Goldman Sachs Sued for Fraud

The gnomes of Wall Street are at it again.

The Securities and Exchange Commission (SEC) dropped the hammer today on Goldman Sachs, charging that Goldman defrauded investors by withholding key information about mortgage securities that the SEC alleges were doomed to fail.  This is the first action the SEC has pursued against firms that profited from the collapse of the housing market.

In a press release, Goldman spokesmen called the allegations “completely unfounded in law and fact”.  Goldman vowed to fight the charges.

The alleged fraud is connected to a financial instrument called Abacus 2007-AC1.  SEC alleges that Abacus was created at the behest of John Paulson, a hedge fund manager who made billions of dollars betting against the housing market.  The Abacus securities were stuffed with mortgage bonds that Paulson wanted to short.  The SEC further alleges that he selected them specifically because he believed their underlying numbers were not as good as their credit ratings suggested, and he believed they would default.

In literature for the Abacus securities, Goldman told investors that the bonds would be picked by an independent manager.  There was no mention of Paulson.  Robert Khuzami, director of the SEC’s division of enforcement said “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”.

In its annual report earlier this month, Goldman said “Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients’”. Goldman alleges the securities were a hedge against other trading positions.

The SEC alleges Many Wall Street firms created mortgage securities known as synthetic collateralized debt obligations, which essentially consisted of insurance policies written on mortgage bonds.  Goldman took out insurance on the bonds in Abacus (which were deemed likely to default).  When the market collapsed, investors in Abacus lost billions, and Goldman and Paulson made billions.  Goldman did not mention in its marketing material that it was taking a short position against the Abacus bonds.

Insurance on most of the bonds was provided by AIG, which lost billions of dollars in the deal.  You may recall that American taxpayers provided $180 billion in bailout funds.

In a nutshell, the SEC alleges the Goldman created a security which consisted of risky bonds picked by Paulson because they were deemed likely to default .  They sold the product to investors, while simultaneously betting that the bonds contained in the security would fail.  When the security failed, Goldman collected billions of dollars in insurance they took out on the bonds.  The insurers that lost money were then bailed out by U.S. taxpayers. In fairness, companies like AIG probably would have needed bailouts regardless of their losses on Goldman products.

What do you think about the Goldman charges?  Are they justified?  Politically-motivated?  Unfounded?  Let us know in the comments section below.