Goldman Sachs has been one of the most politically-connected firms on Wall Street, but apparently that didn’t do much to protect them from the Securities and Exchange Commission.  The SEC charged Goldman Sachs and one of its high-ranking executives with fraud today, alleging that it advised investors to go bullish on mortgages while GS secretly sold short:

The Securities & Exchange Commission charged Goldman Sachs Group Inc. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages.

The SEC said Goldman Sachs structured and marketed a synthetic collateralized-debt obligation, or CDO, that hinged on the performance of subprime residential mortgage-backed securities.

The CDO was structured and marketed by Goldman in early 2007 when the U.S. housing market and related securities were beginning to show signs of distress, the SEC complaint said.

According to the SEC, Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO. …

“Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party,” Mr. Khuzami said.

What makes this particularly interesting was that GS has aligned itself behind the Obama administration’s financial reform plans. Timothy Carney noted that this morning in the Washington Examiner:

The nation’s largest investment bank, famously cozy with top government officials in both parties, has tipped its hand to its shareholders, indicating that major financial “reform” proposals will help Goldman’s bottom line.

“Given that much of the financial contagion was fueled by uncertainty about counterparties’ balance sheets,” Goldman Chief Executive Officer Lloyd Blankfein and President Gary Cohn wrote in a letter at the beginning of the annual report, “we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions.” …

Another pillar of Obama’s financial reform is the “Volcker Rule,” which would restrict the trading banks can do. Blankfein and Cohn, in their letter, indicate to shareholders that this rule will be no big deal for them.

The Volcker Rule would bar “proprietary trading” by Goldman (that is trading simply to benefit Goldman’s bottom line) but would not restrict dealings “related to” serving the bank’s clients. But even Goldman’s most notorious financial dealings, transactions with failed insurance giant AIG, were client-related, Goldman told shareholders: “The net risk we were exposed to,” Blankfein and Cohn wrote, “was consistent with our role as a market intermediary rather than a proprietary market participant.”

In other words, almost any deal Goldman would make could be tied to a client, meaning the Volcker Rule couldn’t touch Goldman, even if it cramps the style of smaller, less well-connected banks.

Carney also gives us a reminder of the importance of GS in Washington politics with this recollection from the last presidential election:

Goldman is lobbying hard on financial regulation, but that doesn’t mean they’re lobbying “against” regulation. And they certainly shouldn’t be considered White House foes: Goldman was Obama’s No. 1 corporate source of funds in 2008.

What will this do for the financial reform efforts on Capitol Hill? They may already be in trouble, as the Wall Street Journal notes that Chris Dodd’s bill makes federal bailouts a lot more likely in the future:

The main author of the Senate bill, Chris Dodd of Connecticut, says the latest draft of his bill to reform financial regulation “will end bailouts.” We wish that were true. This evolving legislation still allows regulators to deploy unlimited sums to rescue financial giants, and with too much discretion. …

The Dodd bill, instead, still gives regulators the authority to rescue essentially the entire financial industry. While much debate has centered around the FDIC’s new “resolution” authority for failing firms, there’s been almost no discussion around a separate FDIC program under which the agency can guarantee corporate debts. To Mr. Dodd’s credit, this provision has improved slightly. In an earlier draft, the Fed and the new systemic risk council could have applied FDIC debt guarantees even if the FDIC itself opposed such bailouts.

Now the FDIC has to be on board, but the core problem remains—an even more explicit taxpayer backstop than anything Fannie Mae and Freddie Mac enjoyed during the housing bubble, and one that’s available to a virtually unlimited number of firms. Federal regulators can create a “widely available program” to guarantee the debts of not just banks, but their parent companies as well, and all of their affiliates.

Fannie and Freddie were rolling the dice with an implied backstop, but this legislation would allow regulators, without a vote of Congress, to explicitly put the full faith and credit of the U.S. government behind Goldman Sachs, JP Morgan and Morgan Stanley, among others. This list could have more than 8,000 names on it, because any bank or company that owns a bank, or is a affiliated with a company that owns a bank, is eligible.

We don’t need to codify bailout strategies; we need to end them. Financial reform should make an absolute end to the necessity of bailouts its primary goal. Instead, we’re getting more “too big to fail” thinking, along with Congress’ natural inclination to grant itself powers the Constitution never intended it to have.

Hopefully, the Goldman Sachs charges will put a brighter light on this mainstreaming of federal bailouts.