Watching Bank of America and AIG rip each other up over mortgage-backed securities is kind of like watching the classic flick "King Kong vs. Godzilla": When behemoths are trampling villagers, it's tough to have a rooting interest. AIG's $10 billion case, split into two pieces when the Judicial Panel on Multidistrict Litigation sent $6 billion in claims against Countrywide to U.S. District Judge Mariana Pfaelzer in Los Angeles, has already spawned one of the ugliest episodes in the four-year-history of MBS litigation, when a lateral partner at Quinn Emanuel Urquhart & Sullivan, which represents AIG, had to resign from the firm in the face of BofA's accusations that he advised Merrill Lynch on MBS defenses when he was a partner at Munger, Tolles & Olson. (The partner, Marc Becker, eventually rejoined Quinn after Bank of America's disqualification motion was denied.) And these two companies -- both of which have been accused of bearing disproportionate responsibility for the financial crisis -- seem poised to continue hacking away at one another for as long as AIG's case continues.

But in a newly filed motion to dismiss the Countrywide piece of AIG's case, Countrywide and BofA have a theory that could bring a quick end to the litigation. (The new brief addresses the merits of AIG's case; you may recall that AIG already survived the banks' motion to dismiss on timeliness grounds.) The banks' lawyers at Reed Smith and Munger are arguing (among many other things) that AIG can't assert claims for common-law fraud and negligent misrepresentation because it assigned those claims to the Federal Reserve Bank of New York in September 2008, when the Fed's Maiden Lane II facility took over billions of dollars in toxic AIG mortgage-backed investments. Whatever AIG's intent -- and the insurer has said it did not intend to sell its tort claims -- "there is simply no plausible reading of the contract that does not result in the transfer of the claims," Countrywide and BofA wrote. "AIG therefore does not own the claims stemming from the majority of the securities on which it has sued."

According to the banks, when the Fed bailed out AIG, AIG transferred "all of its rights, title and interest in and to its share of each (residential mortgage-backed) issue." That's straightforward enough, but the banks then argue that the purchase agreement's phrase "each RMBS issue" encompassed all of AIG's interests in "related instruments," which, in turn, encompassed all of the securitization documents. Under this hand-me-down theory, any rights arising from the pooling and servicing agreements that governed AIG's investments in mortgage-backed notes were transferred to the Fed in the 2008 sale. And since AIG's common-law fraud and negligent representation claims derive from the representations and warranties in those MBS pooling and servicing agreements, according to the banks, those claims now belong to the Fed.

You can be sure that when AIG responds to the dismissal motion, it will point out that its contract with the Fed makes no mention whatsoever of who controls the right to sue for fraud, so those rights can't be construed to have transferred to the Fed. Interestingly, Maiden Lane II has asserted different MBS claims against Countrywide; it was part of the group of 22 institutional investors that first demanded Countrywide buy back underlying mortgage loans that breached representations and warranties, and then negotiated the proposed $8.5 billion put-back deal with BofA on behalf of all investors in Countrywide mortgage-backed notes. But the Fed and Maiden Lane have never sued Countrywide for fraud or federal securities violations. AIG will argue that the Fed hasn't brought those claims because they still belong to AIG.

The banks' dismissal motion makes for fun reading. It's filled with references to AIG's "cynical," "embarrassing" and "absurd" allegations, noting the irony of the nation's largest player in the market for mortgage-related credit default swaps claiming that it was duped about mortgage underwriting standards -- especially because AIG had its own subprime mortgage lending business. AIG, the banks argued, even had the audacity to assert claims based on securities backed by loans that its own mortgage-lending arm originated, in an example of what the brief calls "the thoroughgoing irony and cynicism of AIG's suit." When AIG responds, it will surely cite the recent ruling by Senior U.S. District Judge Jed Rakoff in Assured v. Flagstar, in which Rakoff said that even sophisticated investors are entitled to the benefit of contractual representations and warranties. (I'm betting AIG will also point to a 2010 sophisticated investor case from the New York Court of Appeals that's going to be increasingly important as MBS litigation progresses: DDJ Management v. Rhone Group.)

There's also a chance that AIG's case against Countrywide could be taken out of Judge Pfaelzer's hands entirely. Next week, the 2nd Circuit Court of Appeals will hear AIG's argument that U.S. District Judge Barbara Jones erroneously retained jurisdiction over its MBS case against BofA and Merrill, which stayed in New York federal court after the Countrywide piece of the litigation went to Pfaelzer in California. AIG has argued that Jones should have sent the suit back to New York State Supreme Court, where it was originally filed, rather than keep the case in federal court under an obscure law called the Edge Act. If the 2nd Circuit agrees, AIG will likely argue that the Countrywide piece of the case should also return to state court in New York.

(Reporting by Alison Frankel)

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