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Yesterday, The Goldman Sachs Group Inc. (GS - Analyst Report) was sued by Liberty Mutual Insurance Co. and several other investors including Peerless Insurance Co., Employers Insurance Co., Safeco and Liberty Life Assurance Co. The complaint lodged claims Goldman misrepresented the financial condition of Freddie Mac (FMCC) as an underwriter of Freddie's offering of Series Z preferred stock in late 2007.

Based in McLean, Virginia-Freddie Mac is a company licensed by Congress to provide liquidity to the U.S. mortgage market. It purchases mortgage loans from banks and bundles them into mortgage-backed securities that are sold to investors.

According to the lawsuit, Freddie Mac issued 240 million shares of Series Z preferred shares in November 2007, which raised approximately $5.9 billion. The shares were supported by billions of dollars in subprime residential mortgages.

The investors alleged that Goldman misled them with statements and omissions related to the preferred stock offering based on which they invested $37.5 billion. The lawsuit is filed against Goldman but Freddie Mac is not named as a defendant in the complaint.

According to investors, at the time of the Series Z preferred stock offering, Goldman claimed Freddie Mac has met its regulatory capital requirements and stock offering is conducted to strengthen Freddie Mac’s capital base. Further, they complained Freddie's capitalization level was already known at that time and Freddie was exposed to risky subprime and Alt-A mortgages.

Insurance companies have stated that the purpose of the offering was false and Goldman intentionally misrepresented the fact that Freddie Mac had met its regulatory capital requirements and has remained undercapitalized even after the sale of the preferred stock.

These misrepresentations of the risks faced by Freddie provoked investors to participate in investments, which have virtually no value at current levels. However, a spokesman of Goldman commented the suit is baseless and the company will defend it strongly.

Last year also, Goldman settled a charge by paying $550 million for not disclosing to the buyers the role of a hedge fund in formulating the CDOs and taking a short position and betting on them to perform poorly in the open market. The SEC has stepped up its investigation on Wall Street companies over the sale of CDOs that were responsible for significant losses to investors and the financial crisis.

While such charges will dent Goldman’s reputation and its financials, we believe that investors should feel relieved who have lost their hard-earned money in such investments.

Shares of Goldman currently retain a Zacks #5 Rank, which translates into a short-term Strong Sell rating.

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