Goldman Lawsuit Expresses Populist Rage

The SEC charged Goldman with fraudulently marketing subprime securities, possibly prompting a wave of lawsuits against banks.
By Jake Lynch ,

BOSTON (TheStreet) -- Populism has long posed a threat to the stock-market rally.

But such threats have remained, until today, theoretical. To date, all methods of Wall Street interference, including Kenneth Feinberg, Washington's pay czar, and the so-called Volcker Rule, which is set to be incorporated into the pending Dodd reform, have been viewed as idle threats or marketing schemes. Wall Street compensation has accelerated at many banks despite outrage on Main Street and in Washington.

But today, the world has changed.

The Securities and Exchange Commission filed a lawsuit against Wall Street archetype

Goldman Sachs

(GS) - Get Report

, and investors are panicking. Stocks and commodities dropped, and bonds rose. The suit is precarious in its action and its precedent.

It alleges that Goldman fraudulently marketed a synthetic collateralized debt obligation to investors.

Paulson & Co.

, the most successful hedge fund of 2007, reaped a windfall by betting against subprime securities. In the supposed transaction, Paulson & Co. hand-picked subprime residential mortgage-backed securities from areas that it believed presented the highest default risk. Goldman then packaged the mortgages into a CDO. While Paulson & Co. shorted the CDO, Goldman sold long positions to other institutional investors.

Such action isn't illegal. But the SEC alleges that Goldman failed to disclose Paulson & Co.'s short position to long investors. Furthermore, in marketing materials, Goldman referred to ACA Management as the independent third party, with expertise in credit analysis, that picked the securities. The SEC claims that security selection was actually executed by Paulson & Co., which wanted the opportunity to short-sell the shoddiest mortgages available. Numerous questions need to be answered before an opinion can be rendered about this suit:

What was the actual role of ACA Management in the selection process?

What was ACA Management's relationship with Paulson & Co. and Goldman Sachs, respectively?

Is Goldman legally required to disclose which investors are taking the opposite side of trades in marketing materials?

Did Goldman retain a long or short position in its proprietary accounts?

In certain scenarios, this suit amounts to nothing. But the fact that the SEC has publicized allegations is a troubling precedent. The repercussions of Goldman's actions, which we are all well aware of, are far less important right now than its obscene pay practices are. CDOs are sophisticated financial products for investors who are supposed to be well-informed. Goldman may have skimmed a profit off of professionals who failed to perform adequate due diligence. But there are greater tragedies in the world.

The question, ultimately, isn't the effect of the subprime crisis, but the cause. And it's almost unanimous, even among finance professionals, that the incentive to earn obscene pay with no long-term repercussions for actions taken or securities created is the catalyst of the meltdown. Prosecuting Goldman, and indirectly besmirching Paulson & Co., smacks of populism. Paulson & Co. is considered one of, if not

the

, savviest hedge funds on Wall Street and Goldman is the most reputable investment bank. Their names are conveniently conspicuous.

By virtue of the fact that the Goldman suit has been brought forward, others may follow, alleging misconduct by banks that securitized subprime mortgages. The effect: a sell-off in stocks. Who loses in that scenario? Individual investors who are attempting to rebuild retirement savings. The goal of regulation should be to create and reinforce fair and transparent markets. Right now, we need cost-effective reform that aligns the long-term interests of ordinary people, the economy and investment banks.

So far, the suit is having a destabilizing effect. To discourage wrongdoing and promote economic health, the law must be enforced to the furthest possible extent. If Goldman did, in fact, violate the law, punishment is necessary. But it's a shame that three years after the subprime debacle, all we have witnessed is finger-pointing rather than reform. It speaks volumes about the inefficiency of Washington in tackling our economy's systemic flaws and its willingness to apportion blame.

-- Reported by Jake Lynch in Boston.

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