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Bond Insurer Sues Morgan Stanley—What Are the Ramifications?

Bond insurer MBIA is suing Morgan Stanley over claims made by the bank regarding mortgage backed securities.

Morgan Stanley
Gregory Bull
Morgan Stanley

Specifically, the case involves MBIA claims that Morgan Stanley "made false representations regarding the underwriting standards" of bonds it later insured.

It's not difficult to become a little blasé about lawsuits against banks involving the alleged misrepresentation of underwriting standards on mortgage backed securities.

Mortgage repurchase exposure stories have been swirling for some time. At NetNet, we've covered that storyline before.

But this lawsuit may be quite different from lawsuits typically filed by investors in other repurchase cases.

The reason is that Morgan Stanley may consider the bonds involved in this lawsuit to be 'indemnified.'

First a bit of background.

Typically, when a bank initiates or aggregates mortgages, then later sells securities based on them, those securities are no longer carried as liabilities on the bank's balance sheet once the sale to investors is complete.

The securities become part of something called a 'servicing book'—which is then 'serviced but not held' by the bank.

However, banks are generally required to set aside loan loss reserves, or litigation reserves, which are held aside from earnings, in order to help limit the risks associated with securities held in their servicing books.

In case, for example, the bank is sued by MBS investors for violating representations they had warranted against at the time when the securities were sold. A document called a pooling and servicing agreement (PSA) typically contains all of those representations and warranties.

Typically, those reserves are a fractional percentage of the face value of the security. But the 'indemnified' tranches of the servicing books are typically excluded from those very loan loss calculations.

Therefore, it is possible that no reserves are being held from earnings against the securities currently in dispute in this lawsuit.

It is important to point out that we cannot know that for certain, based only on the information provided by the Reuters story. It is certainly something to think about.

The specifics of the lawsuit discussed in the article seem fairly straightforward:

MBIA's claims center around underwriting standards for securities based on "a pool of approximately 5,000 subordinate-lien residential mortgages."

('Subordinate-lien' would seem to indicate that first-lien creditors would have payment priority in the event of default.)

MBIA claims it has already paid out $71 million in unreimbursed claims.

(When bondholders purchase securities that are backed by bond insurance—essentially a form of credit support—those investors would expect to be paid even if the bond ran into trouble. For example, in a case involving mortgage bonds: If the underlying cash flows supporting the bond begin to falter—which could be caused by homeowners defaulting on mortgage payments —the bond insurer would continue to make principal and interest payments to the bondholder.)

With reference to this case, a Morgan Stanley spokesperson issued the following statement: "The lawsuit is without merit and we intend to defend ourselves vigorously."

MBIA has already filed lawsuits against other financial institutions —including Credit Suisse and Ally Financial's GMAC.

And MBIA is not the only player in the space. Ambac Financial Group, another major insurer of bonds—which recentlyfiled for bankruptcy after missing an interest payment on November 8, 2010—is likely watching this case closely. And weighing its own options.

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