Are There More Cockroaches In Goldman's Kitchen?

On April 16, 2010 the Securities Exchange Commission (SEC) charged Goldman, Sachs & Co. (NYSE:GS) with "defrauding investors by misstatements and omitting key facts" regarding a synthetic collateralized debt obligation (CDO) named Abacus 2007-ACI. John Paulson, a hedge fund investor, made billions shorting the CDO market including an estimated $1 billion from this transaction. According to the filing, Paulson's firm paid $15 million to pick the securities that became part of the portfolio. Paulson's firm created a short position against the CDOs, and then said they did not the market the ABACUS product. Neither Paulson nor his firm was charged. (Find out more about Goldman's hearings and other current news in Water Cooler Finance: Buffett's Armed And Greece Keeps Falling.)

IN PICTURES: Top 7 Biggest Bank Failures Many investors follow the cockroach theory, believing that whenever you encounter a financial misdeed, there is a good chance more will be found. While Goldman claims it did nothing wrong, investors must consider whether there could be more problems uncovered that negatively affect the firm. In other words, are there more cockroaches hidden somewhere?

The Players
Several large banks participated in the CDO market creating and selling these securities to qualified investors. Known by some as "The Magnetar Trade," banks such as Merrill Lynch, JP Morgan Chase (NYSE:JPM) and UBS (NYSE:UBS) set up the riskiest portion of the CDOs in portfolios sold to qualified investors. Several hedge funds helped to create these funds, suggesting what mortgage-backed securities to include in the CDO.

Once the CDO was in place, the hedge funds created a short position, betting against the CDO. The funds sought to profit from the deterioration of the housing market and the sub-prime mortgages. Had the housing market continued to rise, the funds would have lost on their short bets.

Betting against home ownership is considered un-American by many. This places Goldman in the crosshairs of the public, congress, the administration and the press looking for someone to take the fall for the housing and mortgage credit debacle. (For further reading, check out 7 Lessons To Learn From A Market Downturn.)

The Fallout
Congressional grilling is forcing Goldman to suffer the scrutiny of their sophisticated trades. The public blames Goldman for the loss of the value of their homes. Washington uses Goldman's salaries and bonuses as an example of what is wrong with Wall Street. And the press gives everyone quick sound bites with very little analysis of the root cause of the problem.

In its defense, Goldman claims these were sophisticated "qualified investors" capable of evaluating the risks for themselves. However, did Goldman have their client's best interest in mind when the firm believed the mortgage market was in the process of turning down?

As with many problems that arise, people and organizations file lawsuits to try to recover their losses. The Royal Bank of Scotland (NYSE:RBS) and Deutsche Industriebank were both bailed out by their respective governments and are considering whether to sue Goldman. Each bank purchased part of the Abacus CDO that is at the heart of the SEC complaint. More lawsuits are sure to follow. (For related reading, check out Is Your Bank Going Broke?)

Time For An Exterminator?
These new cockroaches create a significant problem for Goldman and its management. The distraction takes them away from running the business. Some customers may look for other banks to represent them or invest their money, as they do not want to take the risk of unfair accusations. Others may not trust Goldman to do what is right.

Bottom Line
A clean house goes a long way to keeping the cockroaches at bay. Even if Goldman's actions turn out to be legal and ethical, they still must address their behavior with clients, shareholders, governments and the public. Making money is a good thing. Making money in a way that gains the respect of all is better. (Learn more about Goldman's case in The Goldman Sachs Fraud Explained.)