By Joe Rauch and Rachelle Younglai

WASHINGTON(Reuters) - The timing of the U.S.Securities and Exchange Commission's case against Goldman SachsGroup Incis "suspicious," a federal watchdog said,suggesting that the SEC used it to divert attention from areport that sharply criticized its probe into accused Ponzischemer Allen Stanford.

The SEC filed civil fraud charges against Goldman inmid-April, the same day it released a watchdog report accusingthe agency of mishandling an investigation into Stanford'salleged $7 billion Ponzi scheme.

The report by SEC Inspector General David Kotz said theregulator suspected as early as 1997 that Stanford was runninga Ponzi scheme but did nothing to stop it until late 2005.

The timing "strains credulity," Kotz told a congressionalhearing Wednesday examining the SEC's handling of theStanford case.

Kotz's report went largely unnoticed.

Stanford is in a Texas jail awaiting trial on 21 criminalcharges related to his alleged Ponzi scheme involving theissuance by his Antiguan bank of certificates of deposit withimprobably high interest rates. The SEC filed civil chargesrelated to the matter in February 2009.

Some Republican lawmakers accused the SEC of suing Goldmanto help Democrats pass the landmark Wall Street reform bill,which was winding its way through Congress in April.

Kotz is probing whether the SEC's lawsuit against Goldman was politically motivated, a charge the SEC vehemently denies.He expects to complete his Goldman report by the end of nextweek.

At the Senate Banking Committee hearing, the topRepublican, Richard Shelby, said the Stanford case represents a"major failure" by the SEC. He also suggested the timing wassuspect and seemed intended to draw lowered scrutiny.

The SEC, still recovering from missing Bernard Madoff's $65billion Ponzi scheme, is under pressure to root out fraud afterthe U.S. housing collapse and Wall Street's ensuing meltdown.

SEC REGRETS

The SEC's enforcement director, Robert Khuzami, and otherSEC officials apologized at the hearing and said they had deepregrets that the regulator failed to act more quickly to limitlosses suffered by Stanford investors.

But apologies did little to assuage Stanford victims, whotraveled to Washington to attend the hearing and snickered asthe regulators testified.

"I feel that the SEC did a good job of covering their owntails. I think they were part of the problem in this wholething," said Richard Muzyka, 67, of Fort Myers Beach, Florida.

Muzyka is a retiree who initially invested with Stanfordbecause of the company's seeming stable returns, which he sawas attractive for someone living on a fixed retirement income.

Kotz's report found the SEC's Fort Worth, Texas, officeexamined Stanford in 1997, 1998, 2002 and 2004, "concluding ineach case that Stanford's CDs were likely a Ponzi scheme or asimilar fraudulent scheme."

In 2005, the enforcement arm of the SEC finally agreed toseek a formal order from the commission to investigateStanford. But Kotz said it failed to conduct due diligence onhis investment portfolio, a missed opportunity.

Kotz said he was talking to criminal authorities about theformer head of enforcement in Fort Worth, Spencer Barasch, who"played a significant role" in quashing investigations ofStanford and sought to represent him on three occasions afterhe left the SEC.

According the report, Barasch briefly represented Stanfordin 2006 before being informed by the SEC ethics office that itwas improper to do so.

Asked why he was so insistent on representing Stanford,Barasch replied: "Every lawyer in Texas and beyond is going toget rich over this case. Okay? And I hated being on thesidelines," according to Kotz's report.

Republican Senator Jim Bunning said he "almost fell off hischair" when he read that and asked Kotz whether that lookedlike criminal negligence.

Kotz only said he was talking to criminal authorities andwould not elaborate further.

Barasch is a partner at the law firm Andrews Kurth LLP.

In a statement, the firm's managing partner, Bob Jewell,called Kotz's testimony "disappointing," and said Barasch"acted properly during his contacts with the Stanford FinancialGroup and the Securities and Exchange Commission. He did notviolate conflicts of interest."

SEVEN RECOMMENDATIONS

The SEC has said that most of Kotz's seven recommendationshave been implemented and that it would carefully analyze thereport and implement any additional reforms as necessary foreffective investor protection.

Kotz's report says that even after SEC examiners identifiedmultiple violations of securities laws by Stanford in 2002, theenforcement division did not open an investigation.

He also said senior Fort Worth office officials perceivedthey were judged by the number of cases they brought.

"Novel or complex cases were disfavored," he concluded. "Asa result, cases like Stanford, which were not considered'quick-hit' or 'slam-dunk' cases, were not encouraged." (Reporting by Joe Rauch and Rachelle Younglai; Additionalreporting by Jonathan Stempel in New York; Editing by Gerald E.McCormick, Andre Grenon and Steve Orlofsky)