Why Goldman charges are a big deal

Well, first of all the market is sinking on the news (Dow was down about 150 points, but it's coming back). It's not just that the SEC is coming down on one of the few Wall Street powers left standing, it's that the accusations involve securities fraud. "When you throw that word fraud in there, all bets are off then," Jay Suskind of Duncan-Williams told the WSJ. The concern is that other firms will be targeted as well. Investors have responded by pulling out of stocks and commodities and into safer havens, like Treasurys.

It's also important because this is the first time regulators are citing a Wall Street firm that helped investors capitalize on the housing market's collapse. From the NYT:

The instrument in the S.E.C. case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so the bank and select clients could bet against the housing market. Those deals, which were the subject of an article in The New York Times in December, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank. As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.

Goldman created the Abacus product at the request of hedge fund manager John Paulson, who earned about $3.7 billion by correctly betting on the housing collapse. The SEC says that Paulson selected mortgage bonds that he wanted to bet against and packaged those bonds into Abacus 2007-AC1. Interestingly, Paulson was not charged - the SEC's head of enforcement says that Goldman was responsible for representing Abacus to its investors, not Paulson. As this thing unfolds, prosecutors will need to prove that by not informing investors of the Paulson manipulation, it was breaking the law - and that may be hard. As for Goldman's position:

In a letter published last week in Goldman's annual report, the bank rebutted criticism that it had created, and sold to its clients, mortgage-linked securities that it had little confidence in. "We certainly did not know the future of the residential housing market in the first half of 2007 anymore than we can predict the future of markets today," Goldman wrote. "We also did not know whether the value of the instruments we sold would increase or decrease." The letter continued: "Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a 'bet against our clients.' " Instead, the trades were used to hedge other trading positions, the bank said.

Thing is, marketing documents claimed that the securities were being selected by ACA Management, a third-party manager, when in fact the selection decisions were influenced by Paulson's fund. Goldman had a duty to disclose that influence. From James Kwak:

It seems like the key will be proving that Paulson influenced the selection of securities enough that it should have been in the marketing documents. Paragraphs 25-35 include quotations from emails showing that Paulson was effectively negotiating with ACA over the composition of the CDO, so it's pretty clear he had influence. The defense will presumably be that ACA had final signoff on the securities, and Paulson was just providing advice, so Paulson's role did not need to be disclosed. (I don't know what kind of standard will be applied here.)