California Attorney General Kamala Harris filed a lawsuit against investment bank Morgan Stanley for misrepresentations about complex investments such as residential mortgage-backed securities, in which large pools of home loans were packaged together and sold to investors. 

These misrepresentations contributed to the global financial crisis and to major losses by investors including California’s public pension funds, the lawsuit claims. The California Public Employees Retirement System (CalPERS) and the California State Teachers Retirement System (CalSTRS) lost hundreds of millions of dollars on these Morgan Stanley investments, according to Harris.

The complaint, 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. In addition to residential mortgage-backed securities, the complaint also focuses on “structured investment vehicle” investments, which involved not just packages of residential mortgage loans but also other types of debt of individuals and corporations.

Specifically, 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, a mortgage lender that received crucial funding from Morgan Stanley. Morgan Stanley purchased and bundled high-risk loans from subprime lenders such as New Century into seemingly safe investments, even though it knew the lenders were “not [using] a lot of common sense” when approving the loans, the complaint alleges. Additionally, 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.

In a statement, Morgan Stanley said, “We do not believe this case has merit and intend to defend it vigorously. 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 victims in this case elected not to pursue their own lawsuit against the firm.”

According to the suit, among other things, Morgan Stanley’s offering documents, which were required to fully and accurately inform investors about the risks, actually misrepresented the quality of the loans contained in the investment packages, by failing to disclose that many of them were underwater—i.e., the mortgage was more than the property was worth—and by failing to disclose the number of delinquent loans. They also used exaggerated appraisals, which overstated the value of the properties securing the loans, and knowingly presented incorrect data concerning owner occupancy and loan purpose, which tended to understate the loans’ riskiness.  

The complaint goes on to allege that Morgan Stanley sometimes even took loans it had already decided to exclude from its investment packages because they were too risky and then included them in later investment packages, despite knowing the loans had problems, and doing nothing to fix them. The complaint alleges that the lack of disclosure prompted a Morgan Stanley employee to observe to his co-workers that someone “could probably retire by shorting these upcoming ... deals,” and “someone needs to benefit from this mess.”

The complaint also alleges that Morgan Stanley played a central role in crafting the Cheyne structured investment vehicle, which sold supposedly safe short-term investments based on mortgage-backed securities and other complex investments. Investors were particularly reliant on accurate disclosure of the risks because of the complicated nature of these investments. The complaint alleges, however, that while Morgan Stanley knew of significant risks, it nevertheless worked to portray the investments as extremely safe. 

Morgan Stanley managed to procure extremely high credit ratings—in some cases, the same ratings as the very safest investments such as U.S. government bonds—for investments in Cheyne notes. According to the lawsuit, Morgan Stanley bragged that it “shaped rating agency technology” to “get the rating we wanted in the end,” prompting a structured investment vehicle (SIV) manager to observe, “It is an amazing set of feats to move the rating agencies so far.” The result of Morgan Stanley’s success was huge losses to investors when the SIV failed, Harris says.    

The lawsuit arises from a multiyear investigation into the issuance and rating of mortgage-backed securities by the Attorney General’s California Mortgage Fraud Strike Force. As a result of that investigation, Attorney General Harris has, to date, recovered over $900 million for California’s public pension funds in settlements with three banks and a credit rating agency over misrepresentations in connection with structured finance investments sold to CalPERS and CalSTRS.