Is the SEC Opening the Floodgates?

The civil suit brought against Goldman Sachs by the Securities and Exchange Commission on Friday involved just a single transaction and a single executive, and in a conference call with reporters, SEC Enforcement Director Robert Khuzami refused to say how widespread his investigation is. But that doesn't make the case any less significant. Securities-fraud charges related to the subprime debacle have been few and far between until now (plenty of mortgage originators have been indicted, but Wall Street has remained mostly unscathed). By naming the most prestigious firm on Wall Street and a world-famous hedge fund—Paulson & Co.—known for making some of the biggest profits by shorting subprimes, the SEC has signaled that there may be a lot more indictments to come.

And there ought to be. All indications are that, in the late stages of the subprime-mortgage bubble, the kind of alleged fraud identified in the complaint was far more common than is typically acknowledged. According to the SEC, the Goldman executive allowed Paulson & Co. to select residential mortgage-backed securities that made up a CDO, or collateralized debt obligation, purely so it could bet against the portfolio, or "short" it. Goldman then allegedly represented to investors that another firm, ACA Management, had picked the securities, presumably because ACA thought they were good investments, the complaint 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," Khuzami said.

The case shows how pathological the markets had become. The cart was beginning to drive the horse: rather than packaging mortgage-backed securities together and selling them around the world in order to spread risk, such products were being created for the sole reason to permit traders to short them and make money on their almost certain failure. As blogger Yves Smith pointed out in her withering review of Michael Lewis's new book, The Big Short, such short sellers kept the subprime market going long after it should have died a natural death by creating products that fooled investors into thinking the market was healthier than it really was.

Another reason why we can expect a lot more cases to come is that the SEC unit that investigated the indictment, Structured and New Products, was only recently created solely to probe dodgy derivatives deals. For years, "structured finance" has been just about the biggest scam on the street, involving the creation of super-complex deals little understood by investors. Wall Street is now running for cover, and it's about time.