Goldman Sachs Group Inc reported blow-out quarterly earnings on Tuesday, but investors appeared to focus on the U.S. fraud case against the bank as Britain's market watchdog launched its own probe.

Goldman's results, which failed to boost its shares, came four days after the Securities and Exchange Commission accused the dominant Wall Street bank of defrauding investors by failing to say that a prominent hedge fund manager bet against a Goldman subprime debt product that he helped design.

Goldman's troubles also caused political reverberations. A top Republican U.S. congressman questioned whether politics affected the timing of the government's case, while in Britain, the Liberal Democrat party's leader said Goldman should be banned from UK government contracts until the case is settled.

The negative headlines muted enthusiasm about Goldman's earnings beat, said Anton Schutz, president of Mendon Capital.

You've probably got some long-term long-holders selling stock because they are afraid, Schutz said. You have shorts pressing it because they think they can run with it. How much bad news keeps coming in terms of regulators and suits? It is hard to know where the end is.

Goldman said first-quarter net income nearly doubled to $3.29 billion, bolstered by strength in fixed income trading and principal investments. The earnings of $5.59 a share easily beat analysts' average forecast of $4.01, according to Thomson Reuters I/B/E/S.

The bank reported its lowest-ever first-quarter compensation ratio, but it still set aside $5.5 billion for compensation and benefits in the period.

The reduction in money set aside served to bolster earnings that could bring more public scrutiny to the 141-year old bank, last year described as a giant vampire squid wrapped around the face of humanity by Rolling Stone magazine.

Goldman shares fell 2.05 percent to close at $159.98, even as many other bank shares, including archrival Morgan Stanley, rallied.

Goldman shares have plunged 19 percent over the past week, compared with a 2.1 percent drop in the sectoral Amex Securities Broker dealer index.

The bank's co-general counsel, Greg Palm, rebutted the SEC charges during the bank's earnings conference call.

Palm said the firm was very disappointed that the SEC brought charges and said Goldman would never mislead anyone.

He also said investors who lost money on the subprime mortgage product that is the focus of the SEC suit had a wealth of experience and background in such deals.

Palm faced questions about Goldman's failure to alert investors when it first received a Wells Notice from the SEC regarding the agency's investigation. Palm insisted that Goldman would disclose any investigation or inquiry that it considered material.

We do not disclose every Wells Notice we get because that would not make sense, he said.

'RECKLESSNESS AND GREED'

Goldman's forecast-beating earnings came as Britain's Financial Services Authority (FSA) said it had started a formal investigation into Goldman Sachs International in relation to the SEC allegations. FSA said it would work closely with its U.S. counterpart.

Nick Clegg, leader of the Liberal Democrats, the UK's third-largest party, said the allegations against Goldman are a reminder, if we needed one, of the recklessness and greed that disfigured the banking industry as a whole.

We believe that Goldman Sachs should now be suspended in its role as one of the advisers to the government until these allegations are properly looked into.

Goldman was distressed by the wave of negative publicity and said that most customers remain loyal, Chief Financial Officer David Viniar said.

We are out talking to our clients, he told analysts on the conference call. You can see from our results last quarter that our clients still support us.

Michael Mulaney, a portfolio manager at Fiduciary Trust in Boston, said the SEC matter had affected his view on Goldman shares in part because of client retention issues.

The problem with the SEC suit is if they indeed are convicted of a fraud, the government can't do business with the company, he said. That has potential ramifications if you look at something like their primary dealership.

Some financial institutions are reviewing their dealings with Goldman during the financial crisis to see if they have any legal recourse. American International Group Inc took a loss of up to $2 billion last year as it ended credit default swaps it had written on some Goldman collateralized debt obligations.

U.S. bailout watchdog Neil Barofsky said during a Senate hearing that he would investigate the Abacus deal that the SEC is focusing on to see if AIG had been a victim of fraud.

AIG declined to comment.

IKB DEAL

On Friday, attorneys for Lehman Brothers Holdings Inc filed notices of subpoena for firms including Goldman, seeking access to documents and employees in a probe of whether certain third parties interfered with and damaged Lehman's business.

Goldman has deregistered Fabrice Tourre with the UK financial regulator, the bank said, given that the employee at the center of the case is on paid leave and was therefore not undertaking his registered activities.

The bank said that it had concluded in an earlier internal investigation that Tourre had done nothing wrong.

In the United States, political tensions were heightened by a split along political lines among SEC commissioners last week in a vote on whether to file suit against Goldman.

A top Republican lawmaker is raising questions about the SEC's fraud case against Goldman Sachs, implying political motives -- a charge that the SEC denies.

The timing of the SEC's filing of a civil securities fraud action against Goldman Sachs has created serious questions about the commission's independence and impartiality, said Darrell Issa, the top Republican on the House Oversight Committee, in a letter to the SEC on Tuesday.

Republicans have raised questions about the timing of the case, filed on Friday just before the Senate was to start debating a bill that would usher in new rules for Wall Street.

SEC Chairman Mary Schapiro told reporters on Tuesday that the agency's decision to charge Goldman was absolutely not politically motivated.

(Reporting by Steve Eder and Paritosh Bansal in New York and Steve Slater in London; Writing by Christian Plumb; Additional reporting by Rachelle Younglai and Kim Dixon in Washington, Douwe Miedema and Jon Hopkins in London and Ed Taylor in Frankfurt; Editing by John Wallace and Robert MacMillan)

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