Goldman Is Charged With Subprime Fraud

The Securities and Exchange Commission on Friday charged Goldman Sachs Group Inc. with defrauding investors, alleging that Goldman let a big hedge fund fill a financial product with risky subprime mortgages and then failed to disclose that to the product’s buyers.

The SEC said in the civil complaint that Goldman and Fabrice Tourre, then vice president, created and sold opaque collateralized-debt obligations, or CDOs, that hinged on the performance of subprime-mortgage-backed securities. The complaint charges that Goldman promoted these securities to customers while failing to disclose that a major hedge-fund client had a role in picking the securities and was betting against them.

Goldman Sachs, which in a statement called the accusations “completely unfounded in law and fact,” could face steep fines and be on the hook to repay nearly $1 billion of investor losses. The charges mark the first action regulators have taken against a Wall Street firm for betting on the housing market’s collapse, and represents another blow to an investment bank under attack for how it handled the financial crisis.

The hedge fund, Paulson &Co., paid Goldman $15 million to create the CDO in early 2007, when the U.S. housing market and related securities were beginning to show signs of distress, the SEC complaint said.

According to the SEC, Goldman Sachs failed to disclose that Paulson played a significant role in selecting the CDO’s portfolio, but the firm then bet against it by entering into a credit-default-swap transaction with Goldman to buy protection on certain layers.

As a result of that bet, Paulson made about $1 billion, SEC said.

“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, Director of the SEC’s Division of Enforcement.

Shares of Goldman plunged 11% in early-afternoon trading.

The complaint didn’t name Paulson because the firm didn’t make any disclosures to investors, said Mr. Khuzami. Most complaints coming out of the SEC involve improper disclosures. Paulson didn’t respond to a request for comment.

The SEC also said in the complaint that Mr. Tourre, who presently works in London as executive director of Goldman Sachs International, was “principally responsible” for creating the CDO.

An attorney representing Mr. Tourre wasn’t immediately available for comment. Mt. Tourre couldn’t be reached by telephone or email for comment.

He started at Goldman in 2001, working at the brokerage’s mortgage and structured-credit trading business. Previous to that, he obtained a master’s degree in operations research at Stanford University after earning a bachelor’s degree in mathematics at French university Ecole Centrale Paris, according to his LinkedIn profile.

In an email about the pending doom of the CDO market, Mr. Tourre told a friend: “The whole building is about to collapse anytime now…Only potential survivor, the fabulous Fab(rice Tourre)…standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities(SIC)!!!!”

The SEC alleges that Goldman and Mr. Tourre knew it would be tough to sell the synthetic CDO if it was known that Paulson, who was heavily betting against the securities, had picked much of the collateral that went into the CDO. So Goldman called ACA Management LLC, a New York-based company that analyzes credit risk in such products, and asked it to serve as “portfolio selection agent.”

After a meeting with Goldman and Paulson, ACA was confused about Paulson’s objectives, the complaint said. Someone from ACA emailed a Goldman representative saying “it didn’t help that we didn’t know exactly how they (Paulson) want to participate in the space,” the SEC complaint says.

A later ACA e-mail said, “For us to put our name on something, we have to be sure it enhances our reputation.”

Eventually, ACA agreed to become the portfolio-selection agent, and a written memorandum identifies Paulson as a hedge-fund equity investor that would buy a tranche of the CDO. The SEC complaint says Mr. Tourre “knew, or was reckless in not knowing,” that ACA had been misled into thinking Paulson was investing on the long side.

ACA didn’t immediately respond to requests for comment.

The Goldman complaint is part of the SEC’s investigation into investment banks and others that securitize complex financial products tied to the U.S. housing market as it was beginning to show signs of distress, according to Kenneth Lench, Chief of the SEC’s Structured and New Products Unit.

“It’s safe to assume that we’re looking at a wide range of products and transactions arising out of the credit crisis,” Mr. Khuzami told reporters during a conference call about the case.

In February, the SEC settled with State Street Corp. on charges that the bank misled investors about its exposure to subprime mortgages. In that case, the SEC said the bank selectively disclosed information about its subprime mortgage investments to specific investors.

The SEC also has brought charges against issuers and fund companies for how they treat mortgage-backed securities and then disclose them to investors.

The charges against Goldman reverberated on Capitol Hill, where lawmakers are weighing how to revamp the rules that govern Wall Street amid widespread public anger about bailouts for financial institutions.

“While its action was slow in coming, I applaud the SEC for finally beginning to deal with the illegal behavior of major Wall Street firms which, in my view, knowingly sold junk products and as a result helped cause the worst recession since the 1930s,” said Sen. Bernie Sanders (I., Vt.).

The SEC case increases pressure on the Justice Department, which has been investigating many of the same Wall Street firms to look for possible criminal wrongdoing at the root of the financial crisis.

At a Wednesday hearing before the Senate Judiciary Committee, Sen. John Cornyn (R., Texas) asked Attorney General Eric Holder whether there were any “show trials” coming up. “We simply haven’t had the people who were guilty of criminal conduct brought to justice,” Mr. Cornyn said. Mr. Holder replied that the cases are hard to put together but he said he expected more cases.

Kara Scannell and Evan Perez contributed to this article.