Wall Street giant Goldman Sachs was accused of securities fraud for allegedly failing to disclose conflicts of interest in subprime mortgage securities it sold to investors, who ultimately lost more than $1 billion.
The Securities and Exchange Commission said in a civil complaint Friday that Goldman failed to disclose that one of its clients—a hedge fund run by billionaire John Paulson—helped create, and then bet against, the subprime mortgage securities.
The charges are a blow to the reputation of the most powerful firm on Wall Street, which earned a record $4.79 billion last quarter and has long profited from high-octane trading.
The allegations come as lawmakers seek to crack down on Wall Street practices that helped cause the financial crisis. Among proposals Congress is weighing are tougher rules for complex investments like those involved in the alleged Goldman fraud.
In a statement released Friday, Goldman called the SEC's charges "completely unfounded in law and fact" and said it will contest them.
And in a later statement, Goldman claimed that it lost money on the transaction—more than $90 million, it says. The firm added that it gave "extensive" disclosure about the securities in question to investors.
Goldman also said that ACA, the fund's largest investor with $951 million, selected the portfolio itself.
The Goldman client implicated in the fraud is one of the world's largest hedge funds, Paulson & Co, which paid Goldman roughly $15 million for structuring the deals in 2007.
Goldman Sachs shares fell sharply after the SEC announcement, which also caused shares of other financial companies to sink. The market itself also fell.
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.
The SEC's enforcement chief said the agency is investigating a broad range of practices related to the crisis.
The agency also charged a Goldman vice president, Fabrice Tourre, 31, who it said was principally responsible for devising the deal and marketing the securities. The SEC is seeking unspecified fines and restitution from Goldman Sachs and Tourre.
Tourre, an executive director in London of Goldman Sachs International, was a vice president at the company's New York headquarters at the time of the activities in early 2007, the SEC said.
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.
Goldman told investors that a third party, ACA Management LLC, had selected the underlying mortgages in the investment. But, the SEC alleges, Goldman misled investors by failing to disclose that Paulson & Co. also played a role in selecting the mortgages 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.
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."
In the letter, Goldman also rejected claims that it profited from the mortgage market meltdown.
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