Goldman Sachs, long Wall Street’s most powerful and revered firm, was charged with fraud yesterday for selling risky mortgage investments without disclosing that the securities were actually created by a client betting on them to fail.
The move by the Securities and Exchange Commission — the most significant action it has taken since the mortgage meltdown kicked off a global financial crisis — sparked a stock market sell-off and emboldened advocates for Wall Street regulation.
Goldman Sachs — famous for its executives’ Mega Millions-sized bonuses and unrivaled influence in Washington — failed to tell European banks that hedge fund king John Paulson helped pick and then bet against the very securities they were buying, according to the civil fraud complaint by the SEC.
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News of the charges rolled in like a tidal wave:
* The Dow Jones industrial average closed 1.13 percent lower, led by a sell-off of bank stocks.
* Goldman Sachs lost 12.79 percent of its value, closing at $160.70 a share.
* Investment guru Warren Buffet lost $1 billion on his Goldman holdings.
* Democrats called for greater regulation of Wall Street.
The SEC complaint, filed in Manhattan federal court, alleges that rising Goldman Sachs exec Fabrice Tourre, 31, siphoned $1 billion from two European banks into the pocket of Paulson, who made $15 billion in 2007 by betting the housing market would collapse.
Paulson himself was not charged because only Goldman made the allegedly fraudulent sales pitches, the SEC said.
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“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,” said Robert Khuzami, SEC’s top enforcement officer.
At the center of the case is Goldman’s Abacus 2007-AC1 series of subprime mortgage-backed securities, created in 2007 just as the first cracks were seen in the nation’s overheated housing market.
Goldman and Tourre rushed to complete the deal before the big real-estate crash — an event they both believed was coming, according to the complaint.
According to the complaint, Tourre e-mailed a buddy at the time: “More and more leverage in the system, The whole building is about to collapse anytime now . . . Only potential survivor, the fabulous Fab standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”
As complex as the derivatives were, the scam was strikingly basic.
“The product was new and complex, but the deception and conflicts are old and simple,” said Khuzami.
Ever keen on shorting the market, Paulson paid Tourre $15 million to create a portfolio of subprime mortgage-backed securities specifically so he could bet against them.
Predicting the wave of defaults around the nation, Paulson — who until 2007 was considered a second-tier Wall Street player — helped Tourre cherry pick a package of the worst-of-the-worst mortgages from the bubble epicenters of Arizona, Nevada, Florida and California.
He demanded riskier adjustable-rate mortgages and borrowers with lower credit scores in the mix. Paulson, who is not related to former Treasury Secretary Henry Paulson, even excluded Wells Fargo mortgages because he felt their lending standards were too responsible.
Paulson then purchased a kind of insurance from Goldman Sachs that would give him a windfall when the mortgages failed — effectively shorting, or betting against, them.
“This is surreal,” Tourre wrote after allegedly misleading ACA Capital Management, a firm that gave its approval to the derivatives, into thinking Paulson was a long-term investor.
Tourre ultimately sold these packages to Dutch banking giant ABN Amro and German commercial bank IKB, allowing them to also believe Paulson was a long-term investor.
IKB lost almost all of its $150 million investment.
Likewise, ABN’s $840 million investment ended up in Paulson & Co.’s coffers after a series of transactions with Goldman Sachs, according to the complaint.
Goldman called the charges “completely unfounded in law and fact.”
It added: “Goldman Sachs, itself, lost more than $90 million. Our fee was $15 million. We were subject to losses and we did not structure a portfolio that was designed to lose money.”
Goldman Sachs has been aggressively trying to turn around its reviled public image, particularly allegations that it bet against its clients’ own interests and unfairly profited from the collapse of insurance giant AIG.
Just this week, Goldman Sachs director Rajat Gupta quit over the Galleon hedge fund insider-trading case.