A hedge fund is taking aim at the world's biggest banks in an effort to recoup $1.2 billion it lost on subprime mortgages, entering a legal fight where so far Wall Street has largely been unscathed.

The lawsuit by Cambridge Place Investment Management against Morgan Stanley , Goldman Sachs Group Inc and about 10 other banks, is one of the biggest cases of its kind to be filed so far in U.S. courts.

The case cites a sizable number of so-called confidential witnesses quoted in the lawsuit, who said underwriting standards were abandoned in order to meet demands for mortgages from Wall Street.

The case could encourage other investors, such as large pension funds, to bring similar lawsuits against Wall Street.

Law firms representing investors have an inventory of related cases that they are considering filing, and they will be following the Cambridge case closely, said James Cox, a professor at Duke University Law School.

Several aspects of the lawsuit might help it overcome some of the problems of earlier attempts to pin the subprime meltdown on Wall Street banks, Cox said. For example, the case was filed under investor-friendlier Massachusetts state law, rather than federal law.

Gerald Silk, a partner at Bernstein Litowitz Berger & Grossmann LLP, which represents the plaintiff, said he believes the Massachusetts investor protection laws provide us with a powerful weapon to uncover the unscrupulous conduct by the Wall Street banks and recover our client's significant losses.

The lawsuit brought by Cambridge centers around residential mortgage-backed securities (RMBS), which are bonds backed by home loans. Cambridge invested $2.4 billion in the securities.

When the U.S. housing market began to collapse in 2006 and 2007, many of the RMBS, which were assembled by the banks, plummeted in value as record number of homeowners fell behind on their housing payments. The collapse of the RMBS spread around the globe and helped spark the financial panic of 2008.

Cambridge in 2007 closed its Caliber Global Investment Ltd, a fund that invested more than $900 million in mortgage securities.

Goldman Sachs and Morgan Stanley declined to comment on the lawsuit. Two other defendants, JPMorgan Chase & Co and Citigroup Inc , also declined to comment.

Investors in subprime securities have faced an uphill battle in their legal fights. The banks that churned out the mortgage bonds largely have been able to point to disclosures that accompanied the securities and have blamed macroeconomic factors for the investment losses.

As a result, the banks have been able to have most subprime-related cases dismissed.

The Cambridge complaint includes a long list of misdeeds unearthed by congressional investigations and allegations by confidential witnesses.

Those include unidentified underwriters and managers at loan originators who say that lending guidelines were tossed aside in order to generate enough loans to feed Wall Street firms.

An underwriter at Option One in Pleasanton, California, was quoted in the complaint describing how managers would fight for approval of loans even after fraud had been discovered.

(Option One) didn't have to worry about it, because once they're done with these crappy loans, they'd sell them off. They were the investors' problem.

Cox said the case could prompt large pension funds to bring similar cases. Some big public pension funds already have brought subprime-related litigation, such as a lawsuit filed by the California Public Employees Retirement System against rating agencies that assigned what the pension fund has said were wildly inaccurate reports on mortgage securities.

Also on Monday, the federal regulator of Fannie Mae and Freddie Mac said it is was investigating whether the issuers of private mortgage bonds are liable for losses suffered by the two housing finance giants. The regulator did not name the target of the investigation.

Jill Fisch, a law professor at the University of Pennsylvania Law School, said the subprime-related cases have lacked a smoking gun, and the Cambridge lawsuit may, too.

It looks like they are saying Morgan Stanley should have done more due diligence, she said. That kind of stuff is hard to prove.

The complaint comes just days after Liberty Mutual Insurance Co sued Goldman Sachs, accusing the investment bank of fraudulently misleading it into buying the now virtually worthless preferred stock of Fannie Mae.

The Cambridge case was also brought against units of Credit Suisse AG , HSBC Plc , Barclays Plc , Royal Bank of Scotland Plc , Deutsche Bank AG , UBS AG FBR Capital Markets Corp , Bank of America and GMAC LLC.

Barclays and Deutsche Bank declined to comment and the others did not return calls for comment.

The case is Cambridge Place Investment Management Inc v Morgan Stanley & Co Inc et al, Suffolk Superior Court, Commonwealth of Massachusetts, No. 10-2741

(Reporting by Tom Hals; Editing by Gary Hill and Tim Dobbyn)

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