Goldman Fraud Charge Crushes Financials

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 |  Includes: BAC, C, FAZ, FXX, GS, JPM, XLF
by: Michael Johnston

Investors had expected this week to be all about earnings reports. And for the first four days it was, with several bellwether firms reporting first quarter results that ranged from disappointing (Google) to impressive (Intel). But the earnings season successes and failures were overshadowed on Friday morning when the Securities & Exchange Commission charged Goldman Sachs and one of its vice presidents with defrauding investors by misstating and omitting critical facts about products tied to subprime mortgages.

The SEC stated that Goldman created and marketed a synthetic collateralized debt obligation that was tied to the performance of subprime mortgage-backed securities in 2007, just as the U.S. housing market was beginning to show early signs of collapsing. At the heart of the complaint is the role that hedge fund Paulson & Co. played in selecting the portfolio while maintaining a short position against the CDO. “Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. ["Paulson"], with economic interests directly adverse to investors in the [CDO], played a significant role in the portfolio selection process,” the complaint said (read more about the charges here).

Financial ETF (NYSEARCA:XLF) Takes A Hit

Goldman Sachs stock plummeted on the news, falling more than 10% in early Friday trading as worries of the scope of the allegations sparked a broad selloff in the stock. Goldman’s freefall also sent shares of the Financials Select Sector SPDR (XLF) sharply lower on the day in one of the most active Fridays in recent memory. XLF had been enjoying a strong week, riding impressive earnings reports from JP Morgan and General Electric’s (NYSE:GE) financial unit. XLF closed Thursday up more than 2.5% on the week, but gave back all of the gains before noon on Friday. XLF was recently trading down about 4.5% on Friday, with trading volume already well ahead of the average daily total.

Goldman Sachs makes up about 5.2% of XLF’s holdings, making the now troubled financial institution one of the fund’s largest holdings. But the news of SEC charges against GS weighed on the entire financial sector. The timing was particularly bad for the industry, as big banks had been aggressively making their case to resist increased oversight on derivatives trading operations. Goldman’s improprieties are sure to add fuel to the “Main Street vs. Wall Street” debate and give Democrats more ammunition in pushing for overhaul of the financial system (see Financial ETFs In Focus As Derivatives Showdown Looms).

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The clear winners in Friday trading following the announcement included the iPath S&P 500 VIX Short Term Futures ETN (NYSEARCA:VXX) and the Direxion Financial Bear 3x Shares (NYSEARCA:FAZ). VXX, which invests in futures contracts on the CBOE Volatility Index, had climbed nearly 5% in Friday morning trading, while FAZ was recently up more than 10% on the day.

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Disclosure: No positions at time of writing.