Shares of Goldman Sachs Group Inc. plunged 9 percent Friday after word that the Justice Department had opened a criminal investigation of the Wall Street powerhouse over mortgage securities deals it arranged.
The criminal inquiry follows civil fraud charges filed by the government against Goldman two weeks ago and as Congress pushes toward enacting sweeping legislation aimed at preventing another near-meltdown of the financial system.
The investigation by the U.S. attorney's office in Manhattan stems from a criminal referral by the Securities and Exchange Commission, a knowledgeable person said Thursday. The person spoke on condition of anonymity because the inquiry is in a preliminary phase.
The SEC brought civil fraud charges against Goldman and a trader in connection with the transactions in 2006 and 2007. The agency alleged the firm misled investors by failing to tell them the subprime mortgage securities had been chosen with help from a Goldman hedge fund client, Paulson & Co., that was betting the investments would fail. Goldman and the trader, Fabrice Tourre, have denied wrongdoing and said they will contest the allegations in court.
Word of the Justice Department action came two days after Goldman executives were grilled and publicly rebuked by senators at a politically charged hearing. And it arrived a day after a group of 62 House lawmakers, including Judiciary Committee Chairman John Conyers, D-Mich., asked Attorney General Eric Holder to order a criminal probe of Goldman.
"This is welcome news indeed," Rep. Marcy Kaptur, D-Ohio, said in a statement Friday. "The American people deserve justice in the matter of Wall Street banks. Federal authorities should leave no rock unturned as they root out any potential fraud that triggered the crisis and caused thousands of families to lose their savings and their homes."
A related online petition drive organized by liberal groups claimed to have amassed 140,000 signatures.
SEC spokesman John Nester declined any comment on the matter, as did Yusill Scribner, a spokeswoman for the U.S. attorney's office in Manhattan.
Goldman spokesman Lucas van Praag said, "Given the recent focus on the firm, we're not surprised by the report of an inquiry. We would cooperate fully with any request for information."
Following news of the probe, Standard & Poor's Equity Research analysts downgraded Goldman's shares to "Sell" from "Hold" and lowered their target price by $40 to $140.
Investors took a pessimistic view of the downgrade as well as the federal prosecutors' probe, notwithstanding that it is far from certain that the inquiry will result in criminal charges being brought. Goldman's stock fell $14.64, or 9.1 percent, to $145.60 in afternoon trading. The stock is down 21 percent since the SEC sued Goldman on April 16. The shares tumbled 13 percent that day but had recovered slightly in recent trading.
The Justice Department move was the latest in a dramatic series of turns in the Goldman saga, which has pitted the culture of Wall Street against angry lawmakers in an election year, in the wake of the financial crisis that plunged the country into the most severe recession since the Great Depression of the 1930s.
"Wall Street Overdrafted Our Economy" and "Reclaim America," said signs carried by protesters as thousands of workers and union leaders marched on Wall Street Thursday to express ire over lost jobs, the taxpayer-funded bailout of financial institutions in the crisis and lending practices by big banks.
At the Capitol on Thursday, following days of failed test votes sought by Democrats, the Senate lurched into action on legislation backed by the Obama administration that would clamp down on Wall Street and the sort of high-risk investments that nearly brought down the economy in 2008.
And two days earlier, a daylong showdown before a Senate investigative panel put Goldman's defense of its conduct in the run-up to the financial crisis on display before indignant lawmakers and a national audience. The panel, which investigated Goldman's activities for 18 months, alleges that the Wall Street powerhouse bet against its clients — and the housing market — by taking short positions on mortgage securities and failed to tell investors that the securities it was selling were at very high risk of default.
Probe in early stages
Goldman CEO Lloyd Blankfein testily told the investigative subcommittee that clients who bought the subprime mortgage securities from the firm in 2006 and 2007 came looking for risk "and that's what they got." Blankfein said the company didn't bet against its clients — and can't survive without their trust. He repeated the company's assertion that it lost $1.2 billion in the residential mortgage meltdown in 2007 and 2008. He also argued that Goldman wasn't making an aggressive negative bet — or short — on the mortgage market's slide.
In addition to the $2 billion so-called collateralized debt obligation that is the focus of the SEC's charges against Goldman, the subcommittee analyzed five other such transactions, totaling around $4.5 billion. All told, they formed a "Goldman Sachs conveyor belt," the panel said, that dumped toxic mortgage securities into the bloodstream of the financial system.
A collateralized debt obligation or CDO is a pool of securities, tied to mortgages or other types of debt, that Wall Street firms packaged and sold to investors at the height of the housing boom. Buyers of CDOs, mostly banks, pension funds and other big investors, made money off the investments if the underlying debt was paid off. But as U.S. homeowners started falling behind on their mortgages and defaulted in droves in 2007, CDO buyers lost billions.
It wasn't immediately known whether the Justice Department's inquiry also encompasses the five other transactions.
The investigation, even though at a preliminary stage, opens a momentous new front in the legal aftermath of the near-meltdown of the financial system.
That the Justice Department has started a criminal inquiry "should not come as a surprise" since Justice and the SEC often work in parallel on such cases, noted Robert Mintz, a former federal prosecutor in New Jersey who heads the white-collar defense practice at McCarter & English in Newark.
Such criminal investigations by Justice don't always result in charges being brought, and indictments against companies — as opposed to individual executives — have been rare. "The more complex the case, the more a variety of factors get thrown into the mix," said Mintz.
Still, he suggested, there's a risk that the mere acknowledgment of the criminal probe could have "serious repercussions for Goldman Sachs."
Burden of proof
The Justice Department and the SEC have previously launched wide-ranging investigations of companies across the financial services industry. But a year after the crisis struck, charges haven't yet come in most of the probes. In addition to fallen mortgage lender Countrywide Financial Corp. and bailed-out insurance giant American International Group Inc., the investigations also have targeted government-owned mortgage lenders Fannie Mae and Freddie Mac and crisis casualty Lehman Brothers.
Last August, a federal jury in New York convicted former Credit Suisse broker Eric Butler of conspiracy and securities fraud for his role in a $1 billion subprime mortgage fraud. But the swift acquittal in November of two former Bear Stearns executives in the government's criminal case tied to the financial meltdown showed how tough it can be to prove that investment bank executives committed fraud by lying to investors. The SEC sued the two executives in a civil suit, and that case is still pending.
The government must show that executives were actually committing fraud and not simply doing their best to manage the worst financial crisis in decades, some legal experts say.
The SEC civil fraud case against Goldman — even with the lower required burden of proof than in a criminal case — also could be difficult and faces pitfalls, in the view of some experts. To prove it, they say, the agency must show that Goldman misled investors or failed to tell them facts that would have affected their financial decisions. The greatest challenge, the experts say, will be boiling the case down to a simple matter of fraud: the issues involved are so complex that Goldman may be able to introduce enough complicating factors to shed some doubt on the SEC's claims.