An Australian hedge fund is suing Goldman Sachs Group Inc over an investment in a subprime mortgage-linked security that hastened the fund's demise in 2007, a lawyer for the fund said.

The lawyer, Eric Lewis, said Basis Yield Alpha Fund is suing Goldman to recoup the $56 million it lost on the now notorious Timberwolf collateralized debt obligation, which garnered a lot of attention during a recent congressional hearing.

The lawsuit, being filed on Wednesday in U.S. District Court for the Southern District of New York, also seeks $1 billion in punitive damages from Goldman.

The hedge fund decided to file the suit after months of settlement talks with Goldman broke down. Reuters first reported on the likelihood of a lawsuit being filed on Tuesday.

The 36-page complaint, a copy of which was provided to Reuters, opens with a rhetorical flourish that repeats a Goldman executive's description of the Timberwolf CDO as one shitty deal.

The suit alleges that Goldman pitched the Timberwolf deal to Basis even as the bank's sales force and mortgage traders knew the market for CDOs could soon crumble. In June 2007, Basis paid $78 million for two pieces of the CDO with a face value of $100 million.

Basis, which financed the transaction with a loan from Goldman, said it lost more than $50 million when Goldman began to make margin calls on the product just weeks after selling the deal. Basis said the margin calls quickly forced it into insolvency.

You can't say you are basically selling a strong performing high-yielding security that you know is going to tank, said Lewis, a partner with the law firm Baach Robinson & Lewis.

Goldman called the suit a misguided attempt by Basis ... to shift its investment losses to Goldman Sachs.

Michael Duvally, a Goldman spokesman, said, Basis is now trying to recoup its losses based on false allegations that it was misled about aspects of the transaction and market conditions.

The $1 billion Timberwolf CDO and the aggressive tactics Goldman employed to sell the deal were a focal point of an April hearing by the Senate Permanent Subcommittee on Investigations. One of the documents unearthed by the Senate panel was an email in which former Goldman montage executive Thomas Montag called Timberwolf one shitty deal, just days after the firm completed the sale to Basis.

(Reporting by Steve Eder and Matthew Goldstein; editing by John Wallace)