Goldman sued by hedge fund over notorious CDO deal

NEW YORK (Reuters) - An Australian hedge fund is suing Goldman Sachs Group Inc over an investment in a subprime mortgage-linked security that contributed to the fund’s demise in 2007.

A Goldman Sachs sign is seen over their kiosk on the floor of the New York Stock Exchange, April 26, 2010. REUTERS/Brendan McDermid

The lawsuit filed on Wednesday accuses Goldman of misrepresenting the value of the notorious Timberwolf collateralized debt obligation, which garnered a lot of attention during a recent congressional hearing.

Basis Yield Alpha Fund sued Goldman to recoup the $56 million it lost on the CDO, said Eric Lewis, a Washington-based lawyer for the fund. The suit also seeks $1 billion in punitive damages.

The litigation is the latest in a string of legal and public relations headaches for Goldman. In April, U.S. securities regulators charged the powerful Wall Street bank with civil fraud in connection with the structuring and sale of another CDO called Abacus 2007.

The Financial Times reported on Wednesday that the U.S. Securities and Exchange Commission was examining another Goldman CDO -- Hudson Mezzanine Funding -- that was not part of the April civil fraud lawsuit. The FT, citing people familiar with the matter, said the inquiry into the $2 billion CDO was part of a wider probe into the CDOs of Wall Street banks.

The Australian hedge fund decided to file suit after months of settlement talks with Goldman broke down. Reuters on Tuesday first reported on the likelihood of a lawsuit. The suit was filed in U.S. District Court for the Southern District of New York.

The 36-page complaint opens with a rhetorical flourish that repeats a Goldman executive’s description of the Timberwolf CDO as “one shitty deal.”

See here for a copy of the complaint.

The suit alleges that Goldman pitched the Timberwolf deal to Basis even as the bank’s sales force and mortgage traders knew the market for CDOs could soon crumble. In June 2007, Basis paid $78 million for two pieces of the CDO with a face value of $100 million.

Basis, which financed the transaction with a loan from Goldman, said it lost more than $50 million when the bank began making margin calls on the product just weeks after selling the deal. Basis said the margin calls quickly forced it into insolvency.

“You can’t say you are basically selling a strong performing high-yielding security that you know is going to tank,” said Lewis, a partner with the law firm Baach Robinson & Lewis.


Goldman called the suit “a misguided attempt by Basis ... to shift its investment losses to Goldman Sachs.”

Michael DuVally, a Goldman spokesman, said, “Basis is now trying to recoup its losses based on false allegations that it was misled about aspects of the transaction and market conditions.”

The $1 billion Timberwolf CDO and the aggressive tactics Goldman employed to sell the deal were a focal point of an April hearing by the Senate Permanent Subcommittee on Investigations. One of the documents unearthed by the panel was an email in which former Goldman mortgage executive Thomas Montag called Timberwolf “one shitty deal,” just days after the firm completed the sale to Basis.

The hedge fund’s lawsuit, which draws on other documents introduced by the Senate panel, alleges that Goldman misrepresented the value of the Timberwolf securities and failed to disclose that Goldman’s trading desk had a role in working with Greywolf Capital Management in picking Timberwolf’s underlying securities.


During the Senate subcommittee hearing in April, Goldman Chief Executive Lloyd Blankfein said the bank’s employees are often unaware of what strategies are being employed elsewhere at the firm.

“We have 35,000 people and thousands of traders making markets throughout our firm,” Blankfein said in response to a question from Senator Carl Levin. “They might have an idea. But they might not have an idea.”

But the Basis lawsuit raises new questions about the coordination between Goldman’s trading desks and its sales staff.

David Lehman, who joined Goldman in 2004 and worked as a managing director in Goldman’s mortgage trading operation, met with representatives of Basis to convince them that the prices Goldman was selling the Timberwolf deal at were fair and legitimate.

The lawsuit alleges that Goldman’s sales and trading desks worked together to sell the deal, while Goldman itself was betting against the performance of the CDO.

“This is not a bad case for dealing with the whole issue of how Goldman was conducting its business,” said Lewis. “They were selling bonds like they were used cars, in that you say what you need to get it done.”


Other investors in Goldman’s CDO products are likely to keep a close eye on the Basis case.

“If they can prove there is some smoke there, many investors could feel they have a right to say they were also harmed in some way,” said Matt McCormick, a portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel in Cincinnati.

Still, lawsuits against firms over the marketing of toxic CDOs have been rare.

Scott Berman, a partner with Friedman Kaplan Seiler & Adelman who frequently represents institutional investors, said it’s a bit of mystery that the financial crisis hasn’t spawned more private litigation over CDOs and other exotic investments.

“Some of it may be being dealt with in private arbitration rather than litigation,” said Berman. “It’s also possible that many institutions are simply wary of suing each other.”

The case is Basis Yield Alpha Fund (Master) v. Goldman Sachs Group Inc, U.S. District Court, Southern District of New York, No. 10-04537.

Reporting by Steve Eder and Matthew Goldstein; editing by John Wallace, Andre Grenon and Bernard Orr