The Securities and Exchange Commission is not just attacking Goldman Sachs–it's attacking all of America and capitalism in the biggest government case to date leveled against Wall Street's leading firm over its role in the subprime meltdown.

But the SEC does have numerous embarrassing internal emails and memos from Goldman that add to the strength of its securities fraud lawsuit against the firm and Goldman trader Fabrice Tourre, 31, over a mortgage-backed security deal dubbed Abacus which lost $1 billion.

At minimum, the emails from Goldman, known for its tight-lipped “Fortress Goldman mentality,” could push the firm into settling, neither admitting nor denying culpability, potentially even paying a fine, a drop in the bucket given its $13.4 billion in net profits last year.

The emails show that Tourre "was standing in the middle of these trades without necessarily understanding them," says a top market official, and that Goldman knew the deal was rotten to begin with.

Goldman did not buy protection from AIG on the CDO that's the subject of the SEC's lawsuit; the firm had previously bought AIG protection on seven other related Abacus CDOs.

However, the SEC could also easily lose the case--we show how, see below, including that Goldman disclosed to investors in the deal documents that the firm itself could even short the deal.

Blankfein " feels that the government is out to kill the firm," that "the whole thing is totally political," and that the SEC securities fraud lawsuit "hurts America," according to one client quoted by the Financial Times.

Goldman, however, tells me that Blankfein did not initiate those client contacts and is merely responding to clients who have raised such concerns.

"Clients have raised the politics of this case with Mr. Blankfein, saying things such as, 'gosh this case seems political, what does this mean for the capital markets in the future,'" a Goldman official tells me.

Blankfein–who once famously, tongue-in-cheek, referred to investment banking as doing "God's work”–is launching his counterattack as President Barack Obama comes to New York City, shooting off pistols in the air to let Wall Street know a new sheriff is in town.

Blankfein's PR counteroffensive came rapidly on the heels of the SEC's securities fraud suit, which says Goldman and co-defendant Tourre materially deceived investors by not disclosing in deal documents that hedge fund manager John Paulson cherry picked bubble-era subprime junk assets for the synthetic collateralized debt obligation [CDO] so he could later short the deal.

Paulson's fund earned $1 billion on its negative bets against the deal; German bank IKB, an investor in other Abacus deals, lost $150 million on this CDO and had to be bailed out; ACA Capital, which acted as agent and picked the securities, lost $900 million; and Goldman lost about $90 million.

Goldman and Tourre “lied” to investors, an SEC official tells me. At issue is an age-old conflict long in play on Wall Street that Goldman and Paulson had an inside track on the deal and could see the potholes in the deal, while other investors could not.

Tourre is a vice president on Goldman's structured product correlation trading desk at its headquarters in New York City; he's now on leave, but may testify along with Blankfein, among other Goldman executives, before the Senate's Permanent Subcommittee on investigations next week.

Beginning in 2006, Paulson's two funds, known as the Paulson Credit Opportunity Funds, had placed bearish bets on subprime mortgage loans by buying protection on various debt securities. Paulson paid Goldman $15 million to market the deal.

It's a tight case, given new developments that ACA, the portfolio selection agent on the deal, and a poorly run bond insurer unsuccessful at managing CDOs, was reportedly told about the shorting by a Paulson executive.

More SEC cases could come, agency officials say.

“Wall Street banks created corrupt securities to fund a corrupt lending Blitzkrieg that rolled tanks through Main Street and damaged the entire U.S. economy,” says Janet Tavakoli, president, Tavakoli Structured Finance.

Tavakoli takes a dim view of the SEC's performance, saying its response is akin to issuing “a traffic ticket to a financial teenager."

Goldman's Embarrassing Internal Emails

The SEC says a Paulson employee explained the investment opportunity to Goldman in January 2007 in an email:

"It is true that the market is not pricing the subprime RMBS [residential mortgage-backed securities] wipeout scenario."

"In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while 'real money' investors have neither the analytical tools nor the institutional framework to take action before the losses that one could 'anticipate based [on] the 'news' available everywhere are actually realized."

The SEC says at the same time, Goldman “recognized that market conditions were presenting challenges” to the successful sale of quickly souring CDOs built on the rickety, eroding matchsticks of rotten mortgage-backed securities.

The SEC says portions of an email in French and English sent by Tourre to a friend on January 23, 2007 stated:

"More and more leverage in the system. The whole building is about to collapse anytime now...Only potential survivor, the fabulous Fab[rice Tourre] ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!! [sic]"

The SEC says similarly, an email on February 11,2007 to Tourre from the head of Goldman's structured product correlation trading desk stated in part, "the cdo biz is dead we don't have a lot of time left."

The SEC says Goldman then sought essentially a front-man with market integrity to sell the deal, a “collateral manager to play a role in the transaction proposed by Paulson."

The SEC says internal emails reflect that Goldman recognized that not every collateral manager would want to put its "name at risk...on a weak quality portfolio."

The SEC says in January 2007, Goldman approached ACA and proposed that it serve as the "Portfolio Selection Agent" for a CDO transaction sponsored by Paulson. Bond insurer ACA had closed on 22 CDO transactions with $15.7 billion of assets.

An internal email from Tourre dated February 7, 2007, stated:

"One thing that we need to make sure ACA understands is that we want their name on this transaction. This is a transaction for which they are acting as portfolio selection agent, this will be important that we can use ACA's branding to help distribute the bonds."  

Likewise, an internal Goldman memo to top Goldman executives dated March 12, 2007 described the marketing advantages of ACA's "brand-name" and "credibility":

"We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering…We expect that the role of ACA as Portfolio Selection Agent will broaden the investor base for this and future ABACUS offerings..We intend to target suitable structured product investors who have previously participated in ACA-managed cash flow CDO transactions…We expect to leverage ACA's credibility and franchise to help distribute this Transaction."

The SEC says in late 2006 and early 2007, Paulson's fund performed an analysis of recent-vintage Triple-B (junk) RMBSs and picked “over 100 bonds it expected to experience credit events in the near future,” meaning a downgrade or default.

Paulson's selection criteria?

Bubble-era securities backed by a high percentage of adjustable rate mortgages, relatively low borrower credit scores, and “a high concentration of mortgages in states like Arizona, California, Florida and Nevada that had recently experienced high rates of home price appreciation.”

The SEC contends investors were not aware of the fund's screening.

The SEC says on January 9, 2007, Goldman sent an email to ACA with the subject line, "Paulson Portfolio." Attached to the email was a list of souring mortgage-backed securities.

The SEC says on January 9, 2007, Goldman informed ACA that Tourre was "very excited by the initial portfolio feedback."

On January 10,2007, Tourre sent an email to ACA with the subject line "Transaction Summary."

Tourre's email began: "We wanted to summarize ACA's proposed role as 'Portfolio Selection Agent' for the transaction that would be sponsored by Paulson (the 'Transaction Sponsor')."

The SEC says on January 22, 2007, ACA sent an email to Tourre and others at Goldman with the subject line, "Paulson Portfolio 1-22-10.xls,” later noting that it picked 55 out of the 123 securities Paulson's fund selected.

On February 2, 2007, Paulson, Tourre and ACA met at ACA's offices in New York City to discuss the portfolio. The SEC contends that unbeknownst to ACA at the time, “Paulson intended to effectively short the RMBS portfolio” it helped select by entering into negative bets on the deal via Goldman.

Given those conflicts, the SEC says, during the meeting, Tourre zoomed an email to another Goldman employee stating: "I am at this aca paulson meeting, this is surreal."

Paulson's economic interest was unclear to ACA, the SEC says, and it later sought clarification from Goldman.

ACA later sent a Goldman sales representative an email with the subject line "Paulson meeting" that the SEC says shows ACA was kept in the dark: "I think it didn't help that we didn't know exactly how they [Paulson] want to participate in the space. Can you get us some feedback?"

The SEC says on January 10, 2007, Tourre emailed ACA a "Transaction Summary" that included a description of Paulson as the "Transaction Sponsor" and referenced a "Contemplated Capital Structure" with a "[0]% - [9]%: pre-committed first loss," purportedly showing that the Paulson fund intended to invest in the deal's equity.

The SEC says on January 14, 2007, ACA sent an email to Goldman raising questions: " I can understand Paulson's equity perspective but for us to put our name on something, we have to be sure it enhances our reputation."

The SEC says Tourre knew, or was reckless in not knowing, that ACA had been misled into believing Paulson intended to invest in the equity of the deal, when his fund was actually shorting it.  

The SEC says an ACA memo dated February 12, 2007 described Paulson's role as follows: "the hedge fund equity investor wanted to invest in the 09% tranche of a static mezzanine ABS CDO backed 100% by subprime residential mortgage securities."

The SEC says a March 6, 2007 email to the Goldman sales representative for IKB, a commercial bank headquartered in Dusseldorf, Germany and a potential investor in the CDO,  said: "This is a portfolio selected by ACA ..."

Tourre subsequently described the portfolio in an internal Goldman email as having been "selected by ACA/Paulson."

How the SEC Could Lose

The Wall Street Journal reports that the government has testimony from a Paulson & Co. official that could contradict its own claims against Goldman Sachs.

The paper says that the executive, Paolo Pellegrini claims he told the SEC that he toldACA that Paulson intended to bet against, or short, the deal, contradicting the SEC's claims that ACA did not know about Paulson's negative bet.   

The SEC does not have an obligation to disclose this testimony in its complaint and it can always take the position in court that it doubted the self-serving testimony of a Paulson employee. 

But, if a Paulson employee gets on the stand and says, “I specifically told ACA that we were going to short the CDO,” the SEC will lose. 

Goldman can also argue, as it says in a statement, that investors “were provided extensive information about the underlying mortgage securities.”  

And page 26 of Goldman's response in September 2009 to an SEC's Wells notice, (to read it, click here) shows that Goldman says it told investors in the deal's prospectus that the firm itself could short the deal, too. Quoting from the deal prospectus, Goldman says:

“The Offering Documents clearly disclosed that Goldman Sachs was the Protection Buyer, and also that the Protection Buyer . . . may hold long or short positions" in the deal and "may enter into credit derivative or other derivative transactions with other parties" in the deal.  

Also, remember that the SEC's premise--that a reasonable sophisticated investor like ACA would have wanted to know that the “legendary” hedge fund investor Paulson wanted to short the portfolio–has to be measured by what investors knew about Paulson in 2006 and early 2007, and whether his name would be a fire-engine red alarm to any investor, Goldman says. 

The “legendary” Paulson did not become the “legendary” Paulson until after he correctly called the housing bust and raked it in on negative bets on Bear Stearns. Paulson was not yet this decade's version of “When E.F. Hutton talks, people listen.”

Goldman says in its response to the SEC's Wells notice that its “theory appears to be that Paulson's role would have been significant both to ACA in its role as Portfolio Selection Agent and to investors because – like Warren Buffett or E.F. Hutton – it would have raised a red flag that a prominent “short” strategist was betting against the portfolio. Paulson's name and precise role were not material, however, particularly at the time of the transaction.”

Which is likely why Paulson noted in his recent letter to investors that in 2007 his firm wasn't viewed as an experienced mortgage investor, and that "many of the most sophisticated investors in the world" were "more than willing to bet against us."

Goldman is also saying long investors were sophisticated, and that as a market maker it doesn't reveal who sits on opposite sides of the trades. In January, Blankfein told the Financial Crisis Inquiry Commission, launched by Congress,  the same in defending its practice of selling securities it also shorted.

Goldman is not a fiduciary with obligations to either side, Blankfein said, though he added: "I do think the behavior is improper, and we regret the result--the consequence that people have lost money.

What Securities Law Says

Rule 10b-5: Employment of Manipulative and Deceptive Practices:

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

The SEC's Allegations

Goldman didn't disclose Paulson's “significant role” picking 55 securities for CDO and didn't disclose Paulson's shorts on the CDO;

That Goldman's marketing materials for the CDO, “including the term sheet, flip book and offering memorandum..all represented” that the subprime securities basket “underlying the CDO was selected by ACA Management,” with no mention of Paulson's fund;

Goldman didn't disclose that Paulson was picking mortgage-backed securities supported by bubble-era loans with low credit scores in Ariz., Calif., Fla. and Nevada. Some 99% of the securities were downgraded nine months after the deal;

And the SEC also alleges Tourre misled ACA into believing that Paulson's fund invested about $200 million in the equity of the CDO, taking a “long position,” when the fund was actually shorting the deal.