An April 2 ruling on RMBS loans in breach of representations and warranties given by a bank is credit positive for investors of both residential and commercial mortgage backed securities, according to Moody’s Investors Service

A New York intermediate appellate court ruled that a residential mortgage-backed securities loan “need not be in default to trigger [a bank’s] obligation to repurchase it” from the trust if the loan breached rep and warranties given by the bank.

In research published today, Moody’s said it was the first time an appeals court has spoken on the issue. Holders of both RMBS and commercial mortgage-backed securities, stand to benefit, as CMBS trusts have R&W repurchase provisions are similar, though not identical, to those of RMBS.

The key contractual language at issue, common in RMBS pooling and servicing agreements, required the defendant, Countrywide Home Loans, to repurchase a loan if it breached R&Ws that “materially and adversely affect the interests of the certificate holders…in [the] Mortgage Loan.”

Countrywide argued that only a defaulted loan triggers the repurchase obligation, and that the words “adverse affect” mean the representation breach must actually cause harm to the mortgage loan, like a default, not just an expectation of harm, as in an increased risk of loss.

MBIA Insurance Corp., the plaintiff, argued that the repurchase obligation triggers if the originator inaccurately represented the credit quality of the loan, regardless of whether or not the loan actually defaulted. If the loan had a higher risk of loss than as originally disclosed, then, MBIA argued, the interests of the certificate holders have been materially adversely affected.

The New York Appellate Division, First Department, agreed with MBIA, writing that “had these very sophisticated parties desired to have an event of default or nonperformance trigger the repurchase agreement, they certainly could have included such language in the contracts. They did not do so, and this Court will not do so now.”

Moody’s said CMBS transactions’ pooling and servicing agreements have language that even more clearly support MBIA’s position. These agreements generally provide that the originator must repurchase a loan if an R&W breach “materially and adversely affects either the value of the mortgage loan or the interests of the certificateholders.”

This double-barreled approach more easily leads to the conclusion that increased risk of loss on the loan alone triggers the buyback remedy, Moody’s said.

However, the April 2 court decision makes clear that whatever the buyback formulation used in pooling and servicing agreements, whether the breach adversely affects the certificate holder “interests” or the loan “value,” the hands of RMBS and CMBS trusts have been strengthened.

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