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SEC Files Suit Against Goldman Sachs

 

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On Friday, the Securities Exchange Commission filed suit against Goldman Sachs, a global investment banking and securities firm, alleging the firm didn’t tell investors in a collateralized debt obligation that Paulson & Co. helped structure the deal and was planning to bet against it. Goldman Sachs had denied all allegations brought forth by the SEC and said the charges are “completely unfounded in law and fact.”

“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,” said Robert Khuzami, director of the SEC’s division of enforcement, according to a statement.

“Once upon a time, Wall Street firms protected clients,” said Christopher Whalen, who heads the research firm Institutional Risk Analytics. “This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another.”

The SEC’s suit is aimed at one of the most profitable hedge-fund trades in History. In 2007 Paulson & Co generated billions in profit from bets against CDOs. Other firms also made huge gains in similar trades at the housing market imploded causing a global financial crisis.

“The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress,” Kenneth Lench, chief of the SEC’s structured and new-products unit, said.

The SEC alleged that Paulson & Co. paid Goldman Sachs to set up a transaction where the Goldman could take short positions against mortgage securities chosen by Paulson & Co. based on the belief that the securities would experience credit events. To make the transaction look legit Fabrice Tourre, a mid-level bank executive then 28, enlists ACA Management to come up with a portfolio of mortgage-backed securities to link to the CDO. ACA Management was never told of Paulson’s real interest in the transaction; the bank said the hedge fun will invest $200 million in the equity of the CDO.

Marketing materials for the CDO told investors the portfolio of residential-mortgage-backs securities underlying the CDO was selected by ACA Management LLC, a third party with expertise in analyzing credit risk. However, the SEC alleged that, undisclosed in the marketing material, and unbeknownst to investors, Paulson & Co. would benefit if the RMBS defaulted.

Full disclosure would have been bad for business because Paulson & Co. is known for being bearish on the mortgage market in turn scaring off potential investors. Even if Goldman couldn’t tell investors that Paulson & Co were betting against the CDO it could have and should have said that Paulson helped plan a majority of the portfolio instead of only listing ACA as the Selection Agent.

The SEC alleges that because of the sophistication of the investors Goldman brought in the ACA to specifically hide Paulson’s involvement in the planning of the portfolio.

The suit has sparked concerns that Goldman might lose some of its dominant share of lucrative markets such as fixed-income underwriting and trading as many institutions begin to shy away.

“There are legitimate concerns over the long-term impact on Goldman’s market share, as some clients may be deterred from doing the same level of business with a firm that is perceived to be a regulatory target,” wrote Steve Stelmach, analyst at FBR Capital Markets, in a note Monday.

Goldman’s net income rose to $3.3 billion, or $5.59 a share, from $1.66 billion or $3.39 a share earned in the first three months of 2009, earnings results showed. The investment bank’s revenue rose to $12.78 billion from $9.43 billion. Goldman was forecasted to make $4.16 a share according to analysts in a FactSet survey. However, shares of Goldman Sachs fell 1.4% on Tuesday afternoon.

“There are legitimate concerns over the long-term impact on Goldman’s market share, as some clients may be deterred from doing the same level of business with a firm that is perceived to be a regulatory target,” wrote Steve Stelmach, analyst at FBR Capital Markets, in a note Monday.

Tuesday, the U.K.’s Financial Services Authority said it has opened a formal probe into Goldman Sachs’ U.K. operations after the SEC filed a civil fraud case against the investment bank.

“Following preliminary investigations, the FSA has decided to commence a formal enforcement investigation into Goldman Sachs International in relation to recent SEC allegations,” the regulator said.

Many are shocked by the “moral bankruptcy” exposed by the SEC’s suit, however Goldman Sachs is far from financially bankrupt. Goldman’s FICC business (short for fixed income, currency, and commodities) generated net revenue of $7.39 billion in the first quarter alone. The trading and principal investments business net revenue was $10.25 billion in the first quarter, a 43% increase from a year ago.

 

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