NEW YORK (TheStreet) -- Goldman Sachs' (GS) - Get Goldman Sachs Group, Inc. Report fraud charge on Friday stunned investors, not only because the investment bank has been untouchable, but also because the Securities and Exchange Commission's lawsuit could serve as the opening salvo in a campaign against corruption on Wall Street. It's been a long time coming.
The allegations center around a deal the New York-based bank made with hedge-fund firm
Paulson & Co.
in which Goldman Sachs would create and sell a collateralized debt obligation (CDO) comprising securities that Paulson picked. The hedge fund was simultaneously betting against the same CDO by purchasing credit default swaps (CDSs) from Goldman that would pay off if the security failed. Eventually, 99% of the underlying securities dropped in value.
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Goldman is in trouble for failing to disclose that conflict of interest. Goldman told investors the securities were selected by an impartial third party rather than the hedge fund, essentially lying about the source of the deal to ensure the sale of the securities, the SEC says.
Investors on Friday dumped stocks, fearing fallout from the scandal. The biggest question in the stock market is whether the Goldman case was isolated.
All signs point to further action by the SEC. ProPublica recently released a story on a hedge fund named Magnetar, which was involved in trades similar to those of Goldman. Magnetar would sponsor a CDO by purchasing the riskiest equity portion of the security and pick assets included in the package, while simultaneously shorting the CDS contracts on a higher tranche. The net result would be a small loss on the equity portion paired with a gigantic gain on the CDS contract, effectively making a profit at the expense of investors betting on an increase.
Magnetar is reportedly linked to investment banks ranging from
(now owned by
Bank of America
), through these trades. If the allegations prove to be true, the pain of Friday's stock-market drop will only be a prelude.
The SEC's enforcement chief, Robert Khuzami, indicated Friday the commission is reviewing other deals, saying "we're looking at a wide range of products," according to the New York Times. "If we see securities with similar profiles, we'll look at them closely."
Bullish investors who jumped into financial stocks since they hit bottom in March 2009 may now be paying the price. While the industry has been hot over the past year, there are still many unknowns.
The SEC's actions won't materially affect banks because any fines will be relatively small compared with their profits. Goldman earned more than $13 billion last year. The main concern is stricter regulations, which would crimp profits and potentially limit types of investments.
Scott Meyers, a Chicago-based securities litigator with Ulmer & Berne LLP, says the Goldman case "raises the question of whether and to what extent these types of activities, which the SEC characterizes as 'conflicts of interest,' must be disclosed in order to avoid allegations of fraud. This case could materially impact how business is done on the Street moving forward."
Goldman's deal with Paulson was worth about $1 billion. ProPublica reported that Magnetar had likely entered into similar deals worth $34 billion, suggesting other banks will be pulled in.
The SEC may be overcompensating by bringing charges to Goldman so late in the game -- the deal with Paulson was struck in 2007 -- though the investment watchdog was widely viewed as a sleeping puppy. Setting an example with Goldman, the most profitable and prestigious investment bank on Wall Street, would put others on notice.
Justice, in any form, is long overdue. By calling out banks on their shady deals, the SEC is improving investors' confidence in the stock market. Cautious investors, who have said the financial crisis isn't over yet, have been proven right.
Some investors may view Goldman's stock-price decline as an opportunity to buy. Bank of America and Citigroup shares also fell, slumping more than 5% on Friday. But until the regulatory framework shakes out, risk-averse investors should be reluctant to jump back in.
-- Reported by David MacDougall in Boston.
Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.