Updated at 6:33 p.m. Eastern
The government has accused Goldman Sachs & Co. of defrauding investors by failing to disclose conflicts of interest in mortgage investments it sold as the housing market was collapsing.
The Securities and Exchange Commission said in a civil complaint Friday that Goldman failed to disclose that one of its clients helped create - and then bet against - subprime mortgage securities that Goldman sold to other investors.
The SEC said the fraud, a blow to the reputation of Wall Street's most powerful firm, was orchestrated in 2007 by a Goldman vice president then in his late 20's. The employee, Fabrice Tourre, has since been promoted to executive director of Goldman Sachs International in London.
Tourre, the SEC said, boasted to a friend that he was able to put such deals together as the mortgage market was unraveling in early 2007.
In an email to the friend, he described himself as "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!!!"
A call to a lawyer for Tourre, Pamela Chepiga at Allen & Overy LLP, wasn't returned.
Two European banks that bought the securities lost nearly $1 billion, the SEC said. The agency is seeking to recoup profits reaped on the deal
Goldman Sachs denied the allegations. In a statement, it called the SEC's charges "completely unfounded in law and fact" and said it will contest them.
Goldman, founded more than 140 years ago, built a reputation as a trusted adviser to its investment banking clients. In recent years, it shifted toward taking more risks with its clients' money and its own. Goldman's trading allowed the firm to weather the financial crisis better than most other big banks.
It earned a record $4.79 billion in the last quarter of 2009.
The SEC's enforcement chief said the agency is investigating a wide range of practices related to the crisis. The prospect of possible legal jeopardy for other major financial players roiled the stock market.
Goldman Sachs shares fell more than 12 percent Goldman and lost $14.2 billion in market capitalization. The Dow Jones industrial average finished down more than 125 points.
The charges come as lawmakers seek to crack down on Wall Street practices that helped cause the financial crisis.
"The SEC is starting to question under what conditions do you have to act as a fiduciary. When do you have to put your clients first. This may be the first time we see the SEC taking some bold action because it's been going on in Wall Street for years where they're working both sides, the buy side and the sell side," CBS MoneyWatch.com editor-at-large Jill Schlesinger told CBS News.
The case involves just a small piece of Goldman's business, but the symbolism is big, reports CBS News correspondent Anthony Mason.
"It goes right to one of the investment vehicles that was at the heart, and perceived to be at the heart, of the overall financial crisis," securities lawyer Tom Curnan told Mason. "This is something that if it sticks could fundamentally address a whole range of conduct by a whole range of firms."
Among proposals Congress is weighing are tougher rules for complex investments like those involved in the alleged Goldman fraud.
President Barack Obama vowed Friday tothat doesn't regulate mortgage-backed securities and other so-called derivatives. Legislation in Congress would for the first time regulate derivatives, whose value depends on an underlying asset, such as mortgages or stocks. Senate Republicans oppose the bill.
The Goldman client implicated in the fraud is one of the world's largest hedge funds, Paulson & Co. The SEC said it paid Goldman roughly $15 million in 2007 to put together an investment offering that was tied to mortgage-related securities the hedge fund viewed as likely to decline in value.
Separately, Paulson took out a form of insurance that allowed it to make a huge profit when those securities became nearly worthless.
ABN Amro, a major Dutch bank, was the biggest loser in the securities, having paid Goldman $841 million, according to the SEC. And IKB Deutsche Industriebank AG, a German commercial bank, lost nearly all its $150 million investment, the agency said. Most of the money they lost went to Paulson in a series of transactions between Goldman and the hedge fund, the SEC said.
"What the government is objecting to is you can't tell one group of investors this is something you ought to buy and then tell another group of investors this is something you ought to sell," Dick Bove, an analyst for Rochdale Securities told Mason.
The civil lawsuit filed by the SEC in federal court in Manhattan was the government's most significant legal action related to the mortgage meltdown that ignited the financial crisis and helped plunge the country into recession.
"What the SEC is trying to do is vindicate itself. The organization has really taken such a hit over the last, say, five years. These are the same people who missed the Madoff scandal," said Schlesinger.
Financial analysts said it's dealt a setback to Goldman's standing.
"It undermines their brand," said Simon Johnson, a professor at the Massachusetts Institute of Technology and a Goldman critic. "It undermines their political clout. I don't think anybody really values being connected to Goldman at this point."
He continued: "There are many people who - until this morning - thought Goldman Sachs was well-run."
The SEC is seeking unspecified fines and restitution from Goldman Sachs and Tourre.
Asked why the SEC did not also pursue a case against Paulson, Enforcement Director Robert Khuzami said: "It was Goldman that made the representations to investors. Paulson did not."
Paulson & Co. is run by John Paulson, who reaped billions by betting against subprime mortgage securities. He is not related to former Treasury Secretary Henry Paulson.
In a statement, Paulson & Co. said: "As the SEC said at its press conference, Paulson is not the subject of this complaint, made no misrepresentations and is not the subject of any charges."
Goldman told investors that a third party, ACA Management LLC, had selected the pools of subprime mortgages it used to create what are known as synthetic collateralized debt obligations. But, the SEC alleges, Goldman misled investors by failing to disclose that Paulson & Co. also played a role in selecting the mortgage pools and stood to profit from their decline in value.
"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," Khuzami said in a statement.
IKB was an early casualty of the financial crisis. It issued a profit warning in 2007 saying it had been hurt by U.S. subprime mortgage investments. IKB was sold in 2008 to Dallas-based Lone Star Funds.
Ed Trissel, a spokesman for Lone Star Funds, declined to comment on the case.
Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, is "pleased that the SEC is departing from the lax enforcement of the Bush administration and is returning to the SEC's proper role of protecting investors in the marketplace," spokesman Steven Adamske said.
The SEC charges come after Goldman Sachs denied last week it bet against clients by selling them mortgage-backed securities while reducing its own exposure to them.
In an annual letter to shareholders, Goldman said it began reducing its exposure to the U.S. mortgage market in late 2006. It said it did so by selling mortgage investments or buying credit default swaps. The swaps are a form of insurance that pays out if the value of the underlying asset declines.
Those hedges, also known as short positions, served Goldman well. As the housing market began cratering and losses piled up for other big banks, Goldman suffered less damage. That led to criticism that the bank benefited at the expense of clients who bought mortgage-backed securities that became toxic. Goldman denied that.
"Our short positions were not a 'bet against our clients,'" Goldman said in the letter. "Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits."