Bond Insurer Win Bad News For Banks

| About: Bank of (BAC)

It's by no means a certainty, but a recent U.S. federal district court decision could lead to more recoveries by insurers such as MBIA (NYSE:MBI), Assured Guarantee (NYSE:AGO), and Ambac Financial (ABKFQ.PK), currently in Chapter 11 bankruptcy. These bond insurers suffered losses as mortgage delinquencies exploded - a result of the burst housing bubble. Since then, they've been pushing for banks to buy back mortgage pools they claim violate the representations and warranties banks made when they sold the securities.

Some believe the insurers have already factored in estimated recoveries leaving little, if any, room for improved profitability even if legal decisions go their way. But, shares of bond insurers exploded late in 2010 when analysts reported they might reap a windfall if banks were forced to buy back mortgages. So, it is possible investors will get some future upside here.

Unfortunately, what's good for the insurers isn't going to be good for banks that were heavily involved in securitizing residential mortgages (RMBS - Residential Mortgage Backed Securities). As it becomes more likely that courts will weigh in on the insurer side, banks will have to increase provisions for loss claims. And, banks may ultimately have to pony up cash to settle those repurchase claims.

Banks have argued that insurers are not entitled to recovery unless they can show bank misrepresentations caused a problem with the loans. They don't want the court to accept the broader "housing meltdown" to support loan repurchase claims.

Insurers have argued otherwise. But, a New York State judge took the insurer's side in a case with Bank of America in January. That ruling is being appealed, but a federal judge in N.Y. just made a similar ruling this week in a case that does not directly involve BofA. If the precedent is applied to other cases, it could lead to more recoveries by insurers.

Bank of America (NYSE:BAC) is potentially the biggest loser if "put-backs" are approved by the courts because of liabilities it took on through the acquisitions of Countrywide and Merrill Lynch. In its recent securities filing, Bank of America, disclosed the potential impact - estimating it could have to increase provisions for mortgage repurchase loses by up to $5 billion more than the almost $16 billion it has already set aside. Changes in bank loss estimates do not affect profit, but actual settlements will.

Other big banks that sold securitized residential mortgage loans include BNP Paribas SA (BNP.PA), Citigroup Inc. (NYSE:C), Credit Suisse Group , Deutsche Bank AG (NYSE:DB), Goldman Sachs Group Inc. (NYSE:GS), Wells Fargo & Co (NYSE:WFC), UBS Holdings PLC (NYSE:UBS), Royal Bank of Scotland Group PLC (NYSE:RBS) and Morgan Stanley (NYSE:MS). Mortgage repurchases could result in significant liabilities for some, but not all of these banks.

The recent court rulings signal banks and investors that the mortgage-repurchase issue is still a potential threat. It's just one more reason for investors to keep informed of the financial strength of banks and insurance companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.