The Securities & Exchange Commission sued Goldman Sachs for securities fraud today, saying that the financial powerhouse made “materially misleading statements and omissions” regarding a structured product sold to investors.

The product was tied to the performance of subprime residential mortgages and was structured and marketed in early 2007, just when the U.S. housing market first showed signs of strain, the suit said.

The SEC alleged that investors were not told that hedge fund Paulson & Co. had a hand in the selection of residential mortgages that were part of the structured product.  Paulson subsequently made a profit of about $1 billion from this product by betting that the housing market would fall.

After the selection of the portfolio for this product, Paulson effectively shorted the residential mortgage backed market by using credit default swaps. The suit says that  “Paulson had an economic incentive to choose [residential mortgages] that it expected to experience credit events in the near future.” And Goldman’s product did not disclose Paulson’s contrarian economic interests. Indeed, Paulson’s selection process for this product favored borrowers with adjustable rate mortgages, relatively low FICO scores, and who were located in states like Arizona, California, Florida and Nevada, which had recently experienced steep inclines in home value.

The suit also names Goldman employee Fabrice Tourre for devising the transaction, preparing the materials and communicating directly with investors. Touure, 31, was a registered rep and vice president on the structured product correlation desk in New York. Tourre currently works in London as Executive Director of Goldman Sachs International. According to the suit, Tourre knew of Paulson’s undisclosed short interest and its role in the selection process.

For his part, Paulson had begun taking a bearish view on subprime mortgages in 2006 and came to believe there would be significant losses in this market. About the same time, Goldman recognized the market conditions in the mortgage market were becoming tougher and products back by mortgage securities were becoming a tough sell.

According to the suit, an email sent by Tourre to a friend on Jan. 23, 2007 said:  “More and more leverage in the system, the whole building is abut to collapse anytime now...”

And less than a month later, Tourre received an email from the structured product correlation trading desk that said: “the cdo biz is dead we don’t have a lot of time left.”

Goldman said in a statement that the SEC’s charges are “completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”

The SEC is seeking “injunction relief, disgorgement of profits, prejudgment interest, civil penalties and other appropriate and necessary equitable relief from both defendants,” the suit said. The SEC could not be reached for further comment.