SEC Suing Goldman for Fraud

The Securities and Exchange Commission is taking action against Goldman Sachs for misrepresenting securities the bank created and sold to investors. The suit (.pdf) is civil, so you won't see any bankers in orange jumpsuits here, but it is significant. The action marks the first time the SEC has accused a major Wall Street bank of fraud involving securities related to the housing bubble. Does the SEC have a case or is this just a feel-good political move on the part of the regulator? That depends on the evidence it has accumulated.

Here's the New York Times' report of the facts:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against -- the ones he believed were most likely to lose value -- and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

The idea is that Goldman structured securities that were designed by an interested manager to go bad, but didn't represent them that way to investors. If the facts of the case are proven to be accurate as depicted above, then it should be very easy for the SEC to prove fraud. Cherry picking bad assets and selling them to investors who thought they were chosen by an "independent manager" is illegal.

Up to now, Goldman has been arguing that it was just making markets in regard to the securities it created and sold that went bad. That isn't generally fraud. Investment banks are free to unite buyers and sellers of securities -- so long as they don't misrepresent what they're selling. But if it worked with a hedge fund to intentionally create a garbage fund and misrepresented that to investors, then that is fraud.

Yet suing Goldman is a slam-dunk for headline grabbing. This point raises the question: is it just a lucky coincidence that the SEC chose the investment bank most demonized by the media to finally sue? It's plausible that many banks engaged in questionable behavior as the housing market began to sink in 2007, so it's curious that the SEC chose to sue Goldman, and only Goldman. There is some chance that the SEC has a weak case, but looks to enjoy some public praise for finally appearing to crack down on Wall Street's much-criticized actions during the housing market's collapse.

So if the evidence described above is there, then the SEC should succeed. But even a win here won't necessarily open the floodgates to lots more lawsuits. This could be an isolated situation where Goldman misrepresented how the securities were designed. If, in fact, an independent manager had chosen the assets in question, then there would be no case.

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