Goldman Sachs prides its commitment to client interests. However, in the wake of a significant lawsuit by the SEC against the firm on Friday, many investors are questioning the heart of Goldman’s very business principals. Friday’s announcement had a widespread negative impact on the financial world. As the public looks to point fingers to the sources of the economic meltdown, many are left wondering if the SEC has a legitimate lawsuit on its hands, or if the firm is suffering from harsher regulation than financial institutions. “Now they have vulnerability. Everyone and anyone, especially politicians, are going to be trying to make hay with this one,” says Scott Moeller, former investment banker and professor at Cass Business School in London.
The SEC alleges that Goldman sold investors a CDO, called Abacus, without disclosing that the hedge fund betting against the mortgages’ demise. Paulson & Co, was involved in the CDO compilation and saw an opportunity to profit against declining housing prices. Goldman, acting as broker, structured a CDO so that Paulson would benefit in the event that such declines occurred. Thus, Paulson & Co. took a short position, or the sale of a security in the expectations that the asset will decline in value. IKB and ACA Capital Management, the investors in the CDO, along with Goldman Sachs & Co., took a long position in the CDOs, thus benefiting if the assets rose in value. As the real estate market flat-lined and the U.S. faced the worst recession since the Great Depression, everyone suffered as a result of the poor performance of the sector, not necessarily the assets that composed the portfolio. Collectively, Goldman, ACA, and IKB lost approximately $1 billion, while Paulson & Co. earned that much from the housing market collapse.
The heart of the SEC’s claims are the lack of disclosure, and the agency must prove that the firm acted recklessly in “…deceiving investors about the hedge fund’s role,” according to Professor Peter Huang at Temple University. Goldman is also facing inquiries from the German and U.K. government after the allegations from the U.S. SEC.
The firm denies all allegations, claiming on their Web site on Friday, “We are disappointed that the SEC would bring this action related to a single transaction in the face of an extensive record which establishes that the accusations are unfounded in law and fact.” Goldman is using the fact that the firm itself invested in Abacus as a defense, proving that it did not intend to mislead their investors. It also claims that the transaction was properly disclosed, IKB and ACA Capital Management had adequate information about the mortgage securities and that they were sophisticated mortgage investors.
In March 2010, Goldman attempted to meet with the SEC to discuss these matters before the lawsuit ensued. The SEC had previously warned Goldman Sachs that it could face charges over the transaction, which total just over $4 billion dollars. However, Goldman’s total net income last year was nearly $14 billion. The company could afford the potential lawsuit, but the real hit would come to their reputation. Goldman’s stock dropped 13% on Friday to just over $160. “The real risk,” according to one analyst, “is the risk to long-term reputation.”