The SEC's investigation of Goldman Sachs

Alleging fraud and the deception of clients is both a further crack in the armour of the golden boy of Wall Street.

The suit against Goldman Sachs filed by America's financial regulator, the Securities and Exchange Commission (SEC), alleging fraud and the deception of clients, is both a further crack in the armour of the golden boy of Wall Street and evidence of the US Government is sharpening its weapons against the investment banking industry.

Goldman Sach's prevalence on Wall Street was confirmed in April as it posted profits of nearly $3.5 billion for the first quarter of 2010 results (over double Morgan Stanley and ahead of JP Morgan which posted $3.3 billion in profit).

Despite the relentlessly impressive financial performance of the company, Goldmans Sach's reputation, and its share price, has taken a severe beating as a result of the action.

The SEC's move follows a year of negative articles that have accused Goldman of double-dealing, excessive bonuses and filling the Treasury with former Goldman employees, all for its own interests and, ultimately, profit.

It also comes amidst claims that the rescued insurer, American International Group (AIG), may take action against Goldman for the significant fees it earned from the New York Fed as derivatives provider.

The SEC are alleging that Goldman defrauded investors by failing to disclose vital information about a colateralised debt obligation (CDO) financial product that was linked to subprime mortgages during the US housing market fragility. The CDO bundled together a portfolio of mortgages which it then sold on to investors, including European banks.

Whilst Goldman claimed that the portfolio had been selected by an independent third party, ACA Management, the SEC alleges that the hedge fund Paulson & Co contributed to the securities selection.

Paulson & Co posted huge profits from betting against the housing market during 2007-8 so was effectively taking a position against the CDO.

Paulson's position against the housing market and, therefore, the CDO was taken using Credit Default Swaps (CDS), effectively insurance against the default of the underlying asset. Paulson had entered into these CDS with Goldman.

As the housing market collapsed, the CDO was downgraded and Paulson benefited from its CDS. In direct contrast to this eventuality, Goldman is alleged to have told ACA that Paulson was to invest $200 million of its equity into the CDO, as evidence of their aligned interests.

Goldman denies that the individuals involved in the CDO knew about the CDS trades and that the sophisticated investors were equipped with extensive information to discern the risks of the portfolio. Paulson points out that ACA, the third-party collateral manager, had sole authority over the selection of securities in the CDO.

Whether or not Goldman emerges from its battle with the SEC unscathed is a little removed from a wider issue, namely that of an increased willingness to take on the behemoths of Wall Street.

The case against Goldman is the first to be brought by the SEC's new structured-products group which is looking at other instruments, implying that Goldman may not be the only investment bank in the firing line.

At the same time, American senators are debating a wide-ranging banking reform bill which covers derivatives such as CDS. The agriculture committee has proposed that the investment banks spin off their derivative trading units. Similarly, pressures are mounting on the banks to spin off their proprietary trading units, which are a driving factor behind investment banking profits.

Goldman has promised to cooperate fully with the ongoing enquiries but if found guilty of the SEC allegations, it, and Wall Street generally, may find themselves on the back foot and weakened in their efforts to fend off the invasion of such reform that may permanently change the face of investment banking.

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