Morgan Stanley is the latest target of MBIA's quest to win back more than $2 billion of claims it paid on MBS that went bust during the financial crisis.

MBIA Monday sued Morgan Stanley for breaches of contract, claiming the bank defrauded it into insuring $223 million of MBS whose value derives from a pool of 5,000 subordinate-lien residential mortgages.

MBIA believes the bank has a legal obligation to repurchase or cure the bonds. It argues the underlying mortgages did not meet clearly-defined guidelines and cites contracts that stipulate the loan originator would replace any ineligible loan.

The complaint was filed in the New York Supreme Court, in Westchester County.

MBIA's two principal insurers,structured-finance guarantor MBIA Insurance and municipal bond insurer National Public Finance Guarantee, are currently inactive owing to low credit grades and ongoing litigation contesting the company's February 2009 restructuring.

The potential to recover money through these mortgage loan putbacks, as hey are called, could be a game-changer for MBIA's future, according to CreditSights, an independent credit researcher.

MBIA said in its complaint that it has "demonstrably false written representations" in which Morgan Stanley claimed it conducted extensive due diligence on the loans in question and maintained that up to 99% of
the pooled mortgage loans met the bank's "seller guide." When the bonds began defaulting, MBIA sought access to the loan origination files and found reality to be quite different.

It has reviewed more than 3,000 loan files and believes that nearly 97% of them contained breaches of the mortgage loan representations.

Breaches include unreasonably stated income or lack of income verification, and debt-to-income ratios that exceed guidelines.

"That review uncovered numerous material breaches of the representations and warranties made by Morgan Stanley," MBIA said in its complaint.

MBIA had paid $71.2 million in claims on the securities originated by Morgan Stanley as of last month, according to court documents.

Mark Lake, a spokesman for Morgan Stanley, didn't return requests for comment. He called the lawsuit "without merit" in other media reports and said the firm would defend itself "vigorously."

The case against Morgan Stanley is the latest in a series of ongoing court battles in which MBIA is seeking loan originators to repurchase allegedly ineligible loans. MBIA stated in its third-quarter earnings
filing that it anticipates recovering $2.2 billion, based on a review of 45,000 loan files. That estimate could rise as MBIA gains access to more files.

MBIA's case against Countrywide, since acquired by Bank of America Merrill Lynch, involves 368,000 loan files, which MBIA gained access to in October.

As of June, MBIA has demanded Countrywide repurchase nearly 14,000 loans with a principal balance of $1.1 billion. Countrywide has agreed to repurchase only 3% of that amount, or $38 million worth.

The case is scheduled to go to trial in June or July 2011.

Since MBIA took legal action to get banks to repurchase faulty loans in late 2008, similar putback cases have been filed against financial institutions by Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Federal Reserve.

Analysts at JPMorgan estimated in October that large banks may have to repurchase between $55 billion and $120 billion of loans in the next few years.

Soleil Securities referred to the putbacks dispute as "the hot-button issue at the moment" in a Nov. 29 report. The equity research firm said investors are assessing MBIA's chances of recovering significant amounts and evaluating what that means for the largest financial institutions mixed up in the deals.

"We believe MBIA will recover a significant portion of the reps and warranty claims that is had made over the past several years," Soleil analysts wrote.

MBIA has been involved in the putback process since it first began writing insurance on non-municipal deals in the 1980s, Soleil said. Before the credit crisis, an occasional loan would be found to be ineligible and MBIA "typically did not have an issue" having it replaced or repurchased.

Once the credit crisis began in late 2007, that changed, according to Chuck Chaplin, MBIA's chief financial officer, who spoke at a Soleil luncheon last month.

The banks MBIA is suing have claimed the alleged contract breaches were immaterial to the defaults. Instead, they argue that the bonds plummeted in value because of the housing collapse and subsequent recession.

Chaplin, according to Soleil's summary of the luncheon, called that argument "a bad dose of circular logic." He maintained it was arguably poor underwriting that caused the housing crisis.

"One can certainly argue," Soleil added, "that the housing crisis may not have occurred had the originator's mortgage loan-underwriting guidelines been strictly adhered to."

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