Big winner in government’s JPMorgan suit: A hedge fund

Seth Klarman, the reclusive Boston hedge fund manager, could be the big winner in the recently filed New York Attorney General’s lawsuit against JPMorgan Chase (JPM).

Klarman’s Baupost Group is acting as the lead plaintiff in a private case against EMC, the former Bear Stearns mortgage unit that is also the focus of NY AG Eric Schneiderman’s case against JPMorgan. And if things go Klarman’s way, Baupost alone could end up collecting about $310 million from JPMorgan, with a big assist from the government.

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Klarman’s suit is one of the many so-called put-back cases bedeviling the banks right now, in which investors who bought mortgage bonds in the year or so leading up the credit crisis, when loan officers were basically handing out mortgages like candy on Halloween, are demanding their money back.

But here’s what’s interesting about the Baupost case: Klarman isn’t one of those investors who got burned in the mortgage bust. In fact, Klarman is famously one of the few investors on Wall Street who made money betting against the housing market. Then, in early 2009, Klarman shifted gears. He began snapping up mortgage bonds. At the time, subprime mortgage bonds were selling for $0.40 on the dollar. That means Klarman probably spent around $160 million on the bonds related to the JPMorgan litigation. And once he did, Klarman put himself and his investors in a position to claim, even though he predicted better than most Wall Street’s house of cards, that they, like other investors, were lied to.

Klarman has a history of unusual investments. Earlier this year, Fortune wrote about how Klarman had bought up a big chunk of Canadian farmland, and that locals were doing everything they could to stop him from turning some of their country’s most fertile land into a quarry.

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On Wall Street, though, Klarman, who has returned his investors nearly 20% a year for the past two decades, gets a much better reception. At Fortune‘s recent Most Powerful Women summit, Pimco’s CEO Mohamed El-Erian said Klarman was one of only three people he has met in his life that he would call brilliant. Klarman’s out-of-print investment book sells for $1,700 on Amazon.

Baupost filed its suit against EMC a little over a year ago. It has to do with one deal, which was called Bear Stearns Mortgage Funding Trust 2007 AR-2.

EMC was the unit of Bear that funded or bought up home loans, packaged together and then turned into those loans into mortgage bonds that were sold off to investors. EMC, along with Bear, was bought by JPMorgan in early 2009. Klarman’s suit says that EMC told investors that the loans had been fully vetted and met a number of underwriting standards that would guarantee that a majority of the loans would indeed be paid back.

Instead, the Baupost suit says, 82% of mortgages in BSMFT 2007-AR2 ended up in default, or had to be liquidated in foreclosure. Among the loans that were included in the trust, according to the suit, was a $720,000 mortgage to someone who worked at an IHOP restaurant, another to a casino maid that brought her debt payments to nearly $5,000 a month and one to someone who claimed they made $130,000 a year pouring concrete.

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A person close to the litigation says that Baupost knew there were problems in the housing and mortgage market, but that the fund bought the distressed mortgage bonds in 2009 anyway because they had fallen to prices that made them attractive. Nonetheless, the person said that Baupost was surprised to later find out that many of the loans tied to the mortgage bonds it had bought never met the qualifications the underwriters claimed.

The NY AG suit, which was filed in early October, also alleges that the mortgages that EMC was buying up and selling off were not what EMC claimed them to be, and that Bear bankers knew it. Both the Klarman suit and the AG suit contain the same same e-mail from an EMC manager detailing the pressure she was under from Bear bankers to make more loans.

“I want to see 500+ each day,” the manager wrote. “I’ll do what ever is necessary to make sure you are successful in meeting this objective.”

JPMorgan says the AG’s suit is based on recycled claims and has to do with behavior that happened before Bear was acquired by the bank.

Not all of Klarman’s bets have paid off, or not as large as he would have hoped. Earlier this year, Baupost dropped its objection to a $8.5 billion settlement Bank of America (BAC) made with bond investors. Baupost had been pushing B of A for more.

But with the AG suit, legal experts say it’s more likely Klarman will get JPMorgan to pay up. “The Martin Act gives the NY AG superior subpena power than any private plaintiff has,” says Isaac Gradman, a lawyer who specializes in securities claims. “So Schneiderman could get much more than anything Baupost has unearthed so far.”