Financial markets sold off Friday after the U.S. Securities and Exchange Commission charged Wall Street giant Goldman Sachs & Co. with civil fraud.

The Dow Jones Industrial Average closed down 126 points, or more than one per cent, at 11,019. In Toronto, the S&P/TSX composite index gave up 150 points, to close at 12,061.

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Goldman Sachs CEO Lloyd Blankfein gestures while testifying on Capitol Hill in Washington in January. The SEC charged Goldman Sachs with civil fraud on Friday. ((Pablo Martinez Monsivais/Associated Press))

The U.S. government has accused the investment bank of defrauding investors in its disclosures about securities it sold tied to subprime mortgage securities as the housing market was faltering.

Goldman issued a statement saying the charges are "completely unfounded in law and in fact and we will vigorously contest them and defend the firm and its reputation."

Goldman Sachs shares finished lower by $23.57 US on the New York Stock Exchange, down 13 per cent at $160.70.

The commission also announced civil fraud charges against a Goldman vice-president, Fabrice Tourre.

The SEC said that the investment bank failed to disclose that one of its clients, the giant hedge fund Paulson & Co., helped Goldman Sachs create — and then bet against — subprime mortgage securities that Goldman sold to other investors. Two European banks that bought the mortgage securities lost nearly $1 billion, the SEC said.

The agency is seeking to recoup profits reaped on the deal.

"The product was new and complex but the deception and conflicts are old and simple," Robert Khuzami, director of the SEC's division of enforcement, said in a release.

"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," he said.

Alleges Paulson paid Goldman $15M

The SEC charged that Paulson paid Goldman $15 million US in 2007 to create the portfolio that was tied to mortgage-related securities the hedge fund viewed as likely to decline in value.

Separately, Paulson took out a form of insurance that allowed it to make a huge profit when those securities became nearly worthless.

Asked why the SEC did not also pursue a case against Paulson, enforcement director Robert Khuzami said, "It was Goldman that made the representations to investors. Paulson did not."

The civil lawsuit was the U.S. government's most significant legal action related to the mortgage meltdown that ignited the financial crisis and helped plunge the United States and much of the world into recession. Khuzami said the agency is investigating a broad range of practices related to the crisis.

The civil complaint came as legislators seek to crack down on Wall Street practices that helped cause the financial crisis. Among proposals Congress is weighing are tougher rules for complex investments like those involved in the alleged Goldman fraud.

'It pulls the curtain back so the investing public can finally see how business is done on Wall Street.'—Bill Singer, securities lawyer

Bill Singer, a New York-based securities lawyer at rrbdlaw.com, told CBC News he applauds the SEC lawsuit, because "it pulls the curtain back so the investing public can finally see how business is done on Wall Street."

"It is attacking the very nature and fibre of how business is done on Wall Street and how it's been done for generations," Singer said.

"A line's been drawn in the sand with this case. [The SEC is] basically accusing Goldman Sachs …  of planting the financial equivalent of an improvised explosive device in the middle of the investing public, knowing that it's going to go off and explode, which it did."

Singer said he expects the case will be decided on whether investors were adequately warned of the risks. The risks should have been well known, he said, given the many warnings analysts were making in 2007 about subprime mortgages.

With files from The Associated Press