The Securities and Exchange Commission has launched a very public attack on a very big fish. Last Friday the US corporate cop filed a civil action against the nation’s most prestigious investment bank, accusing Goldman Sachs of “defrauding investors by misstating and omitting key facts about a financial product tied to sub-prime mortgages as the U.S. housing market was beginning to falter.”

The action is a civil claim, but could become a criminal investigation if proof emerges that the bank intended to defraud investors.

The charges relate to actions undertaken by Goldman when it created an investment vehicle, dubbed Abacus 2007-AC1 (which is a particularly boring name, even by banking standards). The Abacus vehicle was designed to allow a hedge fund client, John Paulson, to “bet against” an overheated housing market.

Paulson, who has not been accused of any wrongdoing, is the founder of hedge fund Paulson & Co. Paulson is estimated to have a net worth of more than US$12 billion, having earned around US$2 billion in fees in 2008 and 2009, with his fund overseeing approximately US$36 billion worth of assets. Paulson made around US$1 billion from the Abacus deal, with most of the losses being borne by Royal Bank of Scotland (which acquired ABN AMRO).

The SEC charges do not relate to the creation of the synthetic instrument (the ‘collateralized debt obligation’ or CDO), but rather to the fact that Goldman sold shares in Abacus to investors without disclosing that the other side of the deal had been sold to Paulson. A CDO is effectively a security which gives the holder the right to income from a variety of assets — in this case, the CDO consisted of rights to a ‘special purpose vehicle’ which owned sub-prime residential mortgage-backed securities.

These securities had effectively been ‘bundled’ together by Goldman Sachs and sold to investors, who would receive the income when mortgage holders paid interest and principal back on their loans.

The SEC alleged “Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.”

The SEC also accused Goldman of falsely representing that the securities in the portfolio had been selected by a company called ACA Management, who were supposedly experts in analyzing credit risk.

The SEC stated that the securities were in fact chosen by Paulson & Co, who paid Goldman US$15 million and proceeded to effectively ‘short sell’ the asset — benefiting from any drop in price. To achieve that, Paulson entered into “credit default swaps” over the CDO (this is basically like taking out an insurance policy over the price of an asset). Paulson’s involvement was not disclosed to investors, who would presumably have been interested to know that the company choosing the assets was also betting against them.

Paulson & Co were certainly adept at selecting mortgages which fell in price — within less than 10 months, 99 per cent of the portfolio had been ‘downgraded’ by ratings agencies.

The named villain in the case (other than Goldman Sachs) is the bank’s Stanford-educated French trader, Fabrice Pierre Tourre, who was at the time a 28-year-old vice-president at Goldman’s structured product correlation trading desk in New York. Tourre (or “Fabulous Fab” as he dubbed himself), allegedly “devised the transaction, prepared the marketing materials and communicated directly to investors.”

Tourre even allegedly told investors that Paulson had invested US$200 million in the CDOs (when in fact he had a ‘short’ position).

Fabulous Fab then did himself no favours when he sent an email to a friend noting that the “only potential survivor, the fabulous Fab … standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [sic]!!!”

Goldman’s woes have been furthered with the news that German authorities are also considering action against the banking behemoth. German interest has been piqued after IKB Deutsche Industriebank AG (which is majority-owned by the Government-owned KfW) lost more than US$4.7 billion after investing in Goldman originated CDOs. The German bank was specifically mentioned in the SEC claim as being “unlikely to invest in the liabilities of a COO that did not utilize a collateral manager to analyze and select the reference portfolio.”

The SEC also alleged that “knowledge of Paulson’s role would have seriously undermined [IKB’s] confidence in the portfolio selection process and led senior IKB personnel to oppose the transaction.” IKB would lose around $150 million of its investment, with most of that money being paid to Paulson.

Goldman shares plummeted after the SEC case was announced, with more than US$10 billion being wiped from the bank’s market value. The shares closed at US$160.70 on Friday, but remain well above their lows of around US$50 during the height of the global financial crisis.

How the charges will play out remains to be seen, but as Forbes’ Neil Weinberg opined, “You’d have to say right now the Goldman Sachs gold standard is very tarnished … nothing could look worse, nothing could look more hypocritical for Goldman Sachs right now than these type of charges.”

Adam Schwab is the author of Pigs at the Trough: Lessons from Australia’s Decade of Corporate Greed.