WASHINGTON — The Securities and Exchange Commission on Friday charged Goldman Sachs & Co. and one of its executives with fraud in a risky offshore deal backed by subprime mortgages that cost investors more than $1 billion.
The SEC also contends that Goldman allowed a client, Wall Street hedge fund Paulson & Co., to help select the securities to be sold. Paulson in turn bought insurance against the deal, and when the securities tanked — losing almost all their value — Paulson made a $1 billion profit.
The civil fraud charges were the first to be filed against Goldman, the Wall Street investment- banking giant that's at the center of multiple inquiries into the causes of the global financial meltdown.
Paulson has acknowledged that it reaped a $3.7 billion profit by betting against the housing market as it nose-dived in 2006 and 2007.
The securities cited by the SEC were part of a series of offshore sales known as ABACUS.
The Goldman executive, vice president Fabrice Tourre, 31, was principally responsible for structuring the ABACUS deal known as 2007-AC1, a so-called synthetic package in which investors didn't buy any actual securities. Instead, they bet on the performance of a specified bundle of home loans to marginally qualified borrowers.
The complaint, filed in U.S. District Court for the Southern District of New York, charges Tourre with making "materially misleading statements and omissions" to investors.
Cornelius Hurley, a former counsel to the Federal Reserve Board who now heads the Boston University law school's Morin Center for Banking and Financial Law, called the complaint stunning and said it raises at least two questions:
* Was this an isolated incident at Goldman, or did the firm engage in similar egregious practices in other deals?
* Did other Wall Street firms engage in similar practices?
"It appears that the financial 'protection' provided by Goldman and described in the SEC complaint may have been more akin to the kind of protection provided by organized crime," Hurley said.
McClatchy Newspapers, in a series published in November about Goldman's role in the subprime lending disaster, found that Goldman sold more than $40 billion in mortgages in 2006 and 2007 while secretly betting on a housing downturn that would sink their value.
McClatchy also reported in late December that Goldman took initial positions in which it bet against the performance of at least a dozen investments, known as collateralized debt obligations, that it assembled and marketed through the Cayman Islands.
Robert Khuzami, the SEC's enforcement chief, was asked on a conference call whether anyone higher up in Goldman might face charges.
"We charged those that we felt appropriate, based on the evidence and the law," Khuzami replied.
Goldman said in a statement: "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 complaint alleged that Paulson, one of the world's largest hedge funds, paid Goldman to assemble a deal in which Paulson would select certain mortgage-backed securities and then take short positions, or bet against them.
Picked by third party
The marketing materials for the CDO all represented that the mortgage-backed securities were selected by ACA Management, a third party.
"The product was new and complex, but the deception and conflicts are old and simple," Khuzami said 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."
The deal, one of about two dozen similar bundles in the ABACUS series, closed on April 26, 2007. Paulson paid Goldman about $15 million for structuring and marketing the deal. Within six months, 83 percent of the mortgage-backed securities in the bundle had been downgraded and 27 percent were placed on negative watch by Wall Street ratings agencies, the complaint said.
By the following Jan. 29, it said, 99 percent of the portfolio had been downgraded, costing investors more than $1 billion.
Khuzami said that the Paulson firm, which is not affiliated with former Treasury Secretary Henry Paulson, was not charged because it did not mislead investors.
However, the complaint said that Goldman and Tourre "knew that it would be difficult, if not impossible," to find investors for a synthetic CDO if they disclosed that a short player, such as Paulson, played a significant role in selecting the securities. Thus, they sought a third party to play that role and approached ACA, calling it "important that we can use ACA's branding" in an internal e-mail.
The complaint quoted Tourre as saying in a Jan. 27, 2007, e-mail to a friend, written in French and English: "More and more leverage in the system, The whole building is about to collapse anytime now.... Only potential survivor, the fabulous Fab(rice Tourre)... standing in the middle of all of these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!"
A Feb. 11, 2007, e-mail to Tourre from the head of Goldman's structured product correlation trading desk said, "the cdo biz is dead we don't have a lot of time left," the complaint said.