Wall Street powerhouse Goldman Sachs today was charged with civil fraud as the Securities and Exchange Commission claimed it misled investors about risky mortgage-backed securities.
The complaint highlights what the SEC says were some of the underlying causes of the collapse of the subprime mortgage market, a catalyst of the Great Recession of 2008. Specifically, the SEC says the Wall Street bank and one of its vice presidents defrauded investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.
The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation, known in Wall Street jargon as a CDO. The value of this particular CDO hinged on the performance of subprime residential mortgage-backed securities. In other words, if the people with the subprime mortgages bundled in the securites made their payments on time, everything would be fine. But if they began to default on the loans, the value of the CDO would drop.
The government says Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.
Betting on failure
That's right. The person instrumental in selecting the mortgage-backed securites for the CDO was a short-seller who, at the time, was actually betting that their value would drop. If investors had been told this information, the SEC says, they likely would not have invested.
"The product was new and complex but the deception and conflicts are old and simple," said Robert Khuzami, Director of the Division of Enforcement at the SEC. "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."
If Goldman Sachs was doing this, is it possible other Wall Street banks were engaging in similar actions?
"The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the U.S. housing market as it was beginning to show signs of distress," said Kenneth Lench, Chief of the SEC's Structured and New Products Unit.
The SEC alleges that one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.
The SEC's action, so far, is civil in nature. The U.S. Attorney for the Southern District of New York, as well as New York Attorney General Andrew Cuomo, declined to comment on media inquiries about potential criminal actions.