Goldman Sachs vs. the SEC: Not Guilty but Not Scot-Free

Goldman Sachs (GS) is in the crosshairs of the Securities and Exchange Commission. An SEC lawsuit centered on the construction and sale of an arcane derivative instrument has sent the stock market, especially shares of the preeminent investment bank on Wall Street, plummeting.

My first thought after the news came out on Friday was, "Serves them right." If Goldman's too-clever-by-half financial engineers did what the SEC alleges, then they are morally bereft weasels who deserve five years in the gas chamber.

Or do they?

The case against Goldman Sachs - not the first time that the company has been accused of ethically questionable behavior - centers on a synthetic collateralized debt obligation, a security whose value was tied to the value of a portfolio of subprime mortgages. The CDO seemed to have been created by Goldman Sachs, in early 2007, to accommodate Paulson & Co., a hedge fund operated by John Paulson, a rich, successful investor.

Paulson believed that subprime mortgages were bad investments (you can see how he became rich and successful), and he wanted a means to bet against them. Goldman Sachs obliged, creating the CDO. The bottom line is that Paulson made $1 billion and the investors who bought the thing lost $1 billion.

The SEC says Paulson's firm picked the assets that it wanted to sell short. Goldman Sachs contends that an independent third party, ACA Management, did the picking.

Paulson & Co. doesn't seem to have done anything wrong and the SEC seems to agree; the firm isn't being sued. But what did Goldman Sachs do wrong? If a client wanted to sell assets short and Goldman found a way to do that, well, that's what investment banks do.

But there was an intervening step. That firm brought in to oversee construction of the portfolio, ACA, was supposed to have had final say on what went into it.

Wait another minute. What if this ACA just did Goldman's and Paulson's bidding and included only mortgages that Paulson wanted in the CDO in the first place and didn't mention that to investors?

Again, so what? Stocks, bonds and everything else, including pooled investments whose portfolios were actively selected, are bought and sold - and sold short - every day. In almost every case, neither party knows the identity of the party on the other side of the trade.

Here's what it comes down to: The CDO was not marketed to gray-haired grannies, except maybe for grannies who run distressed-debt funds for institutional investors. The buyers were professionals who are supposed to know what they're doing.

Either they were fully aware of what mortgages the CDO's value was tied to and made a free choice to invest after assessing the information, or else they invested sight unseen. Both would be bad decisions, and the second would be negligent too. Besides, who invested in subprime mortgages early in 2007 and didn't get wiped out?

So will Goldman Sachs be found not guilty, and will there be no long-term damage to the company and the stock market? Probably and probably not.

Even if Goldman did nothing illegal and will be judged that way, the case is likely to have an impact on Goldman's stock and those of other banks and even the broad market. It could be negative and severe, and it will definitely be discussed here in a post later this week.