Goldman Sachs Group Inc may be looking at new legal headache, as settlement talks with an Australian hedge fund that invested $100 million in a now toxic mortgage-linked security appear to be breaking down, a source said.

Lawyers working for the Basis Yield Alpha Fund could file a lawsuit against Goldman over the transaction -- called Timberwolf -- as early as Wednesday, said a person familiar with the situation.

Negotiations between Goldman and Basis began months ago, but have heated up in the wake of a lawsuit filed by the Securities and Exchange Commission against Goldman over another subprime mortgage-linked security.

A spokesman for Goldman declined to comment.

The hedge fund purchased a $100 million slug of the Timberwolf collateralized debt obligation in June 2007 at a time when the market for mortgage-linked securities was about to crash.

The managers of the Basis fund claim Goldman's sales and trading desk misled them and the ill-timed Timberwolf purchase helped hasten the fund's demise.

Peter Dobson, a director for the Basis fund, declined to comment on whether the fund's lawyers would file a lawsuit. Dobson, reached at Basis Capital Group's offices in Sydney, said managers of the one-time $500 million fund are committed to reaching the best possible outcome for investors.

Naturally we are pretty passionate about the events of 2007, said Dobson.

The $1 billion Timberwolf CDO was memorably described by a former Goldman executive as one shitty deal, according to an email disclosed during a hearing in April by the Senate Permanent Subcommittee on Investigations.

If Basis does sue over the Timberwolf deal, it would come less than two months after the SEC sued Goldman for civil fraud in connection with the structuring and sale of another CDO called Abacus 2007.

FIGHT OR SETTLE?

Goldman has vowed to fight the SEC charges, but there has been speculation on Wall Street that the investment firm is looking to cut a deal with regulators. Analysts estimate the cost of settling the SEC matter could cost Goldman between $500 million and $1 billion in fines and restitution.

But a breakdown in the settlement talks with the Basis fund may be an indication that Goldman is no mood to roll over and reach a quick deal with the SEC either.

In fact, there are indications that Goldman's relations with regulators are becoming increasingly strained and testy.

On Monday, members of a Congressional panel that's looking into the cause of the financial crisis blasted Goldman for dumping some 2.5 billion pages of digitized records on it, after initially refusing to comply with a request for information.

Philip Angelides, chairman of the Financial Crisis Inquiry Commission, said it was as if Goldman pulled a dump truck to our offices.

Goldman's decision to play hardball with the commission might make sense from a tactical point of view. But the firm's feisty approach toward dealing with regulators and politicians isn't winning over investors.

Shares of Goldman are down 26 percent since the SEC filed its lawsuit on April 16.

They should be bending over backwards to cooperate and get the things taken care of so they can get people focused back on the franchise and the business, said Walter Todd, a portfolio manager with Greenwood Capital, which owns Goldman debt.

(Reporting by Steve Eder and Matthew Goldstein)

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