On Friday, Goldman Sachs Group Inc. (GS) was charged by the Securities and Exchange Commission (SEC) in the U.S. for misstating facts and selling bad quality subprime investments to its customers in 2006, without disclosing the risk factors and the vital role of Paulson & Co., a prime hedge fund, in the portfolio selection process.

Goldman has been slapped hard by the SEC charges this time given that the company misrepresented the fact that the hedge fund had taken a short position against the collateral debt obligation (CDO). CDO typically repackages bonds and other assets into new securities.

These are not traded on a public exchange, allowing firms like Goldman to generate fees by brokering deals between buyers and sellers. However, CDOs have performed dismally since they were invested in securities comprising subprime mortgages, which are known to have larger-than-average risk of defaulting in the market. Eventually, the market downturn failed the investment banker’s expectations and led to huge losses for the common investors.

Moreover, the SEC has also charged Goldman of being involved with a hedge fund like Paulson & Co. who had picked most of the bad-quality securities for investment, taking a short position and betting on them to perform poorly in the open market. Paulson & Co. has reportedly earned around $1 billion through this deal. However, the SEC has yet to file a lawsuit against Paulson & Co.

Nevertheless, Goldman has been denying the SEC’s allegation by insisting that the company was just an intermediary in the whole process and has done nothing wrong by concealing the betting done by Paulson & Co. on these bearish securities, as Goldman itself affirms to be incurring losses of about $90 million but earned $15 million as fees, in the venture.

The SEC probe into large investment banks has tarnished Goldman’s already bruised image. In Jan 2010, the company was cited for making unseemly bonus payments to its top executives amid the critical economic scenario.

Additionally, the pension fund also alleged that Goldman had artificially increased its revenues with $10 billion in aid provided by the government’s bailout program and the $13 billion input by insurer American International Group Inc. (AIG) and also by changing the company’s fiscal year. Going forward, such civil-fraud allegations and legal suits could harshly hit the company’s operating capacity in an industry that is largely based on goodwill and trust.

Moreover, such financial and anti-trust regulatory scrutiny may not only spread negative publicity, shaking investors’ confidence in the industry’s most renowned and reliable giants; we believe these lawsuits can provide grist to the mill of Goldman’s peers. Morgan Stanley (MS), who is right behind the industry-leading Goldman along with other rivals such as Deutsche Bank AG (DB) and UBS AG (UBS), is already reported to be poaching on Goldman’s market share, thereby benefiting from the latter’s weakness.

It appears that the gradual market recovery shall now unveil hoaxes that the companies may have carried off in the past to paint an overall favorable picture of their business operations. However, Goldman’s CDO scam is not the first instance; many banks have reportedly faced similar allegations of misleading investors by inflating or disguising securities that are actually tied to risky subprime mortgages.

Moreover, such outcomes of the regulatory probes also justify the government’s initiative to control the misuse of the derivatives in order to combat frauds and to protect investors’ interests. The SEC is also planning to probe into the investment practices of other industry giants such as Bank of America Corp. (BAC), Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM). Taking a cue from the U.S. government’s interrogation, the financial watchdogs of the U.K. and other European nations have also been directed to scrutinize the investment operations of Goldman in those nations.

We believe that issues like these could severely shatter investors’ confidence as a giant of the ilk Goldman is believed to be well positioned in the industry to realize the full benefits of its strategic cost-balancing initiatives and attractive business mix. Moreover, these issues are likely to cast a shadow over the financials of the company that is releasing its first quarter results before the market opens on Apr 20.

If the CDO charges are affirmed, Goldman will have to initiate damage control, which is estimated to be more than $700 million. This could make a dent in the company’s financials and its market reputation.
Read the full analyst report on “GS”
Read the full analyst report on “AIG”
Read the full analyst report on “DB”
Read the full analyst report on “UBS”
Read the full analyst report on “BAC”
Read the full analyst report on “JPM”
Read the full analyst report on “C”
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