Goldman Sachs Fraud Charges Could Shift the Winds on Wall Street

As chatter about an economic resurgence picked up steam lately, much of Wall Street was envisioning a dreamlike scenario for stocks. After all, in a recent survey a third of portfolio managers recently forecast skyrocketing earnings, with low interest rates remaining low -- the highest percentage ever with such a forecast.

But any investors still harboring such overly rosy outlooks may be in for a rude awakening. And the metaphorical cold water in their faces could well be the formal charges of fraud that the SEC leveled against investment powerhouse Goldman Sachs (GS) this week. Just as some on Wall Street were set to coast once again, the charges are a stark reminder that the consequences of a financial crisis that caused soaring unemployment and ravaged retirement savings are hardly a thing of the past.

Shares of Goldman Sachs got pounded and created a broader market sell-off on Friday, despite the firm's assurances that it would vigorously contest the charges. Even if it stakes out a careful legal argument, though, massive amounts of damage have already been done.

Resignations Coming?

Details about the firm's allegedly deeply underhanded conduct are stirring revulsion around the world. That's likely to trigger much higher regulatory scrutiny for the financial sector and create an additional headwind for stocks in the intermediate term.

Both Germany and the U.K. now say they're looking into the possibility of legal actions against Goldman Sachs. British Prime Minister Gordon Brown said he was shocked by the "moral bankruptcy" the SEC allegations have unearthed.

Prominent banking analysts like Dick Bove of Rochdale Securities are predicting the resignations of top Goldman executives like CEO Lloyd Blankfein and Chief Financial Officer David Viniar as a consequence of the firm's damaged reputation. "Someone must 'fall on their swords' for the devastating decline in this company's persona, and they may be forced to do so for public relations reasons," wrote Bove, who estimates Goldman could be liable for as much as $2 billion, in a research note.

Major management shakeups pile on top of other risks, including hugely profitable business lines like derivatives coming under pressure as a chill descends on Wall Street. "The Goldman lawsuit appears to make derivatives reform a slam dunk," some commentators have noted. "This would likely shave billions in easy profits from total S&P 500 earnings."

John Paulson, Still Untouched

Reverberations are already being felt well beyond just the publicly traded banks as investors scramble to anticipate the fallout.

Gold prices sold off sharply on Friday, an unusual move for an asset often seen as a safe haven amid rising uncertainty. But Paulson & Co., the hedge fund that made easy profits of $1 billion from the trade that Goldman arranged, is a big investor in gold.

Billionaire investor and founder John Paulson has so far evaded any charges, but that could change. Some high-profile commentators are already pushing to have him barred from the securities markets, for example. And the prospect of his hedge fund having to liquidate assets if it's hit with redemptions is clearly on the minds of investors.

The improbably bullish outlook many investors have embraced was likely to come apart eventually. By injecting a dose of reality into the markets and serving as reminder that Wall Street's misdeeds are far from forgotten, the Goldman Sachs fraud case may hasten this reckoning.