SEC Questions Goldman Sachs's Complex Securities, Again

The supremely successful, but increasingly beleaguered, Wall Street bank Goldman Sachs (GS) is in trouble again. This time, the Securities and Exchange Commission is said to be escalating an investigation into yet another complex mortgage securities deal manufactured by Goldman.

This would be the third time this week that Goldman has come under scrutiny. Earlier in the week, the Financial Crisis Inquiry Commission accused Goldman of trying to delay and disrupt its inquiry by inundating the panel with about five terabytes of data, or the equivalent of several billion pages.

"They may have more to cover up than either we thought or than they told us," says the Commission's deputy chairman, Bill Thomas.

'Reputation Is Everything' on Wall Street

Wednesday, an Australian hedge fund, Basis Capital, filed a $1 billion lawsuit in New York against Goldman, saying the bank had misled it into buying into Timberwolf, a Collateralized Debt Obligation, or CDO, that the investment bank had structured from mortgage securities. Basis claims that Goldman was betting against dubious mortgage securities at the same time it was reassuring buyers that the investments were sound.

Such allegations aren't good for a firm that prides itself on its reputation. "In this business, reputation is everything," says Jeffrey Rubin, director of research at Birinyi Associates, a money management firm that holds Goldman shares. "Transactions are done on a handshake, and if people don't trust you anymore, that's a big issue."

Thursday, the Financial Times says that the SEC is pursuing an investigation into another similar deal called the Hudson Mezzanine, a $2 billion securities investment it put together in 2006. This would be the second instance of the SEC going after Goldman. Already, the SEC is suing the investment bank for fraud in a deal called Abacus. In that case, the SEC claims Goldman bet against the very investment it had created and sold and didn't disclose its bets to buyers.

Betting Against Their Own Complex Investments

In each case, Goldman sold complex investments based on securities that it is said to have bet against. Goldman, which has called the SEC's complaint unfounded and Basis Capital's lawsuit an attempt to recoup its losses, didn't comment on the news of the SEC investigation into Hudson Mezzanine.

However, Senator Carl Levin (D-Mich.), who heads the Senate Permanent Subcommittee on Investigations, spoke extensively on the Senate floor recently about Goldman's activities and the Hudson deal.

"In late 2006, Goldman Sachs made a strategic decision to begin unloading mortgage-related holdings and to short the mortgage market -- that is, to bet against the market and to profit from its fall. To do so, Goldman assembled a series of financial instruments it would profit from if there were a collapse of the mortgage market."

Hudson Mezzanine Pushed by Sales Force

Levin said that Goldman had constructed a series of complicated financial instruments to bet against the mortgage market, one of them being the Hudson Mezzanine. Goldman constructed this $2 billion CDO to reflect the value of subprime mortgage securities similar to those that Goldman held in its own inventory. Goldman's sales force was told that Hudson Mezzanine was a top priority, and it worked aggressively to sell Hudson securities to clients around the world, said Levin. In essence, Goldman had decided to bet against the housing market and collected money when the "products it had peddled to its clients failed."

Levin went on to say: "That kind of proprietary trading is not 'market making.' It is not matching buyers and sellers. It is one firm acting as a principal, looking out for its own self interest and making bets that were collected at the expense of its clients. Goldman served its own interests, and if clients got burned in the process, so be it."

As damning as that sounds, not all investorshave given up on Goldman yet. Birinyi Associates, for instance, has held on to its Goldman shares, which dropped $3.09, or 2.3%, to $133.71 in Thursday trading. "It's a tremendous franchise and business model, with some of the smartest people in the business," says Rubin.

Since the beginning of the year, the stock has declined 21%. "Of course," Rubin continues, "the greatest worry for an investor is the unknowable -- what's the liability, what's the limit?"