NEW YORK (Reuters) - Goldman Sachs Group Inc was charged with fraud by the U.S. Securities and Exchange Commission over its marketing of a subprime mortgage product, igniting a battle between Wall Street’s most powerful bank and the nation’s top securities regulator.

The civil lawsuit is the biggest crisis in years for a company that faced criticism over its pay and business practices after emerging from the global financial meltdown as Wall Street’s most influential bank.

It may also make it more difficult for the industry to beat back calls for reform as lawmakers in Washington debate an overhaul of financial regulations.

Goldman called the lawsuit “completely unfounded,” adding, “We did not structure a portfolio that was designed to lose money.”

The lawsuit puts Goldman Chief Executive Lloyd Blankfein further on the defensive after he told the federal Financial Crisis Inquiry Commission in January that the bank packaged complex debt, while also betting against the debt, because clients had the appetite.

“We are not a fiduciary,” he said.

The case also involves John Paulson, a hedge fund investor whose firm Paulson & Co made billions of dollars by betting the nation’s housing market would crash. This included an estimated $1 billion from the transaction detailed in the lawsuit, which the SEC said cost other investors more than $1 billion. Paulson was not charged.

Fabrice Tourre, a Goldman vice president whom the SEC said was mainly responsible for creating the questionable mortgage product, known as ABACUS, was charged with fraud.

Goldman shares slid 12.8 percent on Friday, closing down $23.57 at $160.70 on the New York Stock Exchange. The decline wiped out more than $12 billion of market value, and trading volume topped 100 million shares, Reuters data show.

The news dragged down broad U.S. equity indexes, which fell more than 1 percent. The perceived risk of owning Goldman debt, as measured by credit default swaps, increased. Treasury prices rose as investors sought safe-haven government debt.

MORE SEVERE THAN EXPECTED

“These charges are far more severe than anyone had imagined,” and suggest Goldman teamed with “the leading short-seller in the industry to design a portfolio of securities that would crash,” said John Coffee, a securities law professor at Columbia Law School in New York.

“The greatest penalty for Goldman is not the financial damages -- Goldman is enormously wealthy -- but the reputational damage,” he said, adding that “it’s not impossible” to contemplate that the case could lead to criminal charges. Coffee spoke on Reuters Insider.

Goldman vowed to defend itself.

“The SEC’s charges are completely unfounded in law and fact,” it said. “We will vigorously contest them and defend the firm and its reputation.”

E-mails from former Washington Mutual Inc CEO Kerry Killinger read aloud during a congressional hearing this week illustrated clients’ concerns about working with Goldman.

In 2007, Killinger discussed hiring Goldman or another investment bank to help Washington Mutual find ways to reduce its credit risk or raise new capital, according to one of the e-mails, which Michigan Democratic Sen Carl Levin read during the hearing.

“I don’t trust Goldie on this,” Levin quoted one of Killinger’s e-mails as saying. “They are smart, but this is swimming with the sharks. They were shorting mortgages big-time while they were giving (Countrywide Financial Corp) advice.”

The SEC lawsuit announced on Friday concerns ABACUS, a synthetic collateralized debt obligation that hinged on the performance of subprime residential mortgage-backed securities, and which the regulator said Goldman structured and marketed.

According to the SEC, Goldman did not tell investors “vital information” about ABACUS, including that Paulson & Co was involved in choosing which securities would be part of the portfolio.

The SEC also alleged that Paulson took a short position against the CDO in a bet that its value would fall.

In a statement, Paulson & Co said it did buy credit protection from Goldman on securities issued in the ABACUS program, but did not market the product.

Tourre was not immediately available for comment.

Goldman had not disclosed that the SEC was considering a lawsuit but had known charges were possible and had urged the SEC not to file them, people familiar with the situation said on Friday. The sources requested anonymity because the probe was not public.

To better understand CDOs, the SEC in 2008 approached some hedge funds, including Paulson & Co, whose investment Paulo Pellegrini was among those to talk with the regulator.

By betting against subprime mortgage-related debt, Pellegrini helped Paulson’s firm earn an estimated $15 billion in 2007. Pellegrini last year left to start his own firm.

COMING OUT SWINGING

The lawsuit is a regulatory and public relations nightmare for Blankfein, who has spent 18 months fending off complaints that Goldman has been an unfair beneficiary of taxpayer bailouts of Wall Street.

Blankfein became chief executive less than a year before the product challenged by the SEC was created.

“This could be the beginning of a period where you have a regulatory cloud over Goldman Sachs, and perhaps even the entire investment banking industry,” said Hank Smith, chief investment officer at Haverford Trust Co in Philadelphia.

John Paulson is not related to Henry “Hank” Paulson, who was Blankfein’s predecessor as Goldman chief executive and later become U.S. Treasury secretary.

The SEC lawsuit represents an aggressive expansion of regulatory efforts to hold people and companies responsible for the nation’s financial crises.

It could help the regulator rehabilitate its reputation after missing other high-profile cases, including Bernard Madoff’s Ponzi scheme.

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“The SEC has come out swinging,” said Cary Leahey, senior managing director of Decision Economics in New York.

Robert Khuzami, head of the SEC’s enforcement division, said John Paulson was not charged because it was Goldman that made misrepresentations to investors, not Paulson.

Still, Khuzami called Paulson’s firm “a hedge fund that had a particular interest in the securities performing poorly.”

MORE LAWSUITS TO COME?

It is unlikely that criminal charges will be brought, a person close to the matter said. Representatives for the Justice Department declined to comment.

Yet the lawsuit is widely expected to spur other lawsuits, and is “probably the first of several,” according to Doug Kass, president of hedge fund Seabreeze Partners Management.

“Regulators and plaintiffs’ lawyers are going to be looking at other deals, to what kind of conflicts Goldman has,” said Jacob Zamansky, a lawyer who represents investors in securities fraud lawsuits.

“I’ve been contacted by Goldman customers to bring lawsuits to recover their losses,” he added. “With the SEC bringing fraud charges it’s going to expose what’s behind the curtain.”

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E-MAIL TRAIL

According to the SEC, Goldman marketing materials showed that a third party, ACA Management LLC, chose the securities underlying ABACUS, without revealing Paulson’s involvement.

The SEC complaint quotes extensively from internal e-mails and memos, noting that in early 2007 it had become difficult to market CDOs tied to mortgage-backed securities.

It quoted a January 23, 2007, e-mail from Tourre to a friend as saying: “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 monstrosities!!!”

Another e-mail, to Tourre from the head of Goldman’s structured product correlation trading desk, complained: “The CDO biz is dead we don’t have a lot of time left.”

INDEPENDENCE MATTERS TO CLIENTS

Other communications detail the importance of hiring ACA.

The SEC said Goldman reached out to German bank IKB to buy securities that Paulson was selling, knowing it would buy only securities selected by an independent asset manager.

“We expect the strong brand-name of ACA as well as our market-leading position in synthetic CDOs of structured products to result in a successful offering,” a March 12, 2007, Goldman e-mail said.

IKB ultimately took on exposure to ABACUS, as did the Dutch bank ABN Amro Holding NV.

The German government ultimately bailed out IKB in the summer of 2007, in part because of the bank’s investments, while lenders that eventually bought much of ABN Amro were also subjected to their own government bailouts.

In a statement after U.S. markets closed, Goldman said it lost more than $90 million on the transaction, six times the $15 million fee it received, and provided “extensive disclosure” on the securities involved.

It also said it never represented to ACA Capital Management, which invested $951 million in the transaction, that Paulson was going to be a “long” investor, meaning that Paulson was betting the securities would gain in value.

Paulson & Co paid Goldman $15 million to structure and market the ABACUS CDO, which closed on April 26, 2007, the SEC said. Little more than nine months later, 99 percent of the portfolio had been downgraded, the SEC said.

Janet Tavakoli, president of Tavakoli Structured Finance Inc in Chicago and author of a book on synthetic CDOs, said it may have been common on Wall Street for hedge funds to play big roles in picking mortgage-backed securities for use in CDOs.

“Many investors were not aware of how disadvantaged they were by these CDO structures,” she said.

WASHINGTON IMPACT

The charges are expected to fuel anti-Wall Street sentiment on Capitol Hill where sweeping financial industry reforms are expected to soon arrive on the Senate floor for a vote.

A Democratic bill, strongly supported by President Barack Obama, would slap new restraints on major banks, likely curtailing their opportunities for profit and revenue growth.

Similar legislation was approved in the House of Representatives in December. Analysts believe a bill could be signed into law by Obama by mid-year.

“Banks were getting their mojo back, successfully fighting the regulatory reform bill,” said James Ellman, president of Seacliff Capital in San Francisco. “Clearly, such malfeasance could help get the bill to go through.”

Goldman in 2008 won a $5 billion investment from Warren Buffett’s Berkshire Hathaway Inc.

Last month, Buffett praised Goldman as a “very, very strong, well-run business,” and said of Blankfein, “You cannot find a better manager.”

Buffett had no immediate comment, his assistant Carrie Kizer said.

The SEC lawsuit was assigned to U.S. District Judge Barbara Jones, who was appointed to the bench in 1995 by President Bill Clinton. She presided over the 2005 criminal trial of former WorldCom Inc Chief Executive Bernard Ebbers over an $11 billion accounting fraud at the phone company.

The case is SEC v. Goldman Sachs & Co et al, U.S. District Court, Southern District of New York, No. 10-03229. (Reporting by Jennifer Ablan, Maria Aspan, Clare Baldwin, Karen Brettell, Jeffrey Cane, Elinor Comlay, Kevin Drawbaugh, Steve Eder, Ellen Freilich, Burton Frierson, David Gaffen, Joseph A. Giannone, Matthew Goldstein, Svea Herbst-Bayliss, Ed Krudy, Herb Lash, Grant McCool, Jeremy Pelofsky, Christian Plumb, Aaron Pressman, Leah Schnurr, Jonathan Spicer, Jonathan Stempel, Caroline Valetkevitch, Phil Wahba, Dan Wilchins, Rolfe Winkler, Karey Wutkowski and Rachelle Younglai; Editing by Robert MacMillan and John Wallace)