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"Our assets are our people, capital and reputation. If any of these is ever diminished, the last is most difficult to restore."
-- From Goldman Sachs Business Principle No. 2

The hot question on Wall Street these days is whether Goldman violated the securities laws in the Abacus case, as the Securities & Exchange Commission charges. But I don't much care about the legality of what Goldman allegedly did, because something doesn't have to be illegal to be wrong. And almost everything about the Abacus 2007-AC1 "synthetic collateralized debt obligation" deal was wrong.

No, not for legal reasons, but for the reason Goldman cited in Principle No. 2. The firm not only put its reputation at risk in Abacus, but by its own account also managed to lose money on it. It wasn't just dumb, it was double dumb.

Let me explain. Abacus, as we'll soon see, wasn't an investment vehicle -- it was a gambling vehicle. By definition, with a synthetic CDO someone's gain is someone else's loss. Think of it as a big-bucks poker game in which Goldman lined up three high rollers, provided them with a private room, helped negotiate the rules, and took a fat fee for bringing everyone together.

When you host one of these games, you not only have to make sure that it isn't rigged, you can't afford to have it looked rigged, in case the losers (or the people who cover their tab) go to the cops. In addition, if you're smart -- what Goldman calls "long-term greedy" -- you make sure the game doesn't help undermine the society that makes your business possible.

Goldman, based on what I think I know about this case, violated both these principles. (The firm, not surprisingly, declined to comment beyond what it's already said.)

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Goldman Sachs Group Inc. said Tuesday its first-quarter earnings almost doubled to $3.3 billion as its trading business again surpassed the rest of the financial industry. It was a bit of good news for the bank as it faces a government civil fraud charge.

Goldman Sachs earned $5.59 a share on revenue of $12.78 billion as bond, commodities and currency trading buoyed its profits for yet another quarter. That was well above expectations of analysts surveyed by Thomson Reuters. In the fourth quarter, Goldman Sachs earned a record $4.79 billion.

Goldman Sachs also reported sharply higher fees from underwriting stock and debt offerings.

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The market watchdog in UK, Financial Services Authority (FSA), said it would investigate the London units of Goldman Sachs Group Inc. This followed a decision by the Securities and Exchange Commission (SEC) of the US to sue the financial major for fraud.

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Goldman Sachs, Fabrice Tourre and the complex Abacus of toxic mortgages

At the centre of the US regulators' fraud charges against Goldman Sachs and employee Fabrice Tourre is a CDO – a parcel of sub-prime mortgages - called Abacus 2007-AC1.

On January 23, 2007, Fabrice Tourre sat down to write what is likely to go down in the annals of the financial crisis as one of the most memorable emails to have found its way out of Wall Street.

Typing in French and in English to a friend who may never be named, the Goldman Sachs banker shared his apparently true feelings on the state of the US housing market: “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 implication of those monstruosities [sic]!!!”

On January 23, 2007, Fabrice Tourre sat down to write what is likely to go down in the annals of the financial crisis as one of the most memorable emails to have found its way out of Wall Street.

Typing in French and in English to a friend who may never be named, the Goldman Sachs banker shared his apparently true feelings on the state of the US housing market: “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 implication of those monstruosities [sic]!!!”

On January 23, 2007, Fabrice Tourre sat down to write what is likely to go down in the annals of the financial crisis as one of the most memorable emails to have found its way out of Wall Street.

Typing in French and in English to a friend who may never be named, the Goldman Sachs banker shared his apparently true feelings on the state of the US housing market: “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 implication of those monstruosities [sic]!!!”

On January 23, 2007, Fabrice Tourre sat down to write what is likely to go down in the annals of the financial crisis as one of the most memorable emails to have found its way out of Wall Street.

Typing in French and in English to a friend who may never be named, the Goldman Sachs banker shared his apparently true feelings on the state of the US housing market: “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 implication of those monstruosities [sic]!!!”

But a month later, on February 26, French-born Tourre produced another document, a 65-page “flip book” that contained details of a $1bn investment fund, designed to be given to potential investors.

The fund was no ordinary fund, however, but a synthetic collateralised debt obligation (CDO) – a parcel of sub-prime mortgages - to be called Abacus 2007-AC1.

In other words, it was jam-packed with the types of “highly leveraged, exotic trades” he had previously criticised.

Tourre’s role in Goldman Sachs’ scandal – which yesterday saw the bank and Tourre charged with two civil counts of securities fraud – is central to understanding what exactly happened in the marketing of the Abacus fund, and why the world’s biggest bank is now effectively on public trial.

The Securities and Exchange Commission's 22-page court filing details what it portrays as an orchestrated attempt by Goldman and its junior employee to allegedly deceive clients in order to profit twice – once from structuring the Abacus fund, for which it earned $15m, and once from Paulson & Co, the New York based hedge fund run by John Paulson, for which its profits are not known.

Paulson came to Goldman in January 2007, asking it to help buy protection against what it believed would be a fall in US residential mortgage-backed securities, and then “discussed with Goldman possible transactions in which counterparties to its short position might be found.” Those counterparties were to be “found” in Abacus 2007 AC-1 – a new CDO which was part of a wider programme of CDOs structured by Goldman.

Unlike other CDOs, however, the SEC allege that this one had been constructed under the influence of Paulson – which is not itself accused of any wrongdoing.

Having decided to create a CDO to allow investors to invest in a potential increase in the value of sub-prime mortgages – which Paulson would then short – Goldman needed independent validation that what it was selling was kosher. Step forward ACA Management, a specialist in analysing credit risk owned by ABN Amro, the Dutch investment bank.

But although ACA was recruited as the ultimate “portfolio selection agent” of the mortgages within the Abacus derivative for its “credibility”, unbeknown to it – or future investors – Paulson is alleged by the SEC to have initially handed Goldman a list of 123 residential mortgage-backed securities (RMBS) to be considered for inclusion.

The 123 RMBS were based on Paulson’s selection criteria of those most likely to default – and so included mortgages from borrowers with low credit scores, and from states which had seen high rates of house price appreciation, states like Arizona and Florida which have since seen high repossession levels.

After discussion with ACA, the SEC alleges that ACA and Paulson together selected 90 RMBS in which Abacus would invest, but only after Paulson allegedly “kicked out” a number of Wells Fargo mortgages which were “generally perceived” to be of higher quality.

Of course, once Abacus had been constructed, it was up to Tourre to market the issue, and market he did.

The SEC alleges Tourre misled ACA into believing Paulson invested up to $200m in the equity of Abacus, and told IKB, the German bank which invested $150m, that the mortgages were selected by ACA, as the bank had previously informed Goldman it was not interested in investing in CDOs that hadn’t been selected by a third party.

But Tourre also allegedly misled investors by not telling them – either verbally or in the CDO’s marketing documents – that Paulson was all the while shorting the RMBS within Abacus.

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