Goldman Charges Cast Cloud on Bank Rally

The rally in bank stocks has been snuffed out by the SEC's fraud charges against Goldman, leaving investors to ponder a fresh round of regulatory uncertainty.
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NEW YORK (

TheStreet

) -- Just when bank investors started breathing a sigh of relief, the

Goldman Sachs

(GS) - Get Report

-U.S. government cage match reached a new pitch, snuffing out a jubilant, weeklong rally.

The

Securities and Exchange Commission

charged Goldman with fraud on Friday morning for doing what Goldman does best: Making money and serving clients. In an odd state of affairs, regulator seems to be in cahoots with the media, or at least the

New York Times

, which has published

harshly critical stories about Goldman's profiting from the subprime housing crisis.

But before the SEC story hit, bank stocks had been riding a wave of euphoria through Thursday's close. The broad KBW Bank Index ETF was up 2.5% for the week, and Goldman itself was up 2.9%. Some other large-cap names gained at least twice as much value, with Citigroup breaking through the $5 barrier. Stellar earnings reports from

JPMorgan Chase

(JPM) - Get Report

on Thursday and

Bank of America

(BAC) - Get Report

early Friday morning added more fuel to the fire, showing investors that credit costs were no longer the main concern.

Then came the SEC charge, and it all fell apart: Goldman plunged 14% in late-morning trading, with the other large-caps shedding 3% to 4%. The new concern was clear, and less predictable: Public anger, and the government's reaction to it.

The fraud charge stems from a transaction that Goldman negotiated for a large hedge fund run by John Paulson. Paulson has earned a reputation as the smartest hedge fund manager in the room ahead of the subprime crisis, because he made huge profits betting that the mortgage market would go south.

Goldman helped him make those bets.

The firm structured a "synthetic"

collateralized debt obligation that would pay Paulson if the subprime-mortgage market tanked, but hurt him if it kept going strong. At the same time, Goldman was structuring deals for other clients who were still bullish on the U.S. housing market.

The vehicle was structured in April 2007. In less than a year's time, 99% of the underlying mortgage securities had been downgraded. The bullish investors lost more than $1 billion, according to the SEC. Goldman received $15 million for structuring and marketing the product.

The SEC alleges that, because Goldman didn't disclose detailed information about its dealings with Paulson to investors and clients, it committed fraud. It's also targeting Goldman Vice President Fabrice Tourre, who allegedly structured the transaction for the CDO, which was called "ABACUS."

"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," Robert Khuzami, the SEC's director of the division of enforcement, said in a statement.

In a statement, Goldman said the charges were "completely unfounded in law and fact" and pledged to "vigorously contest them and defend the firm and its reputation."

Indeed, it is odd that the SEC is targeting Goldman -- and only Goldman -- when thousands of these kinds of deals and vehicles were created in the heady days of subprime.

American International Group

(AIG) - Get Report

paid Goldman $13 billion for the structured vehicles it insured, but it also paid tens of billions of dollars out to other banks as well, from Wall Street firms to foreign entities like

Deutsche Bank

(DB) - Get Report

,

UBS

(UBS) - Get Report

and Societe Generale.

Furthermore, it isn't clear that Goldman had any obligation to report detailed information about a specific client to investors or other clients. Questions about what firms were or weren't obligated to disclose have surfaced, ever since a report about

Lehman Brothers'

demise was released a few weeks ago.

Another story in the

Times

last weekend was critical of Lehman's use of off-balance sheet vehicles to funnel money through a third-party entity that investors weren't informed about.

The questions are legitimate, but the answers aren't clear. It's also unclear why the SEC and other regulatory agencies didn't take action when the deals were occurring, and the housing market bubble was fast inflating. Lots of banks had major off-balance sheet exposure, particularly

Wells Fargo

(WFC) - Get Report

, as do

Fannie Mae

(FNM)

and

Freddie Mac

(FRE)

. There was little disclosure about

what was in these vehicles, and no rules forcing banks to disclose such information.

Kenneth Lench, who heads the SEC's structured and new products unit, said the agency is looking into other banks' practices as well. But it's clear that, because Goldman's dealings have been so widely publicized -- particularly in not-altogether balanced articles in the

Times

that have been panned by a vocal faction the investment community -- Goldman is being charged first.

As the bull's eye of populist rage, Goldman was taking the brunt of the selloff on Friday. But it's worth noting that heavy-handed government tactics won't stop there, and the SEC charge may be the least of the financial industry's concerns.

Congress is on the cusp of negotiating a huge financial reform overhaul, and the country is approaching midterm elections. The barometer of uncertainty is high, and new restrictions on bank operations -- from hedge funds and derivatives to savings and loans -- could crimp profits in a much more significant way.

-- Written by Lauren Tara LaCapra in New York

.

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