(Reuters) – Goldman Sachs Group Inc was charged with fraud by the U.S. Securities and Exchange Commission over its marketing of a subprime mortgage product, igniting a battle between Wall Street’s most powerful bank and the nation’s top securities regulator.
The civil lawsuit is the biggest crisis in years for a company that faced criticism over its pay and business practices after emerging from the global financial meltdown as Wall Street’s most influential bank.
It may also make it more difficult for the industry to beat back calls for reform as lawmakers in Washington debate an overhaul of financial regulations.
Goldman called the lawsuit “completely unfounded,” adding, “We did not structure a portfolio that was designed to lose money.”
The lawsuit puts Goldman Chief Executive Lloyd Blankfein further on the defensive after he told the federal Financial Crisis Inquiry Commission in January that the bank packaged complex debt, while also betting against the debt, because clients had the appetite.
The case also involves 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 lawsuit, which the SEC said cost other investors more than $1 billion. Paulson was not charged.
Fabrice Tourre, a Goldman vice president whom the SEC said was mainly responsible for creating the questionable mortgage product, known as ABACUS, was charged with fraud.
The news dragged down broad U.S. equity indexes, which fell more than 1 percent. The perceived risk of owning Goldman debt, as measured by credit default swaps, increased. Treasury prices rose as investors sought safe-haven government debt.
“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 [said John Coffee, a securities law professor at Columbia Law School in New York].
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.”
E-mails from former Washington Mutual Inc CEO Kerry Killinger read aloud during a congressional hearing this week illustrated clients’ concerns about working with Goldman.
In 2007, Killinger discussed hiring Goldman or another investment bank to help Washington Mutual find ways to reduce its credit risk or raise new capital, according to one of the e-mails, which Michigan Democratic Sen Carl Levin read during the hearing.
“I don’t trust Goldie on this,” Levin quoted one of Killinger’s e-mails as saying. “They are smart, but this is swimming with the sharks. They were shorting mortgages big-time while they were giving (Countrywide Financial Corp) advice.”
According to the SEC, 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.
The SEC also alleged that Paulson took a short position against the CDO in a bet that its value would fall.
In a statement, Paulson & Co said it did buy credit protection from Goldman on securities issued in the ABACUS program, but did not market the product.
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.
The lawsuit is a regulatory and public relations nightmare for Blankfein, who has spent 18 months fending off complaints that Goldman has been an unfair beneficiary of taxpayer bailouts of Wall Street.
Blankfein became chief executive less than a year before the product challenged by the SEC was created.
John Paulson is not related to Henry “Hank” Paulson, who was Blankfein’s predecessor as Goldman chief executive 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 regulator rehabilitate its reputation after missing other high-profile cases, including Bernard Madoff’s Ponzi scheme.
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.
It is unlikely that criminal charges will be brought, a person close to the matter said. Representatives for the Justice Department declined to comment.
Yet the lawsuit is widely expected to spur other lawsuits, and is “probably the first of several,” according to Doug Kass, president of hedge fund Seabreeze Partners Management.
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 e-mails and memos, noting that in early 2007 it had become difficult to market CDOs tied to mortgage-backed securities.
It quoted a January 23, 2007, e-mail 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!!!”
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 of Representatives in December. Analysts believe a bill could be signed into law by Obama by mid-year.
The SEC 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.