WASHINGTON D.C.
Federal prosecutors allege that Morgan Stanley mislead investors who suffered billions of dollars in losses in connection with subprime mortgage loans, according to officials.
Morgan Stanley agreed to pay $2.6 billion to settle state and federal charges stemming from the sale of residential mortgage backed securities, officials announced today.
“Those who contributed to the financial crisis of 2008 cannot evade responsibility for their misconduct,” said Deputy Assistant Attorney General Benjamin C. Mizer, head of the Justice Department’s Civil Division. “This resolution demonstrates once again that the Financial Institutions Reform, Recovery and Enforcement Act is a powerful weapon for combatting financial fraud and that the department will not hesitate to use it to hold accountable those who violate the law.”
A residential mortgage backed security is a type of security comprised of a pool of mortgage loans created by banks and other financial institutions.
Residential backed securities are secured with residential rather than commercial property, officials said.
Under the settlement, federal prosecutors preserve the government’s ability to bring criminal charges against Morgan Stanley, and likewise does not release any individuals from potential criminal or civil liability.
In addition, as part of the settlement, Morgan Stanley promised to cooperate fully with any ongoing investigations related to the conduct covered by the agreement.
The expected performance and price of a mortgage backed security is determined by a number of factors, including the characteristics of the borrowers and the value of the properties underlying the security, according to officials.
Morgan Stanley was one of the institutions that issued mortgage backed securities during the period leading up to the economic crisis in 2007 and 2008, officials said.
As part of the settlement agreement, officials said Morgan Stanley acknowledged in writing that it failed to disclose critical information to prospective investors about the quality of the mortgage loans underlying its residential mortgage backed securities and about its due diligence practices.
Investors, including federally insured financial institutions, suffered billions of dollars in losses from investing in RMBS issued by Morgan Stanley in 2006 and 2007.
“Today’s settlement holds Morgan Stanley appropriately accountable for misleading investors about the subprime mortgage loans underlying the securities it sold,” said Acting Associate Attorney General Stuart F. Delery. “The Department of Justice will not tolerate those who seek financial gain through deceptive or unfair means, and we will take appropriately aggressive action against financial institutions that knowingly engage in improper investment practices.”
Here are the allegations surrounding this case:
Morgan Stanley told investors that it did not securitize underwater loans (loans that exceeded the value of the property).
However, Morgan Stanley did not disclose to investors that in April 2006 it had expanded its “risk tolerance” in evaluating loans in order to purchase and securitize “everything possible.”
As Morgan Stanley’s manager of valuation due diligence told an employee in 2006, “please do not mention the ‘slightly higher risk tolerance’ in these communications. We are running under the radar and do not want to document these types of things.”
As a result, Morgan Stanley ignored information – including broker’s price opinions, which are estimates of a property’s value from an independent real estate broker – indicating that thousands of securitized loans were underwater, with combined-loan-to-value ratios over 100 percent.
A sales agent uses broker’s price opinion to determine the selling price or estimated value of a real estate property. A broker’s price opinion is used mainly in situations where a financial institution believes the expense and delay of an appraisal is unnecessary, according to financial experts.
From January 2006 through mid-2007, Morgan Stanley acknowledged that “Morgan Stanley securitized nearly 9,000 loans with broker price opinion values resulting in [combined loan to value] ratios over 100 percent.”
In addition, Morgan Stanley told investors that it did not securitize loans that failed to meet originators’ guidelines unless those loans had compensating factors.
Morgan Stanley’s offering documents “represented that ‘[the mortgage loans originated or acquired by [the originator] were done so in accordance with the underwriting guidelines established by [the originator]’ but that ‘on a case-by-case-basis, exceptions to the [underwriting guidelines] are made where compensating factors exist.’”
Morgan Stanley has now acknowledged, however, that “Morgan Stanley did not disclose to securitization investors that employees of Morgan Stanley received information that, in certain instances, loans that did not comply with underwriting guidelines and lacked adequate compensating factors . . . were included in the RMBS sold and marketed to investors.”
So, in fact, “Morgan Stanley . . . securitized certain loans that neither comported with the originators’ underwriting guidelines nor had adequate compensating factors.”
Likewise, “Morgan Stanley also prepared presentation materials . . . that it used in discussions with potential investors that described the due diligence process for reviewing pools of loans prior to securitization,” but “certain of Morgan Stanley’s actual due diligence practices did not conform to the description of the process set forth” in those materials.
For example, Morgan Stanley obtained broker priced opinions for a percentage of loans in a pool. Morgan Stanley stated in these presentation materials that it excluded any loan with a BPO value exhibiting an “unacceptable negative variance from the original appraisal,” when in fact “Morgan Stanley never rejected a loan based solely on the broker priced opinion results.”
Through these undisclosed practices, Morgan Stanley increased the percentage of mortgage loans it purchased for its residential mortgage backed securities even though it was aware about “deteriorating appraisal quality” and “sloppy underwriting” by the sellers of these loans.
The bank acknowledged that “Morgan Stanley was aware of problematic lending practices of the subprime originators from which it purchased mortgage loans.”
However, it “did not increase its credit-and-compliance due diligence samples, in part, because it did not want to harm its relationship with its largest subprime originators.”
Indeed, Morgan Stanley’s manager of credit-and-compliance due diligence was admonished to “stop fighting and begin recognizing the point that we need monthly volume from our biggest trading partners and that . . . the client [an originator] does not have to sell to Morgan Stanley.”
The $2.6 billion civil penalty resolves claims under the Financial Institutions Reform, Recovery and Enforcement Act, officials said.