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California accuses Morgan Stanley of pushing toxic mortgage bonds

Attorney General claims violations of False Claims Act

The alleged malfeasance that surrounded the rating and sale of mortgage-backed securities in the run-up to the financial crisis lead to multiple multi-million and multi-billion dollar settlements, but it appears that the companies involved are not yet out of the woods.

Case in point:  The state of California filed suit against Morgan Stanley over alleged misrepresentations of the quality of pre-crisis mortgage bonds that cost the California Public Employees Retirement System and the California State Teachers Retirement System hundreds of millions of dollars.

According to the office of California Attorney General Kamala Harris, Morgan Stanley allegedly made misrepresentations about complex investments such as residential mortgage-backed securities, which in turn, lead to major losses by investors including California's public pension funds.

California’s lawsuit, filed in San Francisco Superior Court, alleges that Morgan Stanley violated the False Claims Act, the California Securities Law and other state laws by concealing or understating the risks of intricate investments involving large numbers of underlying loans or other assets.

“Morgan Stanley’s conduct in this case evidenced a culture of greed and deception that helped create a devastating economic crisis and crippled California’s budget,” Harris said. “This lawsuit is necessary in order to hold Morgan Stanley accountable for the destruction it caused to California, our people, and our pension funds.”

According to Harris’ office, the complaint alleges that, from 2004 to 2007, Morgan Stanley assembled and sold billions of dollars in mortgage-backed securities, many of which contained “risky” loans made by Morgan Stanley subsidiary Saxon, or by New Century Financial.

Morgan Stanley’s relationship with New Century was at the center of a Department of Justice investigation, involving Morgan Stanley’s role in “actively” influencing New Century’s risky lending practices.

According to Harris’ office, Morgan Stanley purchased and bundled “high-risk” loans from subprime lenders like New Century into mortgage bonds made to appear safe, despite allegedly knowing that lenders were “not using a lot of common sense” in the underwriting process.

Additionally, Harris’ office said that the complaint alleges that Morgan Stanley did not disclose the risks because it did not want its concerns about loan quality to become a “relationship killer” that would cause it to lose its lucrative business with companies making the risky loans. 

California’s complaint alleges that Morgan Stanley misrepresented the quality of the loans contained in the mortgage bonds by failing to disclose that many of them were underwater and by failing to disclose the number of delinquent loans that were contained in the pools.

Morgan Stanley also allegedly used exaggerated appraisals that overstated the value of the properties securing the loans, and knowingly presented incorrect data concerning owner occupancy and the purpose of the loans.

Additionally, California alleges that Morgan Stanley decided to exclude some loans from mortgage bonds because they were too risky, but then added them back in later, allegedly prompting a Morgan Stanley employee to tell some of his co-workers that someone “could probably retire by shorting these upcoming deals,” and “someone needs to benefit from this mess.”

The lawsuit is the latest in a string of allegations against Morgan Stanley for its pre-crisis business practices.

Earlier this year, Morgan Stanley settled with state governments for $3.2 billion over its “deceptive” mortgage bond practices in the run-up to the financial crisis.

Just a few weeks before that, Morgan Stanley agreed to pay $62.95 million as part of a settlement with the Federal Deposit Insurance Corporation, acting as receiver for three failed banks, over mortgage bond misrepresentations.

And last year, Morgan Stanley agreed to two large settlements over its pre-crisis RMBS dealings, including a $2.6 billion settlement with the United States Department of Justice and a $225 million settlement with the National Credit Union Administration.

For its part, Morgan Stanley told Bloomberg that it feels the lawsuit is without merit.

From Bloomberg:

“We do not believe this case has merit and intend to defend it vigorously,” Morgan Stanley said in a statement to Bloomberg. “The securities at issue were marketed and sold to sophisticated institutional investors and their performance has been consistent with the sector as a whole. It is also worth noting that the alleged victim in this case elected not to pursue its own lawsuit against the firm.”

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