Greywolf Cap battles with bank over failed CDO

* Firm with Goldman ties is suing Fortis

* Lawsuit stems from CDO that never came to market

* CDO would have followed controversial Goldman deal

By Matthew Goldstein

NEW YORK, May 6 (Reuters) - Greywolf Capital Management, the little-known investment firm that worked with Goldman Sachs Group (GS.N) on a controversial subprime mortgage-linked security, is embroiled in a legal battle with a European bank over a similar security that never got to market.

The Purchase, New York firm, which manages four small hedge funds, is suing Fortis Securities, now part of BNP Paribas Fortis [FORBK.UL] (BNPP.PA), for more than $175 million in damages.

Greywolf contends it lost money when Fortis backed out of a deal to serve as the underwriter on a $1 billion collateralized debt obligation called Timberwolf II, according to court papers filed in New York State Supreme Court. The Fortis-led deal was going to be the successor to Timberwolf 1, a CDO that Greywolf put together with Goldman and began selling to institutional investors in March 2007.

Fortis, meanwhile, is suing Greywolf for $400 million in damages it claims to have incurred in the process of warehousing, or gathering, some of the underlying subprime-mortgage linked securities that were going to make up the Timberwolf II portfolio.

The nearly two years of legal wrangling between Greywolf and Fortis shows that even deals that never got done in the waning days of the U.S. housing bubble -- not just busted CDOs -- are sparking litigation.

The Timberwolf 1 transaction, which lost most of its value in five months and was liquidated in June 2008, has drawn lots of scrutiny of late. A U.S. Senate panel investigating Goldman's role in the subprime mortgage mess released an email in which a former Goldman executive aptly characterized Timberwolf 1 "as one shitty deal."

Lawyers for Greywolf and Fortis declined to comment on the litigation.

But court papers in the case reveal that the planning for Timberwolf II began even before the ink was dry on Timberwolf. Greywolf and Fortis signed an engagement letter to begin work on Timberwolf II in Feb. 21, 2007.

By summer 2007, Fortis began backing away from the deal because of the value of CDOs began to quickly crumble. Greywolf argues the deal could have been completed that summer had "Fortis not breached its obligations under the engagement letter."

The market for CDOs largely ground to a halt in summer 2007 with the collapse of two Bear Stearns hedge funds that were big investors in subprime-backed CDOs. The Bear hedge funds, for instance, were the single largest investors in Timberwolf 1.

It's not clear from court papers why Greywolf chose Fortis to underwrite the second Timberwolf deal and not Goldman.

But Greywolf and Goldman have close ties.

Greywolf was founded in 2003 by a group of former Goldman distressed bond traders. In January 2007, Greywolf and Goldman joined forces on a $502 million collateralized loan obligation called Greywolf CLO, a deal that bundled together loans used to finance corporate buyouts.

Goldman's hedge fund subsidiary has a $43 million investment in Greywolf Capital Partners II, one of Greywolf's largest hedge funds.

A year ago, Greywolf Capital Partners II reported taking in $525 million from investors mainly in California, Connecticut, Illinois and New York. Other institutional investors in the fund, which invests mainly in distressed securities and bonds, include Bank of America's Columbia Management, Old Mutual and Promark Investment Advisors, according to regulatory filings.

Greywolf did not work on the Abacus 2007 transaction that is the subject of a civil fraud lawsuit filed by the U.S. Securities and Exchange Commission against Goldman. But Goldman used some of the proceeds from the Abacus CDO to purchase a $192 million chunk of the Greywolf CLO that wasn't sold to investors.

Ever since Greywolf's name surfaced in connection with the Goldman scandal, the investment firm's managers have hunkered down. The firm has referred all media inquires to its public relations firm, Abernathy Macgregor, which has declined to comment.

In recent days, Greywolf has taken information down from its website, including biographies of the firm's partners.

Greywolf's assets under management have shrunk considerably in recent years.

In early 2007, the firm reported $2 billion in assets under management and managed six hedge funds. As of Thursday, Greywolf said its assets are down to $848 million.

(Reported by Matthew Goldstein; Editing by Richard Chang)