GOLDMAN SACHS : WATCH THIS CASE / THE NEW YORK TIMES OP EDITORIAL ( HIGHLY RECOMMENDED READING )

April 17, 2010

Editorial

Watch This Case

Months ago, Gretchen Morgenson and Louise Story of The Times exposed Goldman Sachs’s practice of creating and selling mortgage-backed investments and then placing financial bets that those investments would fail. While appalling, it wasn’t clear whether the practice was also fraud. The Securities and Exchange Commission has now decided that it was, charging Goldman on Friday.

We urge everyone to keep a close eye on this case. If it is handled correctly, it should finally answer the question of whether malfeasance — and not merely unbridled greed, incompetence and weak regulation — was also responsible for the financial meltdown.

Goldman insists that what it was doing was prudent risk management. In a letter published in its annual report, it argued that “although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients.’ ” The bank also insists that the investors who bought the structured vehicles were sophisticated professionals who knew what they were doing.

The S.E.C. is now charging just the opposite.

It accuses Goldman of intentionally designing a financial product that would have a high chance of falling in value, at the request of a client, and lying about it to the customers who bought it. It says that Goldman allowed that client — John Paulson, a hedge fund manager — to pick bonds he wanted to bet against, and then packaged those bonds into a new investment.

Goldman then sold this investment to its clients, telling them the bonds were chosen by an independent manager, and omitted that Mr. Paulson was on the other side of the trade, shorting it, in the industry vernacular.

Five months after Goldman sold the investments, 83 percent of the bonds contained in the packaged securities were downgraded by rating agencies.

Goldman vigorously denies any wrongdoing, calling the S.E.C.’s charges “completely unfounded in law and fact.” It will undoubtedly assemble a daunting legal team and mount a vigorous defense. But if the S.E.C. makes its case, it will be a watershed moment, changing the dominant narrative of the financial crisis.

Up to now, the bankers have argued that the financial crisis was like what insurers call an “act of God,” an unforeseeable cataclysm over which they had no control. This has allowed them to shrug off responsibility, even as taxpayers bailed them out. It has allowed them to sleep soundly after collecting their huge bonuses. Goldman is not the only bank to have sold mortgage-backed securities and then bet against them. We suspect that after Friday, others on Wall Street may have a harder time sleeping.

Copyright 2010 The New York Times Company