A Black Swan Swoops in on Goldman Sachs and the Stock Market

Finally the Securities and Exchange Commission [SEC] has filed fraud charges against a Wall Street firm that made billions of dollars while many Americans suffered the consequences of a housing market meltdown largely caused by the reckless and irresponsible actions of Goldman Sachs and other Wall Street firms.

Very likely, this action by the SEC will be one of many such actions as a flock of black swans that have been patiently circling above Wall Street move in for the kill. Surely, Goldman Sachs is one of the most hated financial firms in the world and politicians seeking populist support will pile on in earnest as the politically well-connected Goldman Sachs sees its support melt away under the heat of unleashed voter anger. Many Americans will rejoice as the SEC pursues its case against the arrogant and unrepentant Goldman Sachs.

Today, Friday, April 16, 2010 the Securities and Exchange Commission announced civil fraud charges against the gigantic Wall Street powerhouse and one of its executives. The SEC alleges Goldman failed to disclose that one of its clients helped create — and then bet against — subprime mortgage securities that Goldman sold to investors. In essence, Goldman is accused of pushing a mortgage investment that was fraudulently devised to fail.

The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). The SEC states that Goldman Sachs misled investors by not disclosing that hedge fund manager John Paulson reportedly made more than one billion dollars betting against the CDO that he helped Goldman Sachs to structure. Paulson’s hedge fund paid Goldman Sachs more than $15 million to structure the deal that his hedge fund then bet against.

SEC Enforcement Director Robert Khuzami said in a statement that “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.”

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” finance expert Sylvain R. Raynes told the New York Times about such deals. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

While so far the SEC has brought fraud charges against Goldman for only one of its many CDO deals the SEC has under review a wide range of Goldman Sachs transactions. More than likely, Goldman Sachs is not the only Wall Street bank or firm subject to review.

The charges against Goldman Sachs and the use by the SEC of the word fraud has spooked a stock market that was already set up for a steep correction. At 1:35 PM the Dow Jones industrial averages was down about 150 points. The market immediately began to sell off after the Goldman Sachs, SEC news was released at about 10:30 AM. This could be the black Swan event that ends the bear market rally from the March 2009 lows. Very likely, after the worse financial debacle since the Great Depression there are other shoes to drop and other black Swan events that will occur during the foreseeable future.

At the very least, those long the stock market will have to re-evaluate the risk that being long stocks bears with Goldman Sachs and the entire financial sector once again under severe selling pressure. In my opinion, the current environment is very risky to be long stocks. Technical indicators were already signaling the likelihood of a steep sell off prior to the fraud charges being brought against Goldman Sachs.