By GREGORY ZUCKERMAN, SUSANNE CRAIG and SERENA NG

Goldman Sachs Group Inc.—one of the few Wall Street titans to thrive during the financial crisis—was charged with deceiving clients by selling them mortgage securities secretly designed by a hedge-fund firm run by John Paulson, who made a killing betting on the housing market's collapse.

Goldman vigorously denied the Securities and Exchange Commission's civil charges, setting up the biggest clash between Wall Street and regulators since junk-bond king Drexel Burnham Lambert succumbed to a criminal insider-trading investigation in the 1980s, helping to define the era. "The SEC's charges are completely unfounded in law and fact," Goldman said in a statement, promising to "contest them and defend the firm and its reputation."

The civil charges against Goldman and one of its star traders, 31-year-old Fabrice Tourre, represent the government's strongest attack yet on the Wall Street dealmaking that preceded, and some say precipitated, the financial crisis that gripped the nation and the world. Goldman's shares fell 13%, one of the steepest slides since the firm went public in 1999, erasing some $12 billion of market capitalization.

The SEC lawsuit likely strengthens the position of President Barack Obama as he tries to push financial-overhaul legislation through Congress. He vowed Friday to veto any version of the bill that doesn't bring the derivatives market "under control."

Regulators say Goldman allowed Mr. Paulson's firm, Paulson & Co., to help design a financial investment known as a CDO, or collateralized debt obligation, built out of a specific set of risky mortgage assets—essentially setting up the CDO for failure. Paulson then bet against it, while investors in the CDO weren't told of Paulson's role or intentions.

"The product was new and complex, but the deception and conflicts are old and simple," said Robert Khuzami, the SEC's enforcement chief.

Mr. Paulson and his firm aren't named as defendants. The hedge-fund firm said in a statement that it wasn't involved in marketing the bonds to third parties. "Goldman made the representations, Paulson did not," Mr. Khuzami said.

Mr. Paulson took home $4 billion in 2007 for correctly betting on a housing collapse.

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The SEC said Mr. Tourre was "principally responsible" for piecing together the bonds and touting them to investors. According to the SEC, Mr. Tourre wrote in an email shortly before the bonds were sold that "the whole building is about to collapse anytime now." He described himself in the email as the "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!!!"

But he was hardly alone, the SEC alleges: The deals were signed off by senior Goldman executives, though the SEC didn't specify how high up it believes the knowledge extended.

In the past year, Goldman—the most profitable firm on Wall Street—has emerged as a symbol of excess. The taxpayer-funded rescue of the markets helped catapult Goldman to a huge profit rebound last year and stirred resentment of the firm's bonuses. Goldman paid out about $16 billion in compensation to employees in 2009.

And late last year in a profile in London's Sunday Times, Goldman's chief executive, Lloyd Blankfein, described himself as "doing God's work," a remark that Goldman later explained was made in jest. Still, the quip inflamed Goldman critics who said it showed the firm was tone deaf about concerns over its business practices and rich pay.

Goldman is one of the few financial firms the U.S. government has accused of misleading investors in the subprime-mortgage debacle, although it is one of many that created and sold securities that cratered when the housing market collapsed.

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Reuters

The new Goldman Sachs Group headquarters in New York's lower Manhattan.

The Dow Jones Industrial Average fell 116.38, or 1.04%, to 11028.19, as investors worried that other financial firms could be on a collision course with the SEC over Wall Street's behavior during the crisis.

It has been a brutal week for Goldman. The SEC's charges against the firm came just days after The Wall Street Journal reported that prosecutors are investigating Goldman director Rajat Gupta on suspicion that he provided inside information to the Galleon Group, the hedge fund founded by Raj Rajaratnam now at the center of the biggest insider-trading probe in decades.

The deal at the center of the SEC suit came as Goldman and other firms were deeply involved in making, buying and building complex investments out of subprime loans, just as the market for those loans was beginning to weaken perilously. Critics of such deals say they enriched the firms but magnified what became the worst financial crisis since the Great Depression.

As the housing market sank in 2007 and 2008, investors in the deal, known as Abacus 2007-AC1, suffered losses of more than $1 billion, according to the SEC. The sinking market gave Paulson a profit of about $1 billion. Goldman was paid about $15 million for structuring the bonds and pitching them to investors. Goldman is a major trader of stocks and bonds on behalf of Paulson

In a statement, Goldman said it suffered a $90 million loss on the deal. Goldman said investors were provided with extensive information about the securities in the portfolio. Mr. Tourre, the trader facing civil charges as part of the SEC action, couldn't be reached to comment. He works as executive director in Goldman's international unit.

Analysts said the suit could cost Goldman business and even threaten its executives. "Someone must 'fall on their swords' for the devastating decline in this company's persona," wrote Richard Bove, an analyst with Rochdale Securities.

Goldman and Mr. Tourre both received Wells notices from the SEC in recent months indicating that the staff of the agency could recommend action against the parties in the case, a person familiar with the matter said. Goldman isn't required to disclose the Wells notice if it believed it wasn't a material event. The notices don't always lead to charges or fines.

Goldman employees were stunned by the suit, even though Goldman has been cooperating with the SEC's probe of CDOs. Traders at the company's headquarters in lower Manhattan stopped working when the headline flashed across TV screens.

Goldman has vehemently denied putting its own interests ahead of its clients.' In a letter to shareholders earlier this month, Mr. Blankfein and President Gary Cohn said: "Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits." But it was common knowledge among Goldman executives that the firm created mortgage bonds so clients could bet against housing.

Other firms also used CDOs to offset risk taken on through credit-default swaps with hedge-fund clients, including Deutsche Bank AG, according to people familiar with the matter.

Goldman and Paulson have worked together ever since the hedge-fund firm was established in 1994. By mid-2006, Mr. Paulson and his fund had purchased protection on billions of dollar of potentially toxic mortgages, and he wanted to expand his bearish wager.

'CEO Lloyd Blankfein has drawn heat for Goldman's rich pay and profits in the wake of the taxpayer bailout of the financial system.

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• Heard: Banks Still Paying Bubble Bill

Graphic: See an example of how a mortgage CDO is made.

Goldman and Deutsche Bank were among the firms that agreed to put together deals for Paulson. The fund chose a list of securities to form the foundation of the CDOs, zeroing in on those it saw as particularly risky. In at least some deals, potential buyers of the mortgage bonds were consulted, along with credit-rating agencies, people familiar with the transactions say.

In contrast, one senior banker at Bear Stearns Cos. turned down the business. He questioned the propriety of selling deals to investors that a bearish client was involved in putting together, according to people familiar with the matter.

One investor who lost money on Abacus was German bank IKB Deutsche Industriebank AG, the SEC said. A bank spokeswoman said it is aware of the suit and responded to SEC inquiries.

Middleman

How Goldman Sachs structured the deal under scrutiny. (Click on the image.)

Another big loser: ACA Capital Ltd., which operated a bond insurer that insured a $909 million chunk of the CDO in return for a fee, according to the complaint. When the bond insurer imploded in late 2007, most of its Abacus-related risk wound up with ABN Amro Bank NV, the complaint said.

The Dutch bank, which agreed to cover ACA's obligations if the insurer couldn't pay, was later acquired by a group of banks that included Royal Bank of Scotland PLC. In 2008, RBS paid $840.9 million to Goldman to unwind the agreement. Goldman paid most of that money to Paulson, according to the SEC.

From 2004 to 2007, Goldman arranged about two dozen similarly named deals, according to rating-agency data. American International Group wrote credit protection on $6 billion of Abacus transactions before the insurer nearly collapsed in 2008, though not the deal detailed in the SEC's suit, according to documents reviewed by the Journal. Last year, AIG unwound most of its Abacus-related swaps with Goldman, losing $2 billion.

A 65-page marketing document for Abacus 2007-AC1 reviewed by The Wall Street Journal described the deal as a $2 billion synthetic CDO based on a pool of residential mortgage assets "selected by" another unit of ACA. The logos of Goldman and ACA were printed on nearly every page.

The lawsuit suggests "senior level management" at Goldman was aware of the Abacus transaction and Paulson's connection to the deal. "Goldman is effectively working an order for Paulson to buy protection on specific layers of" the deal's "capital structure," according to excerpts of a 2007 internal memo included with the suit. The Goldman committee that was sent the memo included senior-level management, the SEC said.

According to the SEC, Mr. Tourre misled ACA officials about Paulson's role, saying the firm had invested $200 million in hopes the CDO would rise. ACA and Paulson chose the 90 pools of mortgage assets used to create Abacus, the SEC said.

In a statement, Goldman said it "never represented to ACA" that Paulson was investing in hopes the values would rise. People close to the firm said officials saw no need to disclose to investors that Mr. Paulson had a hand in creating the portfolio or was taking a bearish position.

Abacus 2007-AC1 was issued in April 2007. By October, more than 80% of the underlying mortgage securities in the deal had been downgraded, reflecting the housing market's deepening turmoil. A total of 99% were downgraded by January 2008, according to the SEC.