While we were just chatting about how to stuff a CDO with toxic waste, speak of the devil, someone is suing trying to get their money back.

Morgan Stanley is being sued over a $1.2 billion worth of defaulted CDOs.

Morgan Stanley (MS.N) has been sued by a Virgin Islands pension fund that accused the Wall Street bank of defrauding investors by marketing $1.2 billion of risky mortgage-related notes that it expected to fail.

The lawsuit filed December 24 in Manhattan federal court said Morgan Stanley collaborated with credit rating agencies Moody's Investors Service and Standard & Poor's to obtain "triple-A" ratings for notes marketed in 2007 as part of a collateralized debt obligation (CDO) known as Libertas.

According to the complaint, the CDO was backed by low-quality assets, including securities issued by subprime lenders New Century Financial Corp, which quickly went bankrupt, and Option One Mortgage Corp, then owned by H&R Block Inc (HRB.N).

The complaint alleged Morgan Stanley knew the CDO's assets were far riskier than the ratings suggested, but was "highly motivated to defraud investors" with pristine ratings because it was simultaneously "shorting" almost all the assets. This was a bet that their value would fall, which they did in 2008.

"Morgan Stanley was betting the entire investment it was promoting would fail," according to the complaint, which was made available on Tuesday. "The firm achieved its objective."

So, in seems not only was Goldman Sachs placing bets their own products would default, but other financial institutions were also in on the game!

Will the act of simply placing bets that the product you just sold a bunch of suckers will tank be enough to win a legal case?

For as discussed, proving that the CDO itself was purposely rigged is impossible.

Yet, there are many ways to skin a cat and surely placing major bets almost immediately against a product you just created out of mathematic and computation fictional air, then painted glossy with the collusion of a few credit rating agencies...

surely that will be enough for the plaintiffs to win.

On the other hand, we have an unknown quantity of these toxic derivatives running around. What if everyone sued?

Update: Yves Smith has an exceptional post on Synthetic CDO practices in reference to the above lawsuit.

You should read it because it goes into the differences of CDO types as well as the sham of Goldman Sachs responses to date.

With a synthetic CDO, no one puts up cash. It is a little corporate entity. The asset side is various credit default swaps, in this case, “referencing” mainly subprime bonds, the BBB tranches. So the cash flow comes from the premium payments on these CDS. The liability side is tranched, so you have an equity tranche, BBB, A, AA, and a junior AAA layers, then say two more AAA layers and the infamous super senior tranche (there could be more tranches than this, but you get the general idea). But the investors do not make cash payments; they are effectively protection sellers, or insurers.

The world of derivatives is beyond belief complex and what better place to hide deception and fraud? Yves Smith notes that quite often less than 1000 people in the entire globe had any understanding of a particular CDO structure and type. Not good to be investing in something one has no clue what it's about.