. To the contrary, Goldman Sachs's substantial long position in the transaction lost money for the firm," the company said Friday in a statement.
Goldman also said that two investors in the deal, ACA Capital Management and German bank IKB, are among "the most sophisticated mortgage investors in the world" and "were provided extensive information about the underlying mortgage securities."
Goldman said that that ACA Capital ultimately approved the selection of the mortgage backed securities in the CDO "after a series of discussions, including with Paulson & Co."
The firm took issue with the SEC's arguments about what Goldman had to disclose about the parties involved in the deal.
"The SEC's complaint accuses the firm of fraud because it didn't disclose to one party of the transaction who was on the other side of that transaction," the firm said. "As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was going to be a long investor."
Today's news marks the first time that federal regulators have come forward with charges against a Wall Street deal that took advantage of investors as the housing market collapsed. This is the first case brought by the Structured & New Products unit of the Division of Enforcement at the SEC, which was formed to specialize in bringing cases in these types of conflicts involving complex financial products.
"We're looking at a wide range of products, transactions, and practices arising out of the credit crisis," Khuzami told reporters today.
SEC officials would not comment on whether they have referred Goldman to the Justice Department for possible criminal charges.
Harvey Pitt, former head of the SEC from 2001 to 2003 and currently chief executive officer of the global business consulting firm Kalorama Partners and former, said the SEC would not have taken today's action if it did not have a strong case. It shows, he said, a stronger willingness by the agency to go after cases such as this with greater speed.
"I think it's fair to say that the SEC won't sue a major pillar of the U.S. financial markets without making sure all its facts are correct," Pitt told ABC News. "Under the circumstances, I think this reflects a new determination on the SEC's part to move cases a lot faster than previously."
Today's SEC announcement will also have ramifications in the court of public opinion -- it is likely to increase an already-simmering populist backlash against Goldman Sachs as well as boost Democrats' calls for increased regulation of Wall Street.
Sen. Ted Kaufman, a Democrat from Delaware, applauded the SEC's announcement and called for swift action against illegal actions by Wall Street banks.
"To restore the public's faith in our financial markets and the rule of law, we must identify, prosecute, and punish with stiff fines or prison those who broke the law," Kaufman said. "Their fraudulent conduct has severely damaged our economy, caused devastating and sustained harm to countless hard-working Americans, and contributed to the widespread view that Wall Street does not play by the same rules as Main Street."
ABC News' Alice Gomstyn and Rich Blake contributed to this report.