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Troubles emanating from mortgage backed securities are far from over for Deutsche Bank AG (DB - Analyst Report). A trustee for mortgage-bond investors has charged one of the units of Deutsche Bank for over $183 million in faulty loans underlying the securities, according to a Bloomberg report.

The trustee, HSBC Bank of the HSBC Holdings Plc. , has alleged that DB Structured Products has violated its pledge regarding the quality of loans that were clubbed together and securitized. HSBC is looking for an order that would result in buyback of loans by DB Structured Products.

As a matter of fact, last month, DB Structured Products was sued by Federal Housing Finance Agency (FHFA) over mortgage backed securities, according to a Bloomberg report.

In a court filing, FHFA alleged that Deutsche Bank’s unit violated its promise regarding the loans that were clubbed together and packaged into securities and also failed to buy them back as needed. The investment amount in consideration was, however, not disclosed in the court filing.

The Back Story

In the aftermath of the real estate market collapse in 2008 and the financial crisis, mortgage and mortgage-backed securities occupied a significant share of the total financial system. In several situations, the legitimacy of the mortgages as well as the documents were ambiguous. The mortgage originators did not exercise due diligence in several cases and also deliberately defrauded.

Now, when banks sell mortgage-backed securities to investors and GSEs, there is a clause that can force a bank to buy back the securities in the event of fraudulent or faulty underwriting or origination of the underlying mortgage. Therefore, in cases of fraudulent and faulty origination documents, the holder of the mortgage-backed securities can demand buybacks by the seller of the security.

Moreover, it has been found that in many cases the buyers of the mortgage backed securities were misinformed about the quality of the underlying loans of the securities and they were found to be more risky than claimed.

Our Take

We believe that increasing demand for loan buybacks would remain a headwind in the quarters ahead for Deutsche Bank. Moreover, such suits would result in piling of litigation risks for Deutsche Bank, which poses a menace for both the company’s image as well as it financials.

As a matter fact, a number of the Wall Street stalwarts such as Wells Fargo & Co. (WFC - Analyst Report) and PNC Financial Services Group Inc. (PNC - Analyst Report), are witnessing similar escalation in mortgage buyback demands. These companies have substantially beefed up their reserves for the rising demands.

Deutsche Bank currently retains a Zacks #4 Rank, which translates into a short-term Sell rating.

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