Goldman Charges: Fraud or Sour Grapes?

The SEC's case against Goldman is far from being resolved, and reporter Lauren LaCapra wonders if regulators would care at all if the trade had gone the other way.
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NEW YORK (

TheStreet

) -- Two questions have plagued my mind since news of civil fraud charges against

Goldman Sachs

(GS) - Get Report

hit on Friday: Did the firm, legally speaking, do anything wrong, and would anyone care if the related trade had gone the opposite way?

The answer to the first question is unclear, though the

Securities and Exchange Commission's

case against Goldman, as well as a

sweeping derivatives reform measure being debated in Congress this week, should eventually yield some clarity. The answer to the second question appears to be a resounding "No."

First, some background information:

Back in 2007, a star trader at Goldman named Fabrice Tourre structured a deal related to residential mortgages called "ABACUS 2007-AC1." The transaction related to a "synthetic" collateralized debt obligation, which would allow the hedge fund

Paulson & Co.

to make a bearish bet on the subprime housing market. His bet was based on specific mortgage securities, which two investors -- ACA Capital Management and a German bank called IKB -- would have direct exposure to.

Paulson would not own the securities directly, but instead receive insurance protection against losses, presumably from

American International Group

(AIG) - Get Report

. So, if housing tanked, Paulson would make money. If it didn't, he would lose money, and the investors who actually owned the

RMBS would continue to reap profits. We all know

what happened next. Ultimately, 99% of the mortgage bonds involved in the trade were downgraded, and long investors lost $1 billion.

The illegal part comes in, according to the SEC, when the RMBS securities were being selected, and when Goldman was providing information to long investors about the process.

Goldman told investors in marketing materials - and Tourre allegedly told them directly - that ACA, as the largest investor, had selected the securities. The SEC alleges that Paulson "played a significant role" in picking them, despite a clear conflict of interest. Furthermore, the regulator alleges, Goldman didn't disclose any of this to long investors on the other side of the deal.

"Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future," the SEC said in a press release outlining its charges. "GS&Co did not disclose Paulson's adverse economic interest or its role in the portfolio selection process in the term sheet, flip book, offering memorandum or other marketing materials."

Paulson denied its "authority" in selecting the securities, and while Goldman admitted to having discussions with Paulson about the securities, it characterized those talks as "entirely typical of these types of transactions." The firm offered a muscular defense, contradicting most items in the SEC's case.

While the SEC pointed out that Goldman earned a $15 million fee from Paulson, the investment bank says it lost $90 million on the deal. Goldman also said its disclosures to long investors were "extensive" and appropriate.

"The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world," Goldman said in a statement. "These investors also understood that a synthetic CDO transaction necessarily included both a long and short side."

The SEC's complaint also points out some scandalous e-mails from Tourre in early 2007 indicating that he believed the housing market was about to implode. He also indicates the importance of having ACA as a third-party portfolio selector on marketing materials.

But while the flamboyant 31-year-old vice president - known as "fabulous Fab" - used some colorful language, smoking guns of illegality they are not. What's more telling are reports circulating in the financial press that executives much higher up the food chain -- including CEO Lloyd Blankfein -- were involved in discussions about this Abacus deal and other, similar ones, as the housing market began to totter.

When the CEO of a firm that raked in $20 billion in profit in the midst of a recession stoops down to examine a $1 billion deal, there's a reason.

Goldman asserts that the SEC's charges are "completely unfounded in law and fact" and vowed to "vigorously" fight them, and defend its reputation -- its most vulnerable asset in this whole situation. Others disagree, asserting that discussions with Paulson were absolutely material, and should have been disclosed to long investors.

They point out that even the failed investment bank Bear Stearns refused to structure such a deal for Paulson because it considered it questionable.

Heidi N. Moore, a financial journalist who has also

covered the issue, points out that

a legal decision in 2008 regarding a hedge fund's indirect interest via derivatives in

CSX Corp.

(CSX) - Get Report

would bolster the SEC's case.

But when it comes to derivatives, it's tough to pin down what, exactly, was legal, material, or acceptable by Street standards. To call the market loosely regulated would be generous. The outcome of the SEC case against Goldman will help to define what ought to be disclosed to investors on either side of a trade, and the derivatives reform that comes out of Congress should result in clearly defined rules on what can be traded, and how.

Still, it's hard to imagine that, if the housing market stayed strong, and Paulson had been the one losing $1 billion on the trade, regulators would cast a sideways glance at Goldman's practices. It's unfortunate that regulators who could have softened the blow of the financial crisis, or prevented it entirely, had they not been asleep at the watch, won't get their day in court as well.

"It appears that the SEC is promulgating new standards with this lawsuit," Rochdale Securities analyst Dick Bove said in a note on Sunday. "One wonders if the SEC could have created new regulations rather than suing Goldman Sachs to achieve the same result."

From the standpoint of an investor looking at Goldman's stock -- which nosedived 13% on Friday's news, and was trading lower again on Monday morning -- or those of other big banks involved in such transactions, answering these questions may be less important than the broader picture. The SEC is now examining other banks' practices in structuring exotic investment vehicles, which could result in charges against an array of firms, along with lawsuits from jilted investors.

Bank stock investors seem likely to stay skittish in the near-term, waiting for the proverbial next shoe to drop.

"It's a tough situation for investors; compared to the risk from this case as a discrete event, Goldman' stock has arguably overcorrected," Ada Lee, a senior analyst for Wisco Research, said on a SNL Financial blog on Monday. "But this case is likely not discrete, but the beginning of a trend. Has the stock of Goldman or its peers corrected enough to discount everything to come? Perhaps, but that's not how I would bet."

-- Written by Lauren Tara LaCapra in New York

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