Lloyd Blankfein and Jon Gray, two of the most powerful figures on Wall Street, sat down for lunch last month, just as tensions between their firms were ratcheting up.

It was a friendly chat between Blankfein, head of Goldman Sachs Group Inc., and Gray, heir apparent of Blackstone Group LP, that veered toward a thorny matter. At issue: a controversial trade involving credit-default swaps that has riveted players in the vast derivatives market -- and set Goldman and Blackstone on a collision course.

Gray questioned Goldman Sachs’s opposing role in the deal, which had spilled into public view, according to people with knowledge of the matter. Blankfein stood his ground, expressing disagreement with the way it was structured.

The gathering was a routine relationship-builder between one of the world’s most influential investment banks and one of the industry’s most important clients -- but in the $11 trillion global market for credit derivatives, it’s taken on the weight of a state lunch. Details of Blankfein and Gray’s brief discussion of the deal -- one of various topics at the lunch -- are still being whispered about at both firms, and increasingly, beyond their walls. Traders, managers and senior executives are trying to parse what the friction surrounding the trade portends for business between the companies and whether it will prevent similar transactions in the future.

The tussle revolves around an ailing homebuilder, Hovnanian Enterprises Inc. Last year Blackstone’s credit unit, GSO, struck a sweetheart deal with the company, agreeing to refinance some of its debt, but with an unusual provision. Hovnanian would engineer a default, allowing GSO to cash in on $333 million of credit-default swaps, an insurance-like derivative. Hedge funds and Goldman Sachs found themselves on the hook for payouts to Blackstone and have explored various ways to avert that outcome.

The trade has continued to strain the relationship between the two firms, whose web of deals spans almost all corners of finance. On the trading level, GSO already has scaled back dealings with Goldman, the people said, asking not to be identified discussing a private matter. Some Goldman bankers are concerned Blackstone’s objections may lead the massive client to pull more business from the bank if the situation escalates, the people said.

The lunch meeting happened weeks after Blackstone named Gray, 48, president and chief operating officer -- and therefore the likely successor to Chief Executive Officer Stephen Schwarzman. The chat with Blankfein, 63, didn’t resolve the impasse.

‘Little More Business’
“Lloyd and Jon had a perfectly pleasant lunch last month chatting about the state of the world and how we could do a little more business together,” a spokesman for Goldman Sachs said.

“Jon and Lloyd had a terrific lunch and the relationship between the two firms is quite strong,” a Blackstone spokesman said.

The trade also has been discussed at other levels, including conversations between David Solomon, the heir to the throne at Goldman Sachs, and Bennett Goodman, the head of GSO, according to people with knowledge of the talks. That pair go way back, and are known to have a good working relationship.

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