Bond insurer MBIA is suing Morgan Stanley over claims made by the bank regarding mortgage backed securities, CNBC's NetNet reports.  Specifically, the case involves claims by MBIA that M. Stanley "made false representations regarding the underwriting standards" of bonds it later insured. 

While mortgage repurchase exposure stories have been swirling for some time, 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."

However, banks generally are 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 - e.g., in the evident the bank is sued by MBS investors for violating representations they had warranted against at the time the securities were sold.  A document called a pooling and servicing agreement (PSA) typically contains all of those representations and warranties.

Those reserves are usually 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's possible that no reserves are being held from earnings against the securities currently in dispute in this lawsuit.  It's important to point out that we cannot know that for certain, based only on the information provided by the Reuters story.  It's certainly something to think about.

    Lawsuit Details.   The case discussed in the Reuters article seemed 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 said, "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.  Another major insurer of bonds, Ambac Financial Group, which recently filed for bankruptcy after missing an interest payment on 11/8/10 - is likely watching this case closely.  And weighing its own options.   [CNBC's NetNet, 12/10]