Goldman Sachs Group Inc. (GS) is hogging the headlines for the wrong reasons again. This time, Liberty Mutual Insurance Co. has sued Goldman for misleading it to buy the preferred stock of Fannie Mae (FNMA), which became practically valueless.

Goldman, which had acted as an underwriter for the offering of Fannie Mae in 2007, has been accused of misrepresenting the financial health of Fannie Mae at that time. Liberty Mutual, which had invested $62.5 million to buy the Fannie Mae preferred stock, has claimed a reimbursement for the losses incurred.

Goldman has been alleged of raking in profits while betting against the U.S. mortgage market. According to Liberty, Goldman had also misstated the purpose of the Fannie Mae offering by saying that it was for excess capital raise when it was actually required for staying in business. Fannie Mae was poorly capitalized at that time.

Following the severe crisis in the mortgage market, both Fannie Mae and Freddie Mac (FMCC) were put in conservatorship by the U.S. Treasury Department in September 2008. As a result of this assistance from the government, the preferred stock investors incurred significant losses as dividend payouts were stopped while new preferred shares were issued to the government, which were senior to the existing preferred stocks.

The Bayou Scam

Goldman has been subject to a number of litigations of late. Last month, the securities regulator Financial Industry Regulatory Authority (FINRA) ordered Goldman to pay $20.6 million to settle claims with the creditors of a failed hedge fund. The creditors claimed that Goldman should have known about its clearing brokerage client Bayou Hedge Funds’ fraudulent activities in connection with a Ponzi scheme.

The arbitration panel of FINRA held Goldman responsible for the dispute. However, this was the first time that a bank who has acted as the middleman has been accused of and fined for helping a fund that pulled off a Ponzi scheme.

The Fraud

Recently, Goldman and some of its top officers and directors have been charged with a securities fraud, and a class action lawsuit has already been filed by the Pomerantz Haudek Grossman & Gross LLP in the United States District Court, Southern District of New York.

The securities fraud lawsuit was filed on behalf of the purchasers and receivers of Goldman notes and/or bonds. Goldman has been charged with providing false and misleading facts regarding its business model and the reasons for its accomplishments during Dec 14, 2006 to Jun 9, 2010.

As a result of such misstating of facts, the company’s securities had been trading during the relevant period at prices that were artificially puffed up. Following its exposure, the price of Goldman securities dropped substantially.

The Subprime Allegation

In April, Goldman was charged by the SEC for misstating facts and selling bad quality subprime investments to its customers in 2006. Goldman failed to disclose the inbuilt risk factors including the vital role of Paulson & Co., a prime hedge fund, in the portfolio selection process. Additionally, the SEC accused the investment bank of creating a collateral debt obligation (CDO) called Abacus 2007-AC1, which comprised mortgage-backed securities.

While we believe that Goldman is well positioned to reap the benefits of its strategic cost-balancing initiatives and attractive business mix, we think that such allegations and charges against the company dampen investors’ confidence in the stock. Additionally, such fines also dent the company’s financials. As such, Goldman currently has a Zacks #5 Rank (Strong Sell), implying that there is a significant likelihood of downward pressure on the stock over the next one to three months.
Read the full analyst report on “GS”
Read the full analyst report on “FNMA”
Read the full analyst report on “FMCC”
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