The SEC (Securities and Exchange Commission) today, April 16, charged Goldman Sachs (GS) with civil fraud. And the whole market has sold off. At 12:30 ET the Dow Jones Industrial Average was down 162 points or 1.45%. The Standard & Poor’s 500 Stock Index was down 1.97%.

What is the SEC charging and why is this such a big deal?

The charges go to the heart of a long-standing conflict of interest at Goldman Sachs in particular but also at Wall Street’s big investment houses in general. And they threaten to put an end to Wall Street’s argument that the financial crisis in the United States was an act of God and nobody’s fault.

And they come just as investor were buying up bank stocks in the belief that the sector’s problems were over. (For more on the state of the banks as revealed in JPMorgan Chase’s recent earnings report see my post https://jubakpicks.com/2010/04/15/jpmorgan-chase-disappoints-on-loan-loss-reserves-bank-sector-earnings-pop-delayed/ )

The SEC has charged that Goldman Sachs created a financial product called Abacus—a derivative based on subprime mortgages called a collateralized debt obligation (CDO)—that it sold to one client as a good investment while knowingly allowing another client, hedge fund giant Paulson & Co, to short the product and to influence what subprime mortgages went into this pool of mortgages. Goldman, the SEC alleges, never informed the buyers of Abacus that Paulson & Co. had helped select the mortgages underlying the Abacus portfolio, and indeed represented that the mortgages had been selected by an independent third party, ACA Management. Goldman further, the SEC charges, represented to ACA that Paulson & Co. had invested long in Abacus and thus its interests were aligned with other investors buying the Abacus product when, in fact, Paulson & Co. was betting that Abacus would go down in price. (You can see the official complaint here http://www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf.)

The Abacus deal closed on April 26, 2007, and by October 24, 2007, 83% of the mortgage-backed securities in Abacus portfolio had been downgraded by ratings companies and the other 17% were on negative credit watch. By January 29, 2008, the SEC says, 99% had been downgraded. The SEC’s complaint alleges that investors in Abacus lost more than $1 billion.

The SEC charges note that Paulson & Co. paid Goldman Sachs $15 to structure and market the Abacus CDO. (Paulson & Co. have not been charged in the case.)

This is a big deal for Goldman Sachs because the company’s business model includes a huge dose of conflict of interest between Goldman and its clients. Because Goldman does so many deals for clients in often obscure corners of the financial markets, it frequently becomes the market for all intents and purposes. Clients have long felt—but few have ever said—that Goldman uses its knowledge of these markets to trade for its own profit, frequently against the interest of its fee-paying clients.

Because Goldman is so powerful, few companies have been willing to say this. But the complaint is there and it does occasionally surface. For example, in recent Washington testimony, Kerry Killinger, the former CEO of former mortgage giant Washington Mutual made it clear he didn’t trust Goldman enough to hire the company as an advisor when Washington Mutual’s cratering mortgage portfolio put the company at risk. In one email released as part of the ongoing Congressional investigation of the financial crisis, he wrote of Goldman “They were shorting mortgages big time even while they were giving CfC [Countryside Financial, another aggressive mortgage lender] advice.”

But it’s one thing to have clients grumbling or to have a former CEO complain about your business practices, and quite another to have the SEC file a case that seeks disgorgement of profits and financial penalties from Goldman and that charges specific Goldman executives, in this case Goldman Sachs Vice President Fabrice Tourre, with offenses that carry substanial penalties.

But the worries about this case extend well-beyond Goldman.

So far Wall Street has been very successful in arguing that the financial crisis could not have been anticipated. To hear Wall Street CEOs—and their pals at regulatory bodies such as the Federal Reserve—tell it, you’d think the whole bust that almost took down the global financial system was an act of God. Nobody on Main Street really believes that defense but until today no agency or court with the power to do real harm to Wall Street profits has challenged that view.

In its charges against Goldman Sachs the SEC says, quite plainly, that it just doesn’t buy the act of God defense. There was real fraud at work. Companies and individuals should pay the price.

Wall Street has been hoping that its defense would hold. Even this week’s Congressional hearings at which former Washington Mutual executives detailed the extent of conscious mortgage fraud at that company weren’t too big a problem. Congress could investigate all it wanted but it didn’t have the guts, Wall Street believed, to do anything that would really hurt Wall Street profits. The SEC does.

But most damaging to Wall Street profits as a whole is that the SEC charges come just as Wall Street is trying to fend off meaningful regulatory reform in Washington and to line up its regulatory buddies at the Federal Reserve and the U.S. Treasury to fight against the tough international rules on capital proposed by the Basel Committee on Banking Supervision in what’s called Basel III.

The comment period for Basel III closes today—the same day the SEC filed its charges. Sure makes it tougher for the Fed and Treasury to argue, publicly at least, that banks don’t need strict new rules.