(L-R) Lloyd Blankfein, CEO of Goldman Sachs Group, Inc.; James Dimon, CEO of JPMorgan Chase & Company; John Mack, chairman of the Board of Morgan Stanley; Brian Moynihan, CEO and president of the Bank of America Corporation participate in a Financial Crisis Inquiry Commission hearing on Capitol Hill on January 13, 2010 in Washington, DC. The commission is heard testimony on the root causes of the recent financial crisis.

On April 16 2010, Wall Street giant Goldman Sachs, was formally charged with securities fraud in a civil suit filed by the Securities and Exchange Commission. The criminal charges laid by the SEC claims the bank created and sold a mortgage investment that was secretly devised to fail.

Goldman Sachs defrauded investors by failing to disclose a conflict of interest on mortgage investments it sold as the housing market went sour, according to the criminal charges filed by the Securities and Exchange Commission.

Goldman allegedly failed to disclose to investors that it was betting against subprime mortgage investments it pushed on clients. Essentially, according to the complaint, Goldman pushed a product designed to fail.

How did Goldman do that?

In 2007 Goldman Sachs created what is known as a “synthetic collateralized debt obligation,” or CDO, called “ABACUS 2007-AC1”. It was one of many.

Goldman invited its clients to invest in ABACUS 2007-AC1, explaining in marketing materials that the $2 billion CDO was based on 90 bonds derived from subprime mortgage loans made over the previous 18 months.

If people whose mortgages make up the bonds in ABACUS 2007-AC1 keep up with their house payments, then folks who invest in ABACUS 2007-AC1 — typically banks, insurance companies, and pension fund managers — will make money.

The financial industry jargon for those investors’ position is that they are “long.” They’re betting that the underlying borrowers won’t default.

Goldman told investors the securities in Abacus had been chosen by ACA Management LLC, a firm managing 22 CDOs with assets of $15.7 billion.

The Securities and Exchange Commission says this is where Goldman defrauded their investors. According to the SEC’s charge, the underlying portfolio was put together by John Paulson, a hedge fund manager who hand-picked the worst possible assets in hopes that they would default. He rightly anticipated that the housing market would soon crash, and that people put into mortgages they couldn’t afford would default when they lost the ability to simply refinance based on rising home values.

But John Paulson wasn’t simply gambling. He analyzed the underlying criteria of recent mortgage-backed bonds before making his picks.

“Paulson’s selection criteria [for Abacus] favored [residential mortgage-backed securities] that included a high percentage of adjustable rate mortgages, relatively low borrower FICO 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 complaint says. “Paulson informed [Goldman Sachs] that it wanted the reference portfolio for the contemplated transaction to include the RMBS it identified or bonds with similar characteristics.”

John Paulson picked those lousy underlying assets for the Abacus CDO so that he could bet against them by purchasing “credit default swaps” — insurance policies that pay out if borrowers default.

Paulson’s position is called “short.” He set up a CDO that would be perfect to short (short is both a noun and a verb).

Goldman Sachs also shorted the CDO, according to the SEC.

“[Goldman Sachs] arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests,” the SEC’s complaint says, “but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

Fabrice Tourre, the Goldman executive who helped set up Abacus, emailed a friend in January 2007:

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

Hedge fund manager John Paulson paid Goldman Sachs $15 million in April 2007 to set up and market the Abacus CDO, according to the SEC.

Within a year, 99 percent of the underlying assets in Abacus had been downgraded by ratings agencies, costing investors $1 billion and earning Paulson $1 billion. The amount of investors losses were exactly the amount of Paulson’s gains.

How does this affect the rest of us? The New York Times explains that, the “creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against.”

“When you buy protection against an event that you have a hand in causing,” said a structured finance expert, “you are buying fire insurance on someone else’s house and then committing arson.”

Goldman denies the allegations: “The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”

Goldman Sachs’s securities fraud charges are just the beginning. The SEC has other Wall Street banks to investigate and indict in what is now being touted as the worse securities fraud and insider trading case in US history.

Janet Tavakoli, a derivatives expert deduced that the scandal is “related to activity of aiding and abetting fraudulent mortgage lending, creating phony securitizations and mis-selling them. Massive damage came from the massive risk of massively leveraging securities that could only go down in value, because [banks] created those bad securities. It was malicious mischief.”