Goldman Sachs Charged With Subprime Loan Fraud, SEC Alleges

Visit msnbc.com for breaking news, world news, and news about the economy

Visit msnbc.com for breaking news, world news, and news about the economy

U.S. Charges Goldman With Subprime Fraud


Goldman Sachs Group Inc was charged with fraud by the Securities and Exchange Commission over its marketing of a subprime mortgage product designed to fail.

The civil lawsuit is the biggest crisis in years for Goldman, which emerged from the global financial meltdown 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, and it comes as lawmakers in Washington debate sweeping reform of financial industry regulation.

The case has also ensnared John Paulson, a hedge fund investor whose firm Paulson & Co made billions of dollars by betting the nation's housing market would crash. This included an estimated $1 billion from the transaction detailed in the SEC lawsuit, which the agency said cost other investors more than $1 billion.

Fabrice Tourre, a Goldman vice president who the SEC said was mainly responsible for creating the questionable mortgage product, known as ABACUS, was also charged with fraud.

Goldman vowed to defend itself.

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

In its lawsuit, the SEC alleged that Goldman structured and marketed ABACUS, a synthetic collateralized debt obligation 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.

Paulson & Co said it did buy credit protection from Goldman on securities issued in the ABACUS program, but did not market the product. Tourre was not immediately available for comment.

Shares of Goldman fell as much as 15.6 percent, and dragged broad U.S. stock indexes lower.

"These charges are far more severe than anyone had imagined," and suggest Goldman teamed with "the leading short-seller in the industry to design a portfolio of securities that would crash," said John Coffee, a securities law professor at Columbia Law School in New York.

"The greatest penalty for Goldman is not the financial damages -- Goldman is enormously wealthy -- but the reputational damage," he said, adding that "it's not impossible" to contemplate that the case could lead to criminal charges. Coffee spoke on Reuters Insider.

Goldman had not disclosed that the SEC was considering a lawsuit but had known charges were possible and had urged the SEC not to file them, people familiar with the situation said on Friday. The sources requested anonymity because the probe was not public.

Visit msnbc.com for breaking news, world news, and news about the economy

Coming out swinging

The lawsuit 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 chief executive 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.

John Paulson is not related to Henry "Hank" Paulson, who was Blankfein's predecessor as Goldman CEO and later become U.S. Treasury secretary.

The SEC lawsuit represents an aggressive expansion of regulatory efforts to hold people and companies responsible for the nation's financial crises. It could help the SEC rehabilitate its reputation after missing other high-profile cases, including Bernard Madoff's Ponzi scheme.

"The SEC has come out swinging," said Cary Leahey, senior managing director of Decision Economics in New York.

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 Paulson.

Still, Khuzami called Paulson's firm "a hedge fund that had a particular interest in the securities performing poorly."

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

In afternoon trading, Goldman shares sank $23.82, or 12.9 percent, to $160.45 on the New York Stock Exchange, after earlier falling to $155.57. The perceived risk of owning Goldman debt, as measured by credit default swaps, increased.

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

The SEC 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.

It quoted a Jan. 23, 2007, email from Tourre to a friend 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."

Independence matters to clients

Other communications detail the importance of hiring ACA. According to the SEC, Goldman reached out to German bank IKB to buy the securities that Paulson was selling, knowing it would buy only securities selected by an independent asset manager.

"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 March 12, 2007, Goldman email said.

IKB ultimately took on exposure to ABACUS, as did the Dutch bank ABN Amro Holding NV. Germany's government bailed out IKB in the summer of 2007, in part because of the bank's investments, while lenders that eventually bought ABN Amro also were forced into their own government bailouts.

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 percent of the portfolio had been downgraded, the SEC said.

Janet Tavakoli, president of Tavakoli Structured Finance Inc in Chicago and author of a book on synthetic CDOs, said it may have been common on Wall Street for hedge funds to play big roles in picking mortgage-backed securities for use in CDOs.

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

Washington Impact

The 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 in December. Analysts believe a bill could be signed into law by Obama by mid-year.

"Banks were getting their mojo back, successfully fighting the regulatory reform bill," said James Ellman, president of Seacliff Capital in San Francisco. "Clearly, such malfeasance could help get the bill to go through."

Goldman in 2008 won a $5 billion investment from Warren Buffett's Berkshire Hathaway Inc.

Last month, Buffett praised Goldman as a "very, very strong, well-run business," and said of Blankfein, "You cannot find a better manager."

Buffett had no immediate comment, his assistant Carrie Kizer said.

The lawsuit was assigned to U.S. District Judge Barbara Jones, who was appointed to the bench in 1995 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, U.S. District Court, Southern District of New York, No. 10-03229.


View Larger Map


Sources: CNBC, MSNBC, Google Maps