Financial services giant Morgan Stanley may be facing charges it perpetrated a massive fraud in the sale of mortgage-backed securities, but no one can accuse the firm of lacking a sense of humor about it. Last month, e-mails surfaced in a 2010 New York civil fraud case showing that the firm’s executives sold the instruments to a Taiwanese bank for hundreds of millions of dollars knowing the impending collapse of the US housing market made the securities a hazardous investment – and they laughed about it.
An email by Philip Blumberg, a Morgan Stanley vice president, suggested disparaging names for the product known as a collaterized debt obligation (CDO). He proposed names, such as “Nuclear Holocaust,” “Subprime Meltdown” and even simply “S**tbag.” Ultimately, the group of securities that were sold to the China Development Industrial Bank (CDIB) in Taiwan was named STACK 2006-1.
In 2010, the bank filed a class action alleging that Morgan Stanley misrepresented the value of the securities and concealed information that would have allowed accurate assessment of their value. CDIB seeks damages that approximate its $228 million in losses, cancellation of its obligations under the securities, and $12 million in punitive damages.
Morgan Stanley is said to have undue ‘influence with credit rating agencies’
Of the $500 million supposed value of the assets in the STACK CDO sold to CDIB in 2007, $415 million ultimately proved to be worthless when the US subprime mortgage market collapsed in 2008.
According to court documents, Morgan Stanley told CDIB that STACK was rated “higher than AAA” quality, the highest rating that the Standard and Poor’s Rating Services (S&P) extends.
CDIB says Morgan Stanley produced this ratings with “grandfathered models and protocols and assumptions that were no longer applicable,” along with its “influence over credit rating agencies.”
A mortgage-backed security is a security insured by a mortgage or collection of mortgages. Typically, for a mortgage-backed security to be a viable investment, it must have one of the top two ratings from an accredited credit rating agency and must originate in select financial institutions. A bundle of mortgage-backed securities is called a CDO.
Trading in substandard mortgage-backed securities played a significant role in the crash of the US housing market and the 2008 worldwide financial crisis of.
More emails indicate Morgan Stanley employees questioned sale of securities
Other emails include details about the questionable value of the mortgages that supported the CDO. Steven Shapiro, a Morgan Stanley adviser, wrote that “the loan requests do not make sense.”
Discussing a borrower in a $900,000 mortgage, Shapiro said, “[This] borrower… makes $12K a month as an operations manager for an unknown company – after research on my part I reveal it is a tarot reading house. We are seeing what I would call a lot of this type of profile.”
An email from Robert Travis, a Morgan Stanley director of due diligence and corporate due diligence, said, “There are typical missing documents and credit issues that are just ‘missed.’ Specifically what I have been seeing… is the borrower with light credit… buying a high priced home on a stated income loan program…. Bottom line, there is not a lot of ‘common sense’ being used when approving these… loans.”
Morgan Stanley says bank was ‘sophisticated’ investor, knew investment risks
Morgan Stanley has argued that the CDIB executives were ‘sophisticated’ and possessed enough information about the nature of the CDO to assess the quality of the investment. It also asserts that the transaction document clearly told CDIB to review the value of the investment independently.
It highlighted language that disclaimed “investment advice or a recommendation” in the information and explanations it provided to CDIB.
Judge Melvin L. Schweitzer, of the New York Supreme Court, which is the state’s trial court, denied the motion to dismiss. He said the complaint sufficiently alleged that Morgan Stanley had information about the securities that was not available to CDIB.
Wall Street banks facing charges of similar fraud in several suits
Morgan Stanley is not the only institution that is said to have perceived the imminent failure of the US housing market and continued selling investments in mortgage-backed securities on the eve of the collapse.
Emails uncovered in a suit by the Belgian-French bank, Dexia, against JPMorgan Chase show that executives of the New York-based global giant knew a collapse of the housing market was imminent, ignored apparent troubles with mortgage-backed securities, and continued selling them. Dexia purchased $1.6 billion in troubled mortgage-backed securities from JPMorgan and has sued the institution for fraud and aiding and abetting fraud.
In September 2011, the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, sued 17 financial institutions, including Bank of America, JPMorgan and Morgan Stanley, of fraud in the sale of at least $200 billion worth of troubled mortgage-backed securities to the housing agencies. The case is pending in a federal court, the Southern District of New York..
On February 4, the US Justice Department sued S&P alleging it ignored its standards in rating mortgage securities and helped cause the implosion of the housing market in 2008. The Department is seeking $5 billion in damages.
Attorney General Eric Holder said on February 5, “We allege that S&P falsely claimed that its ratings were independent, objective, and not influenced by the company’s relationship with the issuers who hired S&P to rate the securities in question…,”.
“In reality, the ratings were affected by significant conflicts of interest, and S&P was driven by its desire to increase its profits and market share to favor the interests of issuers over investors,” he added. “This alleged conduct… goes to the very heart of the financial crisis.”