The SEC stepped up to the plate today and filed fraud charges against Goldman Sachs, a company with investments in, well, everything and a pulse on the top leaders in government.

The move marks the first time that regulators have taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market. Goldman itself profited by betting against the very mortgage investments that it sold to its customers. [emphasis mine]

The suit also named Fabrice Tourre, a vice president at Goldman who helped create and sell the investment.

An excellent book explaining the concept of betting against a financial product and specifically the bundled CDO (collateralized debt obligations) is ‘The Big Short: Inside the Doomsday Machine‘ by Michael Lewis. It details in a very entertaining way how other, less unscrupulous, traders recognized the mortgage bubble would burst and bet against it and even tried to warn people. But this suit alleges…

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

The gist of the suit is that Goldman lured its own investors/customers to be on the opposite side of the bet to enable the firm to make billions.

…in the S.E.C. complaint, Mr. Paulson pinpointed those mortgage bonds that he believed carried higher ratings than the underlying loans deserved. Goldman placed insurance on those bonds — called credit-default swaps — inside Abacus, allowing Mr. Paulson to short them while clients on the other side of the trade wagered that they would not fail.

But when Goldman sold shares in Abacus to investors, the bank and Mr. Tourre only disclosed the ratings of those bonds and did not disclose that Mr. Paulson was on other side, betting those ratings were wrong.

This is a fascinating story for those of us who favor decentralization of pretty much everything and of course favor strong regulatory protections for consumers. It should also be noted how many former Goldmanites now sit in positions of power next to President Obama setting financial policy in Washington.

UPDATE – Turns out the cleverly orchestrated bet against its own GS trader John Paulson earned $3.7B while costing his investors $1B. Meanwhile GS stock fell 10% after news of the civil suit but the ever plucky traders, according to an as yet unconfirmed tweet, apparently having inside information, bet against their own stock in advance of the news! Another big short!