Dec. 21 (Bloomberg) -- Lehman Brothers Holdings Inc., the largest U.S. underwriter of mortgage-backed bonds, faces legal action by Australian municipal governments after the value of their subprime-related investments dropped as much as 86 percent.

Wingecarribee Shire Council, in the Southern Highlands in New South Wales state, is suing Lehman for ``deceptive and misleading conduct'' in selling A$3 million ($2.6 million) of subprime-linked collateralized debt obligations, the council's managing director Mike Hyde said in a media statement today.

New York-based Lehman, which manages up to A$1 billion on behalf of 35 councils in New South Wales and Western Australia states, may face further action as the assets in its U.S. mortgage-linked product have declined amid a shakeout in global credit markets.

``We strongly deny the claims made in the press statement that we have not acted in their best interests, or that we have engaged in any misleading or deceptive conduct,'' Sinead Taylor, a spokeswoman for Lehman said, in an e-mailed note. ``We have, however, not yet received any notification of any legal claims.''

CDOs are pools of mortgages, corporate loans or commercial real estate loans sliced into bonds with different credit ratings and maturities. Prices for CDOs backed by subprime mortgage bonds have slumped as late payments on loans to U.S. borrowers with poor credit histories mounted over the past six months.

`Angry and Disappointed'

Lehman Brothers Australia, which was rebranded from Grange Securities after being acquired by the New York-based investment bank, is offering to buy Wingecarribee's CDOs for less than 16 percent of their face value. They make up more than 5 percent of the council's total investments.

``We're very angry and disappointed at the way Lehman Brothers is continuing to behave,'' Hyde said in an interview. ``We are taking them to court in view of their intransigence to buy back the investment. We believe that they haven't acted in the council's best interest.''

Municipal governments including Manly Council and Gosford City Council, both in New South Wales, may follow Wingecarribee in suing Lehman ``within three to five months or sooner,'' Hyde said.

Manly, with about A$1 million invested in Lehman subprime- related securities, supported councils which sought legal advice, Peter Macdonald, the city's mayor, said in an interview. Brian Shackleton, a financial manager for Gosford, declined to comment.

Lehman, the fourth-biggest securities firm, this month reported its fourth-quarter net income fell 12 percent to $886 million from $1 billion a year earlier as it wrote down the value of its mortgage-related securities. The firm's subprime exposure was $5.3 billion at the end of the fourth quarter, down from $6.3 billion in the previous period.

Lehman also shut its subprime lending unit, BNC Mortgage LLC, in August after cutting lending to $200 million a month from more than $2 billion a month last year.

To contact the reporter for this story: Stuart Kelly in Sydney skelly22@bloomberg.net

Last Updated: December 20, 2007 22:26 EST