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Goldman Sachs: Merely the SEC's Opening Shot?

Goldman Sachs is charged with fraud by the SEC, and the market is abuzz with speculation that other banks may be next. What do you think?

(Goldman Sachs story updated for Goldman earnings, U.K. probe)



) -- The Securities and Exchange Commission fraud charges against

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. Report

, have set off fears that Goldman will just be the first of the banks targeted by the SEC.

Goldman Sachs has faced a high level of ire from the U.S. public throughout the worst of the financial crisis and recession, but the attacks on Goldman stopped short of allegations of crime. The SEC has certainly delivered a big blow to Goldman, but will the SEC charges serve as a shot across the bow to the entire banking sector?

Even if legal actions against other banks are an open question, it seemed more likely on Tuesday that Goldman, at least, would face additional regulatory pressure.

Goldman Sachs reported earnings that blew past Street estimates on Tuesday morning, but the earnings outperformance was muted by news that the U.K. counterpart to the Securities and Exchange Commission, the Financial Services Authority, had launched its own investigation into actions of Goldman Sachs International. The FSA said it would be coordinating closely with the SEC.

Regulatory pressure on Goldman Sachs could get worse yet, as Germany's financial regulator has also hinted it might pursue an investigation.

Bank investors in Scotland and Germany that were on the losing end of the Goldman subprime mortgage CDO were also considering lawsuits.

The SEC only charged Goldman over the marketing of one subprime mortgage product from its


lineup of synthetic CDOS with $1 billion in investor assets, but in all, there were more than $12 billion in funds raised by similar Abacus products.

Goldman's earnings outperformance did not give its shares a bounce, either. Goldman shares were down more than 1% on Tuesday after its doubling of quarterly profit.

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The Goldman Sachs earnings conference call on Tuesday morning was the first chance for the Street to get additional information from Goldman beyond its initial claim last Friday that the SEC case was unfounded and that the bank would vigorously contest the charges.

Goldman Sachs did not provide too much additional information, though. When asked on the Goldman Tuesday morning earnings conference call by a Barclays analyst how many of the 60 to 70 synthetic CDOs that Goldman marketed in 2006-2007 have been reviewed by the SEC, Goldman co-general counsel Greg Palm would only reiterate that a case has only been brought by the SEC based on one CDO.

The Goldman co-general counsel reiterated Goldman's position, saying, "We are very disappointed that the SEC would bring this action, which relates to a single synthetic CDO transaction involving two professional institutional investors in the face of an extensive record which we believe that the establishes the allegations are unfounded."

Palm also declined to answer a question from a Street analyst about whether Goldman had received any more Wells Notices -- indications of possible charges -- from the SEC, saying that Goldman releases information of a material nature, but not all Wells Notices from the SEC.

Last Friday, on the SEC conference call immediately following the filing of the fraud charges against Goldman Sachs, the first question out of the gate by the press was if other banks that marketed subprime mortgage products, including

Deutsche Bank

, would also be charged with similar fraud.

The SEC was boilerplate in its answer, saying that it continues to investigate the subprime mortgage product market, but that it would not be appropriate to comment on ongoing investigations.

Goldman contended just last week in its annual letter to shareholders that it had not profited from subprime mortgage profits. The SEC says that Goldman made $15 million in service fees from the subprime product trading, but that's really a minor point in the SEC complaint.

Goldman co-general counsel Palm said on Tuesday's conference call that Goldman lost more than $100 million on the subprime CDO, and that fact showed that Goldman had little reason to design a product to fail, as the SEC case alleges. "We wouldn't have taken on this risk if we believed there was something wrong in this transaction, we wouldn't have put our skin in the game in that way," Palm said on the call.

The significant issue is that the Goldman Sachs subprime product in question, Abacus, was designed in conjunction with famed hedge fund manager John Paulson of

Paulson & Co

. Paulson has become even more famous for the "brilliance" of his bet against the housing market -- there is even a new book from Michael Lewis that has hit the best-seller list covers the history of Paulson's short on the housing market.

A recent profile in

The New Yorker

made the claim that Paulson's brilliant bet on the housing market meltdown was an example of the risk-averse, well-reasoned moves made by the smartest investors. The best capitalists don't play a game of putting all their chips in the pot after a few whiskey shots, the argument runs.

With Friday's SEC charges against Goldman and the details on Paulson's role, it seems Paulson may not just have been a risk-averse investor, but Goldman was busy blindfolding all the other players at the table while Paulson stacked the deck before putting all his chips in the pot.

Maybe Paulson's brilliant betting wasn't as brilliant as it was typical of insider manipulation of securities in a market that few on the outside could even begin to understand. Then again, market manipulation by another name might be brilliance -- or, in the case of Goldman Sachs, fraud.

The SEC alleges that Goldman allowed Paulson to help pick the subprime mortgages that would be placed in Abacus. Paulson would go on to short the investment, while the subprime mortgages that he had helped to pick for the mortgage product tanked.

Paulson is not a subject of the SEC fraud charges.

The SEC charges focus on Goldman providing misleading information to investors who went long on the subprime product. Goldman allegedly told the investors that Paulson was long on the product while he was busy shorting it.

Goldman's co-general counsel reiterated the general argument on Tuesday morning's call that these bank investors were "sophisticated investors." Palm also contended on the conference call that it made no difference in the end which subprime securities went into the CDO pool, because any and all securities in the subprime category at that time were fated to be losers.

Palm was also questioned by analysts about the role of the collateral manager, ACA, in the deal, and the SEC claim that Paulson actually structured the investment.

"If the question is, what was ACA thinking? I don't know for sure what they were thinking, simply because as I have described we have been part of this case; and the only evidence we have been given as to what they were, quote, thinking is the SEC's statements as to what they were thinking and as to how we influenced that thinking, as to what they were thinking, you'd see it in the complaint. So I don't have any -- I have no knowledge beyond that."

There were questions as to why Paulson was not charged as well, but the bigger question for the banking sector is whether the SEC charges against Goldman will be the first in a wave of fraud charges over similar subprime mortgage selling practices at other big banks.

A specific Goldman vice president in charge of the subprime mortgage product, Fabrice Tourre, was also charged in the SEC complaint. Tourre was instrumental in creating and selling Abacus.

Will Goldman be able to play the fraud charges as the actions of a rogue official operating from within the bank, or will the SEC's Goldman suit be just the first of many indications that the banking industry knew exactly what it was doing in piling up and packaging the toxic mortgage debt and selling it to investors?

The biggest issue may ultimately be

whether the SEC's fraud charges against Goldman Sachs serve as the political weapon needed to pass a financial reform package in Congress, and just what that reform package will mean for the big banks' bottom line.

In light of all this, what do you think of the bigger question about the renewed scrutiny for banks? Is Goldman merely the tip of the SEC iceberg? Or is this an isolated incident? Take our poll below to learn the consensus of TheStreet -- and don't hesitate to leave a comment, while you're at it.

-- Reported by Eric Rosenbaum in New York.

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