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For Goldman Sachs, a Winning Bet Carries a Price

By Louise Story and Gretchen Morgenson|The New York Times
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Accusations that Goldman defrauded customers who bought investments tied to risky subprime mortgages have only just begun to reverberate through the financial world.

Goldman Sachs
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The civil lawsuit filed against Goldman on Friday by the Securities and Exchange Commission seemed to confirm many Americans’ worst suspicions about Wall Street: that the game is rigged, the odds stacked in the banks’ favor.

It is the first big case — but probably not the last, legal experts said — to delve into a Wall Street firm’s role in the mortgage fiasco.

The move against Goldman came at a particularly sensitive time for Wall Street. Washington policy makers are hotly debating a sweeping overhaul of the nation’s financial regulations, and the news could embolden those seeking to rein in the banks. President Obama on Saturday stepped up pressure for financial reform by accusing Republicans of “cynical and deceptive” attacks on the measure.

The S.E.C.’s action could also hit Wall Street where it really hurts: the wallet. It could prompt dozens of investor claims against Goldman and other Wall Street titans that devised and sold toxic mortgage investments.

And it raises new questions about Goldman, the bank at the center of more concentric circles of economic and political power than any other on Wall Street. Goldman — whose controversial success has leapt from the financial pages to the cover of Rolling Stone — has fiercely defended its actions before, during and after the financial crisis. On Friday, it called the S.E.C.’s accusations “unfounded.”

Wall Street played a complex and, at times, seemingly conflicted role in the mortgage meltdown. Goldman and others worked behind the scenes, bundling home loans into investments for sale to investors the world over. Even now, more than 18 months after Washington rescued the teetering financial system, no one knows for sure how much money was lost on those investments.

The public outcry against the bank bailouts was driven in part by suspicions that a heads-we-win, tails-you-lose ethos pervades the financial industry. To many, that Goldman and others are once again minting money — and paying big bonuses to their employees — is evidence that Wall Street got a sweet deal at taxpayers’ expense. The accusations against Goldman may only further those suspicions.

“The S.E.C. suit against Goldman, if proven true, will confirm to people their suspicions about the total selfishness of these financial institutions,” said Steve Fraser, a Wall Street historian and author of “Wall Street: America’s Dream Palace.” “There’s nothing more damaging than that. This is way beyond recklessness. This is way beyond incompetence. This is cynical, selfish exploiting.”

On Friday, Goldman’s stock took a beating, falling 13 percent and wiping out more than $10 billion of the company’s market value. It was a possible sign that investors fear that the S.E.C. complaint will damage Goldman’s reputation and its ability to keep its hands on so many sides of a trade — a practice that is immensely profitable for the firm.

It is unclear whether the S.E.C. can prevail against Goldman. The bank has long maintained that it puts its clients first and, in a letter in its latest annual report, reiterated that position. Goldman said that it never “bet against our clients” in its trades but rather was trying to hedge against other trading positions.

Still, Wall Street analysts said Goldman and other banks, having navigated the financial crisis, might now face a new kind of risk: angry investors. Most major Wall Street banks also created collateralized debt obligations, which are at the heart of the Goldman case. C.D.O.’s, which are essentially bundles of securities backed by mortgages or other debt securities, turned out to be among the most toxic investments ever devised.

“Any investor who bought these C.D.O.’s and lost a significant amount of money is probably looking at their investment and wanting to know: what were the details behind the sale?” said William Tanona, an analyst at Collins Stewart. “Will they contact the S.E.C. and say, ‘Here’s the transaction we participated in, and we’d love to know who is on the other side of it?’ ”

Among the investors were several European banks, the S.E.C. complaint said. The biggest victim was the Royal Bank of Scotland, which inherited a loss of $841 million after it took over the Dutch bank ABN Amro, which made the original investments in 2007. According to a person briefed on the matter, Royal Bank, now controlled by the British government, is studying the documents but is not yet ready to decide whether to take action to recoup some or all of the money from Goldman.

Goldman faces a dilemma in its response. Wall Street firms tend to settle cases like this one, but Goldman’s statement Friday indicated it intended to dig in its heels and fight, perhaps in part to discourage suits by investors. But that strategy could set it up for a drawn-out, messy and public battle.

The S.E.C. complaint named just one Goldman employee: Fabrice Tourre, a vice president in the bank’s mortgage operation who worked on the questionable transaction.

But securities lawyers say Mr. Tourre appears to be a small fish. Federal investigators may try to gain his cooperation and extend their investigation to other Goldman employees. On Friday Mr. Tourre’s lawyer did not provide a comment on the complaint.

A big question is how far up this might go. The S.E.C. said the deal in its complaint had been approved by a committee at Goldman called the Mortgage Capital Committee.

“It’s typical that they’d start with someone lower down on the chain and try to exert pressure on that person,” said Bradley D. Simon of Simon & Partners, a white-collar defense lawyer in New York. “Is it really conceivable that no one else was involved in this?”

As the housing market began to fracture in 2007, senior Goldman executives began overseeing the mortgage department closely, according to four former Goldman Sachs employees, who spoke on the condition of anonymity because of the sensitivity of the matter.

Senior executives routinely visited the unit. Among them were David A. Viniar, the chief financial officer; Gary D. Cohn, the president; and Pablo Salame, a sales and trading executive, these former employees said. Even Goldman’s chief executive, Lloyd C. Blankfein, got involved.

Top executives met routinely with Dan Sparks, the head of the mortgage trading unit, who retired in the spring of 2008. Managers instructed several traders to sell housing-related investments. Indeed, they urged Mr. Tourre and a colleague, Jonathan Egol, to place more bets against mortgage investments, the former employees said.

A Goldman spokesman did not reply to a request for comment on these executives’ roles. It is unclear if any of the top executives knew about all of Mr. Tourre’s actions.

Mr. Blankfein has already been questioned about the toxic vehicles Goldman devised and sold, even as the bank realized the housing market was in trouble.

Recent public statements made by Mr. Blankfein seem to conflict with the account laid out by the S.E.C.

In testimony before the Financial Crisis Inquiry Commission in January, for example, Mr. Blankfein described Goldman’s approach to dealing with its clients: “Of course, we have an obligation to fully disclose what an instrument is and to be honest in our dealings, but we are not managing somebody else’s money.”

But the S.E.C. complaint says Goldman misled investors who bought one of the bank’s so-called Abacus deals. The bank failed to tell them that the mortgage bonds that underpinned the investment had been selected by a prominent hedge fund manager who wanted to bet against the investment, the S.E.C. says. Those bonds were especially vulnerable, the commission says.

The deal cost investors just over $1 billion, a relatively small deal by Wall Street standards. At a conference in New York in November, Mr. Blankfein talked about the risks to the firm’s reputation that it faced as a result of the mortgage mania and ensuing credit crisis.

“Are we worried about our image and reputation, and what are we doing to fix it? The answer, of course, is we’re very concerned about this,” Mr. Blankfein said. He added: “People understand our bona fides who deal with us.”