A bankruptcy court judge sunk investors' hopes in their latest lawsuit against Lehman Brothers, which they claim broke contracts in junk mortgage-backed securities sold during the bubble years.

Judge Shelley Chapman of the U.S. Bankruptcy Court for the Southern District of New York on Wednesday denied the investors' motion to more than double the $5 billion that Lehman's bankruptcy estate set aside for their claims. The investors, represented by four bank trustees, had argued in August that the liability reserve should actually amount to $12.14 billion.

Chapman delivered a second blow later in the day, as well, one that may be equally as consequential. She ruled that all 209,000 mortgages spread across the trusts in question must be reviewed one by one. The method for doing so was set to be fought over on Friday.

The loan review could well take 21 years to complete, one forensics expert for the trustees testified. In stark contrast, Lehman's experts claim it would only take one year.

"This is just a nightmare," a banker involved in the case said. "It obviously won't take 21 years, but the intent is clear that Judge Chapman is opening this thing for a settlement."

The cost of re-underwriting is estimated to be $250 to $500 per mortgage.

A lawyer involved in the case, speaking on condition of anonymity, said it is unlikely that investors will tolerate trustees paying up to $100 million to re-underwrite the loans. The issue is much less about the time it would take than the money required.

Lawyers for the two parties have by the end of Friday, to tell Judge Chapman whether they have agreed to a protocol for reviewing the loan pool. If they have not agreed, the parties will have until the end of Tuesday to submit competing proposals.

Banks suing on behalf of investors fear they may never recoup their losses if the dispute is not resolved quickly.

"Lehman has no incentive to reach a timely settlement with the [residential mortgage-backed securities] trustees. If the RMBS claims are not addressed promptly, the $5 billion reserve will soon serve as a cap on the claims, which is contrary to the intent of the court's reserve order," the banks said in August.

The four trustees are U.S. Bank, Wilmington Trust, Law Debenture Trust and Deutsche Bank.

In 2012, those four banks, along with Citigroup and HSBC, entered negotiations with Lehman. At the time, they sought $37 billion from the defunct investment bank, which went bankrupt in 2008. Citigroup and HSBC have since left the case and sought to settle their claims separately, though no agreements have been reached with any of the parties.

The $12.7 billion estimate that Judge Chapman declined would have equaled 10% of the original pool amount. Lehman argued that settlements by other issuers, such as JPMorgan Chase's and Citigroup's, did not include recoveries that high.

Bond investors today are scouring loan pools of legacy mortgage bonds for potential new investments. They are looking for pools such as the one caught up in this Lehman trustee case. Such vintages are winding down in supply.

The banks' witnesses argued for a statistical sampling of the loan pool to subject to underwriting tests, in order to determine a breach of representations and warranties made on the securities.

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