U.S. charges Goldman Sachs with civil fraud

Goldman calls the charges ‘unfounded’ and says it will ‘defend the firm’

by msnbc.com news services

WASHINGTON - The government has accused Goldman Sachs & Co. of defrauding investors by failing to disclose conflicts of interest in mortgage investments it sold as the housing market was faltering.

The Securities and Exchange Commission announced Friday civil fraud charges against the Wall Street powerhouse and one of its vice presidents. The agency alleges Goldman failed to disclose that one of its clients helped create — and then bet against — subprime

Investors in the mortgage securities are alleged to have lost more than $1 billion, the SEC noted. The agency is seeking to recoup profits reaped on the deal.

Goldman said the charges were “unfounded.”

“The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation,” the firm said in a statement.

The Goldman client implicated in the fraud is one of the world’s largest hedge funds, Paulson & Co., which paid Goldman roughly $15 million for structuring the deals in 2007.

Reuters reported that an ex-Paulson manager, Paolo Pellegrini, who co-managed the firm’s credit opportunities fund, cooperated with the SEC in the case. The Reuters story was based on an unnamed source familiar with the matter.

“New York-based Paulson & Co correctly bet that housing prices would fall in 2007, which helped transform the firm into one of the industry’s most successful. Pellegrini had been instrumental in the bet, but split from Paulson in 2008, becoming the only person to leave the firm that year. He has now set up his own hedge fund. A spokesman for Pellegrini had no immediate comment,” the Reuters story said.

Goldman Sachs shares fell more than 12 percent after the SEC announcement, which also caused shares of other financial companies to sink. The Dow Jones industrial average fell more than 120 points in midday trading.

Wide probe

The civil lawsuit filed by the SEC in federal court in Manhattan was the government’s most significant legal action related to the mortgage meltdown that ignited the financial crisis and helped plunge the country into recession. The SEC’s enforcement chief said the agency is investigating a wide range of practices related to the crisis.

A Goldman Sachs spokesman didn’t immediately return a call seeking comment.

The agency also charged a Goldman vice president, Fabrice Tourre, 31, who it said was principally responsible for devising the deal and marketing the securities.

The SEC is seeking unspecified fines and restitution from Goldman Sachs and Tourre.

Goldman told investors that a third party, ACA Management LLC, had selected the underlying mortgages in the investment. But, the SEC alleges, Goldman misled investors by failing to disclose that Paulson & Co. also played a role in selecting the mortgages and stood to profit from their decline in value.

“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,” SEC Enforcement Director Robert Khuzami said in a statement.

The SEC charges come less than 10 days after Goldman Sachs denied it bet against clients by selling them mortgage-backed securities while reducing its own exposure to such investments before the housing market crashed.

Served Goldman well

In an annual letter to shareholders, Goldman said it began reducing its exposure to the U.S. mortgage market in late 2006. It said it did so by selling mortgage-related investments or buying credit default swaps. The swaps are a form of insurance that pays out if the value of the underlying asset declines.

Those hedges, also known as short positions, served Goldman well. As the housing market began cratering and losses piled up for the biggest banks, Goldman suffered less damage. That led to criticism that the bank benefited at the expense of clients who bought mortgage-backed securities that later became toxic. Goldman steadfastly denied that.

“Our short positions were not a ‘bet against our clients,’” Goldman said in the letter. “Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”

In the letter, Goldman also rejected claims that it profited from the mortgage market meltdown.