Goldman's sweep for internal emails containing client insults like "muppet," a scoop by my Reuters colleague Lauren LaCapra, got lots of well-deserved snark as the bank's latest too-little-too-late response to Greg Smith's "Why I Am Leaving Goldman Sachs" op-ed. In case you're just returning from a vacation in Antarctica, which is pretty much the only way you could have avoided the financial world's equivalent of Kim Kardashian's divorce, Smith, a London-based Goldman executive director, said he was sick and tired of the bank's callous treatment of its clients. "It's purely about how we can make the most possible money off of them," Smith wrote in the New York Times. "If you were an alien from Mars and sat in on one of these meetings, you would believe that a client's success or progress was not part of the thought process at all."

Why Smith's piece was considered a revelation is mystifying, given Goldman's starring role in last April's 635-page Senate report on Wall Street and the financial crisis. We all know about the Securities and Exchange Commission scrutiny of the Abacus deal, in which Goldman permitted hedge fund manager John Paulson to pick underlying mortgages that doomed the collateralized debt obligation it was hawking to clients, and the famous "one shitty deal" otherwise known as the Timberwolf mortgage-backed CDO. As the Senate report explains, both were part of Goldman's institutional effort to secretly reverse its own long position in residential mortgage-backed securities even as it marketed MBS investments to clients.

That's the campaign U.S. District Judge Victor Marrero of federal court in Manhattan detailed in a 64-page ruling Wednesday that greenlights most securities and common law fraud claims by investors in two other rigged-to-fail CDOs, Hudson 1 and Hudson 2. (Here's Jon Stempel's Reuters story on the ruling.) Marrero's decision doesn't have the freewheeling rhetorical flair (or 1980s pop references) of Delaware Chancellor Leo Strine's much-discussed opinion on Goldman's conflicts in Kinder Morgan's proposed acquisition of El Paso Corporation, but in a way it's a much more devastating ruling. Marrero portrays a sweeping, months-long effort, initiated by Goldman CFO David Viniar, to shed the bank's exposure to subprime mortgages in mortgage-backed securities -- and simultaneously to take advantage of clients who were slower to perceive the looming MBS market collapse.

As I read through Marrero's decision, I kept thinking of the movie Margin Call, in which Kevin Spacey suffers a crisis of conscience as he oversees a sell-off of his bank's MBS portfolio, at the expense of the clients buying the securities. Goldman, like the unnamed investment bank in the movie, came to a sudden realization that it had to shed MBS exposure. But its bankers were much smarter than their counterparts in Margin Call. They didn't just sell off their portfolio, according to the Marrero ruling. They created doomed CDOs, hedged against the (inevitable) failure of their own instruments, and gladly accepted fees from the clients they allegedly duped into buying the securities. It was a breathtakingly brilliant campaign, if you're of a ruthless bent. Goldman's secret MBS short, as Marrero depicts it, tricked not just its own clients but the entire MBS marketplace.

I should note here that Marrero's ruling is preliminary. To decide whether to dismiss the case at this stage, the judge must assume all of the allegations in the Hudson investors' complaint are true. (The investors, represented by Berger & Montague, relied heavily on evidence from the Senate subcommittee report.) There hasn't been additional discovery in the Hudson case, and Goldman's lawyers at Sullivan & Cromwell have argued that the bank fully disclosed its hedge against the CDO to the sophisticated investors who purchased Hudson instruments; other federal judges who've considered securities fraud class actions based on similar allegations regarding other controversial Goldman CDOs have agreed with the bank's argument. (Goldman declined a Reuters request to comment on the ruling.)

With those caveats, Marrero portrays a scheme he describes as "not only reckless, but bordering on cynical." As early as 2005, he said, Goldman began to understand through its own underwriting and its relationship with the outside mortgage appraiser Clayton Holdings that mortgage lending standards were deteriorating. Goldman Sachs had bet heavily on the continued success of mortgage-backed securities, and by the summer of 2006, knew that was a bad bet. The problem, according to the co-manager of the bank's structured products unit (quotes in Marrero's ruling), was that there were "few opportunities" to shed Goldman's MBS risk. The market believed the bank was "very long for the foreseeable future," according to another Goldman official Marrero cited.

Nevertheless, in December 2006, CFO Viniar directed the structured finance group to begin aggressively ridding the bank of subprime risk and positioning Goldman to take advantage of "very good opportunities as the market goes into what is likely to be even greater distress." Thus was born the program of shorting Goldman-devised (and Goldman-sold) CDOs based on mortgage-backed securities. The program was so successful that according to filings Marrero cited, Goldman had a net short position of $2.1 billion in credit default swaps on mortgage-backed instruments by March 2007. By August 2007, Goldman told the SEC, it had reduced its overall exposure to subprime mortgage backed securities from $7.2 billion to $2.4 billion. Through what Marrero called "the fine art of financial transubstantiation," Goldman (in the words of one of its bankers) managed "to make some lemonade from some big old lemons."

The Hudson CDO offerings came smack in the middle of Goldman's risk reduction campaign, context that was crucial to Marrero's decision not to dismiss most of the investors' case. Goldman's own actions -- "selecting the referenced (residential) MBS and then betting heavily against them" -- indicated to Marrero that the bank well understood the risks of its subprime exposure and "maneuvered" to offload it. "All Goldman needed for the success of its venture was large 'sophisticated' investors (to) drink up the bittersweet potion despite Goldman's boilerplate warnings," the judge wrote. "Goldman thus managed to shift its significant subprime risk over to its own clients."

That's muppeteering on a whole different level.

(Reporting by Alison Frankel)