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The SEC Takes On the Vampire Squid: How Goldman Sachs Hoodwinked Investors

The SEC 's new lawsuit against Goldman Sachs (GS) marks the first time financial regulators have gone after a Wall Street firm that sought to exploit both investors and the housing crash. And it's a big deal.

In essence, the Feds have charged Goldman with hawking collateral debt obligations, a type of credit derivative, to investors without letting them know that the CDOs were designed by a guy who fully expected them to fail. And not just any guy -- Goldman let hedge fund kingpin John Paulson pick which subprime mortgage bonds he wanted the CDOs to contain. Why? So he could short the hell out of them on the open market.

More broadly, the complaint highlights the tentacle-like conflicts of interest that engulf Wall Street. Those conflicts themselves are nothing new -- they've been festering since brokers started loitering near a buttonwood tree in lower Manhattan a couple centuries ago. But it does dramatically highlight how investment banks reap huge rewards by playing investors off each other.

Paulson, and Goldman, famously cleaned up on the collapse in the housing market. The fund manager made $20 billion in 2007 and 2008, earning plaudits for what some called "The Greatest Trade Ever." That description may now require revision.

"This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another," said independent banking analyst Chris Whalen in a note to clients.

The SEC says Paulson's firm in 2007 paid Goldman to develop a financial instrument, which the bank dubbed "Abacus," that would allow him to take short positions against various mortgage securities. Knowing which ones to short was easy because Paulson had selected the investments himself expressly because they were likely to lose value.

Meanwhile, Goldman VP Fabrice Tourre was pushing Abacus on pension funds, banks and other investors, partly by indicating that the CDO would be handled by a prominent funds management firm, ACA. None of the company's marketing materials for the product disclosed Paulson's involvement in the deal, according to the SEC. Tourre also misled investors into believing that Paulson had taken a "long" position on Abacus by investing $200 million. He hadn't.

Writes Felix Salmon:

The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told Abacus that Paulson had a long position in the deal when in fact he was entirely short.
The CDO subsequently bombed, and the investors lost big. Pauslon paid Goldman roughly $15 million to set up Abacus, closing the deal in April 2007. By January of the next year, the value of virtually the entire portfolio of securities had plunged. Investors lost more than $1 billion; Paulson made $1 billion.

"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, director of the agency's Division of Enforcement, in a statement. "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."

Goldman denies it did anything wrong. "The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation," the bank said in a statement.

We'll see. One question here is why the SEC didn't also charge Paulson, along with Goldman and Tourre. Idle speculation here, but perhaps it's because conspiracy is hard to prove. It isn't evident from the suit that Paulson knew the company was misrepresenting his interest in Abacus in pitching other investors.

With a little help from the feds, Goldman emerged from the housing bust financially unscathed. If the SEC is right, it also used a sting to make Paul Newman and Robert Redford proud. But the case also raises a larger question: Were other banking giants doing the same thing? It'll be interesting to see if Goldman is the only firm charged by the SEC or whether this is the first in a wider campaign targeting conflicts of interest on the Street.