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SUPREME COURT OF THE STATE OF NEW YORK COUNTY OF NEW YORK ALLSTATE INSURANCE COMPANY, ALLSTATE LIFE INSURANCE COMPANY, ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK, AGENTS PENSION PLAN, and ALLSTATE RETIREMENT PLAN Plaintiffs, v. MORGAN STANLEY; MORGAN STANLEY & CO., INC., MORGAN STANLEY ABS CAPITAL I INC., MORGAN STANLEY MORTGAGE CAPITAL INC., MORGAN STANLEY CAPITAL I INC., MORGAN STANLEY MORTGAGE CAPITAL HOLDINGS LLC, Defendants.
Index No. SUMMONS Date Index No. Purchased: July 5, 2011
FILED: NEW YORK COUNTY CLERK - PENDING INDEX NO. UNASSIGNED
NYSCEF DOC. NO. 1 RECEIVED NYSCEF: 07/05/2011
TO THE ABOVE-NAMED DEFENDANTS:
Morgan Stanley 1585 Broadway New York, NY 10036 Morgan Stanley & Co., Inc. 1585 Broadway New York, NY 10036 Morgan Stanley ABS Capital I Inc. 1585 Broadway New York, NY 10036 Morgan Stanley Capital I Inc. 1585 Broadway New York, NY 10036 Morgan Stanley Mortgage Capital Inc. 1221 Avenue of the Americas, 27th Floor New York, NY 10020 Morgan Stanley Mortgage Capital Holdings LLC 1221 Avenue of the Americas, 27th Floor New York, NY 10020
YOU ARE HEREBY SUMMONED to answer the complaint in this action and to serve a
copy of your answer, or if the complaint is not served with this summons, to serve notice of
appearance, on the plaintiff’s attorneys within twenty (20) days after the service of this
summons, exclusive of the day or service (or within thirty (30) days after service is complete if
this summons is not personally delivered to you within the State of New York); and in case of
your failure to appear or answer, judgment will be taken against you by default for relief
demanded herein.
Venue is proper in this Court because Defendants maintain their principal places of
business in New York County.
Dated: New York, New York Respectfully submitted, July 5, 2011
BERNSTEIN LITOWITZ BERGER & GROSSMANN LLP Gerald H. Silk Avi Josefson Lauren A. McMillen Michael D. Blatchley Ross Shikowitz 1285 Avenue of the Americas, 38th Floor New York, NY 10019 Tel: (212) 554-1400 Fax: (212) 554-1444 [email protected] [email protected] [email protected] [email protected] [email protected] -and- Blair Nicholas 12481 High Bluff Drive, Suite 300 San Diego, CA 92130
Tel: (858) 793-0070 Fax: (858) 793-0323 [email protected] Counsel for Plaintiffs
SUPREME COURT OF THE STATE OF NEW YORK COUNTY OF NEW YORK ALLSTATE INSURANCE COMPANY, ALLSTATE LIFE INSURANCE COMPANY, ALLSTATE LIFE INSURANCE COMPANY OF NEW YORK, AGENTS PENSION PLAN, and ALLSTATE RETIREMENT PLAN Plaintiffs, v. MORGAN STANLEY; MORGAN STANLEY & CO., INC., MORGAN STANLEY ABS CAPITAL I INC., MORGAN STANLEY MORTGAGE CAPITAL INC., MORGAN STANLEY CAPITAL I INC., MORGAN STANLEY MORTGAGE CAPITAL HOLDINGS LLC, Defendants.
Index No. COMPLAINT JURY TRIAL DEMANDED
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TABLE OF CONTENTS
Page
I. SUMMARY OF THE ACTION ..........................................................................................1
II. JURISDICTION AND VENUE ..........................................................................................7
III. THE PARTIES.....................................................................................................................7
A. Plaintiffs ...................................................................................................................7
B. Defendants ...............................................................................................................8
IV. FACTUAL BACKGROUND UNDERLYING ALLSTATE’S CLAIMS ..........................9
A. The Morgan Stanley RMBS Purchased By Allstate ................................................9
B. Morgan Stanley’s Activities In The Subprime Mortgage Arena ...........................13
C. Morgan Stanley’s Role Was To Ensure The Quality Of The Loans Backing The RMBS ...............................................................................................15
D. Factors Impacting The Quality Of The Morgan Stanley RMBS ...........................18
V. THE OFFERING MATERIALS MISREPRESENTED THE UNDERWRITING AND QUALITY OF THE LOANS BACKING THE MORGAN STANLEY RMBS ................................................................................................................................22
A. New Century Violated Its Underwriting Guidelines .............................................24
B. WMC Mortgage Corporation Violated Its Underwriting Guidelines ....................33
C. Decision One Violated Its Underwriting Guidelines .............................................36
D. First NLC Violated Its Underwriting Guidelines ...................................................42
E. AIG Violated Its Underwriting Guidelines ............................................................47
F. The Other Morgan Stanley RMBS Originators Violated Their Underwriting Guidelines ........................................................................................53
VI. MORGAN STANLEY KNEW THE TRUTH ABOUT THE ORIGINATORS’ LENDING PRACTICES ...................................................................................................55
A. Morgan Stanley Knew The Loans It Was Securitizing Were Destined To Fail .........................................................................................................................56
B. Morgan Stanley’s Due Diligence Identified Defects In The Loan Pools Morgan Stanley Purchased For Securitization .......................................................62
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C. Morgan Stanley Knowingly Purchased Defective Loans In Order To Keep Its Subprime Profit Machine Running ...................................................................68
D. Morgan Stanley Dumped Defective Loans Into Securitizations To Reduce Its Exposure To Its Warehouse Lines Of Credit ....................................................73
E. Morgan Stanley Unloaded Toxic RMBS Onto Investors Like Allstate To Limit Its Exposure As The Mortgage Crisis Intensified ........................................76
VII. MORGAN STANLEY KNEW THE CREDIT RATINGS ASSIGNED TO THE MORGAN STANLEY RMBS MATERIALLY MISREPRESENTED THE CREDIT RISK OF THE RMBS ........................................................................................78
VIII. DEFENDANTS’ FALSE AND MISLEADING MISSTATEMENTS AND OMISSIONS OF MATERIAL FACT IN THE OFFERING DOCUMENTS...................85
A. The Offering Materials Misrepresented The Originators’ Underwriting Guidelines. .............................................................................................................85
B. The Offering Materials Misrepresented Morgan Stanley Mortgage Capital Inc.’s Loan Purchasing Guidelines ........................................................................87
C. The Offering Materials Misrepresented The Appraisals And LTV Ratios Of The Securitized Loans ......................................................................................89
D. The Offering Materials Misrepresented Morgan Stanley’s Due Diligence Into The Loan Sellers And The Mortgage Loans Backing The RMBS .................90
E. Defendants Materially Misrepresented The Accuracy Of The Credit Ratings Assigned To The Certificates ...................................................................92
F. Defendants’ Purported Warnings Regarding The Risks Of The RMBS Contained False And Misleading Statements And Omissions Of Material Fact .........................................................................................................................93
IX. ALLSTATE’S INVESTMENT IN THE RMBS AND RELIANCE ON MORGAN STANLEY’S MISREPRESENTATIONS ......................................................96
X. BECAUSE OF DEFENDANTS’ FRAUDULENT CONDUCT, ALLSTATE SUFFERED LOSSES ON ITS PURCHASES OF RMBS ................................................99
FIRST CAUSE OF ACTION (Common Law Fraud Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC) ....................................................................................................100
SECOND CAUSE OF ACTION (Fraudulent Inducement Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley
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Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC) ....................................................................................102
THIRD CAUSE OF ACTION (Aiding And Abetting Fraud Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC) ....................................................................................103
FOURTH CAUSE OF ACTION (Negligent Misrepresentation Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC) ....................................................................................105
PRAYER FOR RELIEF ..............................................................................................................108
1
Plaintiffs Allstate Insurance Company, Allstate Life Insurance Company, Allstate Life
Insurance Company of New York, Agents Pension Plan, and Allstate Retirement Plan
(collectively, “Allstate” or “Plaintiffs”), by their attorneys Bernstein Litowitz Berger &
Grossmann LLP, for their Complaint herein against Morgan Stanley, Morgan Stanley & Co.,
Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley
Mortgage Capital Holdings LLC and Morgan Stanley Mortgage Capital Inc. (collectively,
“Morgan Stanley” or “Defendants”), allege as follows:
I. SUMMARY OF THE ACTION
1. This action arises from a fraud perpetrated by Morgan Stanley against Allstate,
which invested in residential mortgage-backed securities (“RMBS”) that contained loans
purchased, financed, and securitized by Morgan Stanley. Allstate invested in highly-rated
RMBS, bearing AAA ratings, in reliance on Morgan Stanley’s representations that it had
conducted due diligence on the mortgages backing the RMBS and that those mortgages were
originated according to specific underwriting guidelines and collateralized by accurately
appraised properties. Those representations and the AAA ratings the RMBS carried led Allstate
to believe that the Morgan Stanley RMBS it purchased were safe investments.
2. Allstate purchased over $104 million in Morgan Stanley RMBS in six offerings
between 2005 and 2007 (the “Certificates”) in reliance on registration statements, prospectuses,
draft prospectus supplements, prospectus supplements and term sheets (the “Offering
Materials”) prepared by and provided to them, directly or indirectly, by the Defendants. The
Offering Materials contained numerous representations about the purportedly conservative
mortgage underwriting standards applied by the mortgage originators, the appraisals of the
mortgaged properties, and other facts regarding the collateral underlying the RMBS that were
material to Allstate’s investment decisions. Allstate decided to purchase the Certificates on the
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basis of those representations, and on the central role that Morgan Stanley played in creating
and selling the RMBS.
3. Allstate’s investment in the Certificates was based, in large part, on Morgan
Stanley’s role as a principal in the securitization process, in which Morgan Stanley first
purchased the loans from the originators before securitizing them into the RMBS purchased by
Allstate. Morgan Stanley represented to Allstate that Morgan Stanley had conducted due
diligence on the mortgage originators and the loans they issued before purchasing them for
securitization, providing assurance to Allstate that the loans backing their RMBS investment
conformed to the stated underwriting standards employed by those originators, that the appraisal
values and other characteristics were valid and accurate, that the Certificates were deserving of
the AAA ratings they had been assigned, and that the quality of the RMBS as represented in the
Offering Materials matched Morgan Stanley’s reputation.
4. In truth, and as Allstate and the world would only later discover, the originators
whose loans collateralized the Morgan Stanley RMBS purchased by Allstate were among the
worst of the worst culprits in the subprime lending industry. These infamous lenders included
New Century Financial Corp. (“New Century”), WMC Mortgage Corporation (“WMC”),
Decision One Mortgage Company (“Decision One”), First NLC Financial Services LLC (“First
NLC”), and AIG Federal Savings Bank and Wilmington Finance Inc. (collectively, “AIG”).
These originators have since folded up their operations, filed for bankruptcy or been shut down
by regulators, and are the subject of numerous governmental investigations and private lawsuits
alleging misconduct arising out of pervasive illegal and improper mortgage lending practices
and other violations of law.
5. Morgan Stanley knew or recklessly disregarded that those lenders were issuing
high-risk loans that did not conform to their respective underwriting standards. Morgan Stanley
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did, in fact, conduct extensive due diligence on the loans it purchased for securitization, as
represented in the Offering Materials. In the course of that extensive due diligence process,
which, in many instances, included an extensive re-underwriting review of the loans it
purchased by an independent third-party due diligence provider, Clayton Holdings, Inc.
(“Clayton”), Morgan Stanley learned that the originators routinely and flagrantly disregarded
their own underwriting guidelines, originated loans based on wildly inflated appraisal values,
and manipulated the underwriting process in order to issue loans to borrowers who had no
plausible means to repay them. Indeed, both the President of Clayton and the head of Morgan
Stanley’s own due diligence arm testified as to the extensive deficiencies identified through
Morgan Stanley’s due diligence. Specifically, over one-third of the loans Morgan Stanley
evaluated for purchase and securitization at the height of the mortgage boom (from 2006
through mid-2007) failed to meet the originators’ own underwriting guidelines.
6. In fact, between January 2006 and June 2007, Morgan Stanley purchased and
securitized over half of the sampled loans that Clayton determined failed to meet the
originator’s underwriting guidelines, meaning that Morgan Stanley knew the loan pools it
securitized were riddled with defective loans that were underwritten in a systematically
deficient manner that flatly contradicted the representations in Morgan Stanley’s Offering
Materials.
7. Numerous former Morgan Stanley and Clayton employees interviewed by
Allstate’s counsel confirm that Morgan Stanley was well aware of the poor quality of the loans
it purchased, securitized and sold to Allstate. A former Executive Director on Morgan Stanley’s
Residential Mortgage Trading Desk told National Public Radio that Morgan Stanley “bought
loans, lots of loans” that “he knew in his gut they were bad loans” and admitted that “It felt
4
wrong way back when and I wish we had never done it. Unfortunately, what happened . . . we
did it because everyone else was doing it.”
8. Not only did Morgan Stanley fail to inform investors that its due diligence had
discovered that these originators routinely flouted the law and disregarded basic underwriting
standards, Morgan Stanley traded on that information to its benefit. Specifically, as described
by several former Morgan Stanley and Clayton employees, Morgan Stanley would negotiate
cheaper prices for loans that it knew were not compliant with the originator’s guidelines. In
addition, as described by one former Morgan Stanley employee who had intimate knowledge of
Morgan Stanley’s loan purchasing and due diligence operations (referred to herein as “CW 1”),
Morgan Stanley would itself degrade the quality of the RMBS by turning “full documentation”
loans—which require the borrower to validate the income and other information in the loan
application—into “stated income” loans, where such proof of income is not required, in order to
pay a lower price to acquire the loan and increase its own profit.
9. According to CW 1, this was Morgan Stanley’s way of exploiting the fact that it
routinely purchased loans that never should have been originated in the first place, knowing that
these originators would capitulate because they depended on Morgan Stanley’s willingness to
continue buying their product. Similarly, when a full documentation loan showed that the
borrower’s income was insufficient, Morgan Stanley would shred the documentation, and tell
the originator to get a new, “stated” income, that made the loan appear reasonable. According
to CW 1, Morgan Stanley did this to increase its own profits, which were dependent on the
spread between what Morgan Stanley paid for a given loan pool and what it received from
selling those loans into a securitization. Because Morgan Stanley never disclosed these
practices, investors such as Allstate were not compensated for the additional risks that they
unknowingly took on in purchasing those Morgan Stanley RMBS.
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10. Morgan Stanley was driven to routinely purchase and securitize defective loans
because those very loans secured the warehouse lines of credit that Morgan Stanley extended to
the originators. According to CW 1, Morgan Stanley provided warehouse lines of credit to
originators that essentially locked Morgan Stanley into buying their loans, regardless of their
quality. As the credit crisis intensified, Morgan Stanley took drastic steps to ensure its
warehouse lines would be paid back, even ignoring the fact that originators advanced borrowers’
mortgage payments to make it appear as though a loan was performing so that it could be
securitized by Morgan Stanley and sold to investors like Allstate.
11. Morgan Stanley not only concealed the truth about the mortgage originators from
Allstate, it also knowingly provided false information to the credit rating agencies in order to
secure a triple-A blessing for its RMBS. Morgan Stanley also exploited its powerful influence
over the rating agencies to obtain desired ratings. As described by CW 1, if Morgan Stanley
was unhappy with a given rating, it would simply fire that credit rating agency and hire another
one that would provide Morgan Stanley’s desired rating. As a result of these practices, Morgan
Stanley knew that the ratings assigned to its securitizations did not reflect the true credit quality
of the Certificates Allstate purchased.
12. The scope of Morgan Stanley’s fraud and the strength of Allstate’s claims are
reflected by Morgan Stanley’s agreement to pay $102 million to resolve an investigation by the
Massachusetts Attorney General into its role in precipitating the subprime mortgage meltdown
by financing, purchasing and securitizing high-risk loans. As alleged by the Massachusetts
Attorney General and as discussed in further detail below, Morgan Stanley knew that, contrary
to the representations in the Offering Materials, the loans it purchased and securitized were
originated without regard to prudent underwriting standards, a borrower’s ability to repay, or
compliance with the law.
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13. This misconduct has resulted in astounding rates of default on the loans
underlying the Morgan Stanley RMBS and massive downgrades of the Certificates, which are
all now considered “junk.” As of May 2011, on average, over 35% of the mortgage loans
underlying the Certificates were over 60 days delinquent, in foreclosure, bankruptcy or
repossession as reflected by the chart below. This figure does not include the substantial losses
suffered by Allstate since the RMBS’ issuance due to foreclosures and defaults, and the removal
of those failed mortgage loans from the current loan pool and current delinquency figures.
Indeed, had such mortgage loans remained in the securitization, the average serious delinquency
rates would have been substantially higher. Accordingly, the Certificates are no longer
marketable or salable at or near the prices Allstate paid for them, and Allstate has suffered
significant losses as a result of the fraud perpetrated by Morgan Stanley.
Collateral Performance of Securities Underwritten by MS&Co. Serious Delinquencies ( = 60 Day + 90 Day + Real Estate Owned + Foreclosure)1
# Offering 12
Months24
MonthsAt 36
MonthsAt 48
Months May 2011
1 MSAC 2006-HE4 17.74 42.60 54.12 47.53 40.29
2 MSHEL 2006-3 16.80 43.00 43.76 37.93 35.05
3 MSIX 2006-1 17.77 41.81 52.92 50.58 44.60
4 MSM 2006-10SL2 7.63 23.86 25.27 12.86 10.02
5 MSAC 2006-HE8 20.96 44.25 57.89 50.44 44.93
6 MSAC 2007-NC4 39.35 54.02 47.05 N/A 38.20
Averages: 20.04 41.59 46.84 39.87 35.52
1 Real Estate Owned Properties (“REO”) are properties owned by a bank after an unsuccessful foreclosure auction.
2 The trustee for the MSM 2006-10SL RMBS does not publicly report foreclosures or REOs on loans backing that RMBS.
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14. Allstate seeks compensatory and/or rescissionary damages against Defendants
for fraud, fraud in the inducement, aiding and abetting fraud, and negligent misrepresentation.
II. JURISDICTION AND VENUE
15. This Court has jurisdiction over each of the Defendants because each of them
transacts business within the State of New York within the meaning of CPLR § 302(a)(1) and
each of them committed a tortious act inside the State of New York or outside the State of New
York causing injury within the State of New York within the meaning of CPLR §§ 302(a)(2)
and 302(a)(3). The amount in controversy exceeds $150,000.
16. Venue is proper in this Court because Defendants maintain their principal places
of business in New York County.
III. THE PARTIES
A. Plaintiffs
17. Plaintiff Allstate Insurance Company is an insurance company formed under the
laws of, and domiciled in, the State of Illinois, with its principal place of business in
Northbrook, Illinois. It is the nation’s largest publicly-held personal-lines insurer, selling
property and casualty insurance. Allstate Insurance Company is licensed to do business in New
York and writes insurance policies to New York residents. Allstate Insurance Company is a
wholly owned subsidiary of Allstate Insurance Holdings, LLC, which is a Delaware limited
liability company. Allstate Insurance Holdings, LLC is a wholly owned subsidiary of The
Allstate Corporation, which is a Delaware Corporation.
18. Plaintiff Allstate Life Insurance Company is an insurance company formed under
the laws of, and domiciled in, the State of Illinois, with its principal place of business in
Northbrook, Illinois. It sells life insurance and annuity products. Allstate Life Insurance
Company is a wholly-owned subsidiary of Allstate Insurance Company.
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19. Plaintiff Allstate Life Insurance Company of New York is an insurance company
formed under the laws of, and domiciled in, the State of New York, with its principal place of
business in Hauppauge, New York. It sells life, accident and health insurance and annuity
products. Allstate Life Insurance Company of New York is a wholly-owned subsidiary of
Allstate Life Insurance Company.
20. Plaintiff Agents Pension Plan is an Employee Retirement Income Security Act
(“ERISA”) plan sponsored by Allstate Insurance Company.
21. Plaintiff Allstate Retirement Plan is an ERISA plan sponsored by Allstate
Insurance Company.
B. Defendants
22. Defendant Morgan Stanley (“MS”) was, at all relevant times, a Delaware
corporation with its principal place of business at 1585 Broadway, New York, New York
10036. MS is a global financial services firm that trades on the New York Stock Exchange
under the ticker “MS.” MS’ business units include its Institutional Securities division which,
among other things, acts as an underwriter of residential mortgage-backed securities, provides
warehouse lending to subprime and other mortgage originators, trades, makes markets and takes
proprietary positions in mortgage- backed securities, and structures debt securities and
derivatives involving mortgage-related securities. MS serves as the parent corporation for
Morgan Stanley & Co., Inc.
23. Defendant Morgan Stanley & Co., Inc. (“MS&Co.”) is owned by MS and served
as an underwriter for all of the Morgan Stanley RMBS purchased by Allstate.
24. Defendant Morgan Stanley ABS Capital I Inc. is a direct, wholly-owned
subsidiary of MS, and has its executive offices at 1585 Broadway, 2nd Floor, New York, New
9
York 10036. Morgan Stanley ABS Capital I Inc. served as a depositor in all but one of the
Morgan Stanley RMBS purchased by Allstate at issue here.
25. Defendant Morgan Stanley Capital I Inc. is a Delaware corporation that has its
principal offices at 1585 Broadway, New York, New York 10036. Defendant Morgan Stanley
Capital I Inc. served as a depositor of the 2006-10SL RMBS purchased by Allstate.
26. Defendant Morgan Stanley Mortgage Capital Inc. was a New York corporation
until 2007, when it was merged into Defendant Morgan Stanley Mortgage Capital Holdings
LLC, which is Morgan Stanley Mortgage Capital Inc.’s successor-in-interest. Defendant
Morgan Stanley Mortgage Capital Inc. served as a sponsor of the MSAC 2006-HE4, MSAC
2006-HE8, MSHEL 2006-3, MSIX 2006-1 and MSM 2006-10SL RMBS purchased by Allstate.
27. Defendant Morgan Stanley Mortgage Capital Holdings LLC, a New York
liability company, is a successor-in-interest by merger to Morgan Stanley Mortgage Capital
Inc., and has its principal executive offices at 1221 Avenue of the Americas, New York, New
York 10020. Defendant Morgan Stanley Mortgage Capital Holdings LLC served as a sponsor
of the MSAC 2007-NC4 RMBS purchased by Allstate.
28. The Defendants identified in ¶¶ 22-27 are hereinafter collectively referred to as
“Morgan Stanley” or “Defendants.”
IV. FACTUAL BACKGROUND UNDERLYING ALLSTATE’S CLAIMS
A. The Morgan Stanley RMBS Purchased By Allstate
29. RMBS, such as the Morgan Stanley RMBS purchased by Allstate, provide the
RMBS investor with an interest in income generated by a pool of mortgages. The actual
securities themselves represent a participating interest in an “issuing trust” that holds the
mortgage loan pool. Although the structure and underlying collateral of the mortgages varies
among the six Morgan Stanley RMBS that Allstate purchased, they all function in a similar
10
manner: The cash flows from the borrowers who make interest and principal payments on the
individual mortgages comprising the mortgage pool are “passed through” to the certificate
holders, like Allstate. Accordingly, failure by those borrowers to make their mortgage
payments directly impacts the returns Allstate earns on its investment. Moreover, a default
resulting in foreclosure may cause the trust to sell the subject property at a loss – a risk that
increases when the appraisals utilized in underwriting the loans overstated the value of the
property that serves as collateral for the mortgage. For these reasons, the proper underwriting
of the mortgages underlying the RMBS – including verifying the credit quality of the borrower
and the value of the real estate – is essential to ensuring that the RMBS perform according to
the representations made to investors like Allstate.
30. The first step in creating an RMBS is the acquisition by a “depositor” of an
inventory of loans from a “sponsor” or “seller,” which either originates the loans or acquires the
loans from other mortgage originators, in exchange for cash. The type of loans in the inventory
varies, and can include conventional, fixed-rate or adjustable-rate mortgage loans, secured by
first liens, junior liens, or a combination of first and junior liens, with various lifetimes to
maturity. The depositor then transfers, or deposits, the acquired pool of loans to an “issuing
trust.” Although there can be more than one “sponsor” or “depositor” in a given securitization,
in all of the Morgan Stanley RMBS purchased by Allstate, Morgan Stanley entities acted as the
“depositor” and “sponsor” of the securitization.3
31. The depositor then securitizes the pool of loans in the issuing trust so that the
rights to the cash flows from the pool can be sold to investors. The securitization transactions
are structured such that the risk of loss is divided among different levels of investment, or
3 In the MSIX 2006-1 RMBS purchased by Allstate, Morgan Stanley Mortgage Capital Inc. and IXIS Real Estate Capital Inc. served as sponsors.
11
“tranches,” with each having a different level of risk and reward. Typically, losses on the
underlying loans—whether due to default, delinquency, or otherwise—are generally applied in
reverse order of seniority. As such, the most senior tranches of pass-through securities are rated
by credit rating agencies as the best quality, or “AAA/Aaa.” Junior tranches, which usually
obtained lower ratings, ranging from “AA/Aa” to “BB/Ba,” are less insulated from risk, but
offer greater potential returns in the form of higher rates of interest. All of the Morgan Stanley
RMBS purchased by Allstate were among the most senior, risk-averse tranches of the relevant
offerings and were all rated “AAA/Aaa” at issuance and when purchased by Allstate.
32. Once the tranches are established, the issuing trust passes the securities back to
the depositor, which becomes the issuer of the RMBS. The depositor then passes the RMBS to
MS&Co.—which offers and sells the securities to Allstate and other investors in exchange for
cash that is passed back to the depositor, less any fees collected by MS&Co. for serving as an
underwriter of the securitization. Typically, underwriters like MS&Co. would collect between
0.2% to 1.5% in discounts, concessions or commissions in serving as an underwriter of an
RMBS securitization. On the six Morgan Stanley RMBS purchased by Allstate, these
commissions would have yielded MS&Co. up to $104 million in underwriting fees. By serving
as a sponsor and depositor of the securitizations, Morgan Stanley earned even more.
33. Morgan Stanley entities were involved in almost every step of the process of
selling all of the Morgan Stanley RMBS to Allstate. Morgan Stanley Mortgage Capital Inc. and
Morgan Stanley Mortgage Capital Holdings LLC, which served as the sponsor for all six RMBS
purchased by Allstate, provided warehouse financing to the originators that issued the mortgage
loans, acquired the mortgage loans from the originators, and initiated the securitization of the
mortgage loans into RMBS by transferring the loans to Morgan Stanley ABS Capital I Inc. or
Morgan Stanley Capital I Inc., the relevant depositor. The relevant depositor, controlled by MS
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in all of the Morgan Stanley RMBS purchased by Allstate, obtained the mortgage loans from
Morgan Stanley Mortgage Capital Inc. or Morgan Stanley Mortgage Capital Holdings LLC (the
relevant sponsor) to place into the issuing trust for sale in privately negotiated transactions to
investors like Allstate. Importantly, Morgan Stanley provided the information that Allstate used
to decide whether to purchase the securities.
34. Because the cash flow from the loans in the collateral pool of a securitization is
the source of funds to pay the holders of the RMBS issued by the trust, the credit quality of
those securities depends upon the credit quality of the loans in the collateral pool. The most
important information about the credit quality of the loans is contained in the “loan files” that
the mortgage originator develops while making the loans. For residential mortgage loans, each
loan file normally contains documents including: the borrower’s application for the loan;
verification of the borrower’s income, assets, and employment; references; credit reports on the
borrower; an appraisal of the property that will secure the loan and provide the basis for
important measures of credit quality, such as loan-to-value ratios.
35. The collateral pool of loans for each securitization usually includes thousands of
loans. Instead of each potential investor reviewing thousands of loan files, Morgan Stanley, in
its role as a sponsor and underwriter of the securitization, is responsible for gathering, verifying
and presenting to potential investors accurate and complete information about the credit quality
and characteristics of the loans that are deposited into the trust. Indeed, the single most
important factors for Allstate—and, for any investor—in purchasing Morgan Stanley RMBS
were: (1) the ability of the underlying borrowers to repay their mortgages; (2) the ability for the
trust to recover its losses in case of default by ensuring the properties were appropriate collateral
for the loans and were accurately valued; and (3) the rate of interest received on the RMBS.
The loan files themselves are not provided or available to RMBS investors like Allstate, who
13
must instead rely upon Morgan Stanley’s representations about the mortgages underlying the
RMBS and the process used to select and review those loans.
36. As noted, all of the Morgan Stanley RMBS purchased by Allstate were rated
triple-A at issuance, as set forth below:
Deal and Tranche Face Amount
Purchased
Moody’s Rating
at Issuance
Moody’s Current Rating
S&P’s Rating
at Issuance
S&P’s Current Rating
Top Originators
& Sellers
MSAC 2006-HE4 A3 $14,844,054 Aaa Ca AAA CCC WMC; Decision One; New Century
MSAC 2006-HE8 A2C $40,880,000 Aaa Ca AAA CCC New Century; Decision One;WMC
MSAC 2007-NC4 A2A $14,551,042 Aaa Ca AAA CC New Century
MSHEL 2006-3 A3 $8,366,749 Aaa Ca AAA CCC AIG; Aegis Mortgage Corp.; Meritage Mortgage Corp.
MSIX 2006-1 A3 $14,207,490 Aaa Ca AAA CCC First NLC; Meritage Mortgage Corp.; Accredited Corp.
MSM 2006-10SL A1 $11,971,253 Aaa C AAA CCC Various loan originators
B. Morgan Stanley’s Activities In The Subprime Mortgage Arena
37. Morgan Stanley’s activities as a buyer, financer and securitizer of residential
mortgage loans have been the focus of numerous government investigations and prosecutions as
well as private investor lawsuits. At the height of the subprime bubble, MS’ executives became
concerned about competition in the RMBS arena from rivals such as Goldman Sachs, Lehman
Brothers, and Bear Stearns. In response, Morgan Stanley aggressively pursued opportunities to
profit from the booming subprime mortgage securitization industry. As explained by MS CFO
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David Sidwell during a 2007 earnings conference call, “we felt that we were underrepresented
in the mortgage business . . . that we did not have the scale of penetration in the mortgage
markets that we should have. It was with that that we have said over the last couple of years
that we wanted to increase our footprint in mortgages. . . .” There is no question that Morgan
Stanley aggressively increased that footprint. In 2006 alone, during the height of the mortgage
bubble, Morgan Stanley securitized almost $30 billion in RMBS that were sold to Allstate and
other investors.
38. As MS’ CFO David Sidwell explained on a March 21, 2007 quarterly earnings
conference call, Morgan Stanley participated in the “subprime mortgage market in a number of
ways. Through our securitized products group, we purchase loans from originators and
originate loans. . . . We are active in the structuring, securitization, and distribution of subprime
products, including CLOs and CDOs. Third, we manage our risk through a variety of hedging
strategies and we also take proprietary risk positions.”4 As noted by Sidwell, during that
quarter, Morgan Stanley’s subprime mortgage activities were “a significant contributor” to
Morgan Stanley’s financial results.
39. Morgan Stanley’s activities were integral to the growth and proliferation of high-
risk mortgages that contributed to the financial crisis. Mortgage originators generated profits
primarily through the sale of their loans to investment banks like Morgan Stanley, and the
originators were therefore driven to originate and sell as many loans as possible. Increased
demand for mortgages by banks like Morgan Stanley (which, as noted above, were competing
to sell mortgage-backed products) led to increased volume in mortgage originations. That
increased volume, in turn, led to a decrease in the gain-on-sale margins that mortgage 4 CLOs are collateralized loan obligations. CDOs are collateralized debt obligations. Both are examples of complex structured investments backed by mortgages or other loans that, like the RMBS sold to Allstate, were arranged and sold to investors by Morgan Stanley.
15
originators received from selling pools of loans. As a result, originators began to borrow money
from the same large banks that were buying their mortgages in order to fund the origination of
even more mortgages.
40. One of the principal ways originators obtained such capital was by establishing a
warehouse line of credit with an investment bank such as Morgan Stanley. The line of credit, in
turn, would be secured by the very mortgage loans that investment banks like Morgan Stanley
would purchase for securitization. Morgan Stanley earned fees and interest income on those
warehouse lines of credit. From 2005 to 2007, Morgan Stanley extended warehouse lines of
credit totaling billions of dollars to several of the originators whose loans backed the Morgan
Stanley RMBS sold to Allstate, including New Century, WMC, Accredited and Aegis Mortgage
Corp (“Aegis”).
C. Morgan Stanley’s Role Was To Ensure The Quality Of The Loans Backing The RMBS
41. Morgan Stanley and the mortgage originators utilized two methods to securitize
mortgages into RMBS for sale to investors. Specifically, the originators aggregated the loans
into pools and would either (1) deposit them into a trust that would issue RMBS backed by the
loans (referred to herein as an “originator securitization”), or (2) sell the loan pools to an
investment bank, and the investment bank would then deposit the securities into a trust that
would issue securities backed by the loans (“principal securitization”). Under the first
approach, Morgan Stanley profited by the fees it received by MS&Co. serving as an underwriter
of the securities issued by the originator. Under the second approach, referred to herein as a
“principal securitization” because the investment bank is securitizing the loans on its own
behalf, Morgan Stanley profited off of the difference in the price it paid for the loan pools it
purchased from the originator and that which it received from the sale of those loans as RMBS.
16
42. All of the Morgan Stanley RMBS purchased by Allstate at issue in this action
were securitized through principal securitization, whereby Morgan Stanley entities would first
purchase loan pools originated by third-party originators and/or loan sellers and then sell those
loans into the RMBS trust as the sponsor of a mortgage securitization. Some investors prefer
principal securitizations to originator securitizations because the involvement of a sophisticated
investment bank such as Morgan Stanley throughout the securitization process indicates a
higher degree of oversight and due diligence on the mortgages being selected for inclusion in
the RMBS.
43. Indeed, Morgan Stanley had its own internal due diligence team based in Boca
Raton, Florida, and routinely used an outside third-party due diligence provider, Clayton
Holdings, Inc. (“Clayton”), to perform due diligence on the pools of mortgages that Morgan
Stanley would securitize. For example, the prospectus supplements stated that “[p]rior to
acquiring any residential mortgage loans, Morgan Stanley Mortgage Capital Inc. conducts a
review of the related mortgage loan seller that is based upon the credit quality of the selling
institution,” which may include “reviewing select financial information for credit and risk
assessment and conducting an underwriting guideline review, senior level management
discussion and/or background checks.” According to the prospectus supplements, the “scope of
the mortgage loan due diligence varies based on the credit quality of the loans.”
44. Specifically, before purchasing loans from an originator in a principal
securitization, Morgan Stanley would perform due diligence on the mortgage loan pools by
examining three areas—credit, compliance and valuation. First, credit diligence examined a
sampling of the individual loans in a given loan pool to assess their quality and compliance with
the underwriting guidelines of the originator. An originator’s underwriting guidelines are a
critical tool for investors to evaluate the risk of default on the loans that serve as collateral for
17
RMBS. Prudent lending standards—as articulated in an originator’s underwriting guidelines—
are addressed in numerous federal guidance statements requiring that federally-regulated
institutions adopt well-defined underwriting parameters such as acceptable loan-to-value ratios,
debt-to-income ratios, and minimum acceptable credit scores.5 Those federal standards have
been adopted by the subprime industry as a whole through substantially similar guidance
published by the Conference of State Bank Supervisors and the American Association of
Residential Mortgage Regulators. These standards are intended not only to protect borrowers to
ensure that they can repay their loans, but also to ensure the safety and soundness of individual
lending institutions and the financial system as a whole. Second, compliance diligence focused
on whether the loans were originated in compliance with state, federal and local laws, including
predatory lending and truth-in-lending statutes. Third, valuation diligence checked the accuracy
of the originator’s reported property valuations of the collateral backing the loans. In a
principal securitization, this due diligence provides comfort to investors that Morgan Stanley
has ensured that only mortgages that conform to the requirements of the RMBS at issue are
being securitized.
45. In truth, Morgan Stanley routinely ignored the pervasive defects that its due
diligence identified in the loans Morgan Stanley had purchased for securitization. Morgan
Stanley deliberately concealed these defects from Allstate and other investors in order to
increase its own profits, preserve its ongoing business relationships with the RMBS originators,
and move risk from its own balance sheet onto investors. Instead, as discussed in further detail
below, Morgan Stanley used its asymmetrical informational advantage to reap illicit profits. 5 See, e.g., 12 C.F.R. Part 34, subpart D (Office of the Comptroller of Currency standards); 12 C.F.R. Part 208, subpart C (Board of Governors of the Federal Reserve standards); 12 C.F.R. Part 365 (Federal Deposit Insurance Corporation standards); 12 C.F.R. 560.100 and 12 C.F.R. 560.101 (Office of Thrift Supervision standards); and 12 CFR 701.21 (National Credit Union Administration standards).
18
D. Factors Impacting The Quality Of The Morgan Stanley RMBS
46. Federal regulators have long recognized the importance of sound lending and
have for years issued guidance on subprime mortgage products to ensure that borrowers are able
to repay their loans. For example, the 1993 Interagency Guidelines for Real Estate Lending,
issued jointly by the Board of Governors of the Federal Reserve System (Morgan Stanley’s
primary federal regulator), the Office of the Comptroller of the Treasury, the Federal Depository
Insurance Commission, the Office of Thrift Supervision, and the National Credit Union
Administration, provided that prudently underwritten real estate loans (subprime or otherwise)
“should reflect all relevant credit factors, including . . . the capacity of the borrower, or income
from the underlying property, to adequately service the debt.” Federal regulators responded to
the growth of newer subprime products with enhanced guidance in 1999, warning that if risks
associated with subprime lending were “not properly controlled, the agencies consider subprime
lending a high-risk activity that is unsafe and unsound.”
47. The 1999 guidance recognized the critical role that banks such as Morgan
Stanley, which comprised the primary market for the sale of subprime loans, played in dictating
and enforcing underwriting standards for subprime mortgage lending:
Institutions should not accept loans from originators that do not meet their underwriting criteria, and should regularly review loans offered to ensure that loans purchased continue to meet those criteria. Deterioration in the quality of purchased loans or in the portfolio’s actual performance versus expectations requires a thorough reevaluation of the lenders or dealers who originated or sold the loans, as well as a reevaluation of the institution’s criteria for underwriting loans and selecting dealers and lenders. Any such deterioration may also highlight the need to modify or terminate the correspondent relationship or make adjustments to underwriting and dealer/lender selection criteria.
48. The guidance also required that “institutions . . . perform an ongoing analysis of
subprime loans,” “have information systems in place to segment and stratify their portfolio (e.g.,
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by originator, loan-to-value, debt-to-income ratios, credit scores) and produce reports for
management to evaluate the performance of subprime loans,” determine “whether performance
meets expectations,” and “consider the source and characteristics of loans that do not meet
expectations and make changes in their underwriting policies and loan administration procedures
to restore performance to acceptable levels.”
49. Indeed, the fundamental basis upon which RMBS are valued is the ability of the
borrowers to repay the principal and interest on the underlying loans and the adequacy of the
collateral. Thus, proper loan underwriting is critical to assessing the borrowers’ ability to repay
the loans, and a necessary consideration when purchasing and pooling loans. If the loans
pooled in the RMBS suffer defaults and delinquencies in excess of the assumptions built into
the certificate payment structure, RMBS investors suffer losses because of the diminished cash
flow into the RMBS.
50. Likewise, independent and accurate appraisals of the collateralized real estate are
essential to ensure that the mortgage or home equity loan can be satisfied in the event of a
default and foreclosure on a particular property. An accurate appraisal is necessary to determine
the likely price at which the foreclosed property can be sold and, thus, the amount of money
available to pass through to certificate holders.
51. An accurate appraisal is also critical to calculating the loan-to-value (“LTV”)
ratio, which is a financial metric commonly used to evaluate the price and risk of RMBS. The
LTV ratio expresses the amount of mortgage or loan as a percentage of the appraised value of
the collateral property. For example, if a borrower seeks to borrow $90,000 to purchase a home
worth $100,000, the LTV ratio is equal to $90,000 divided by $100,000, or 90%. If, however,
the appraised value of the house has been artificially inflated to $100,000 from $90,000, the real
LTV ratio would be 100% ($90,000 divided by $90,000). The term combined loan-to-value
20
ratio (“CLTV”) applies to the situation in which more than one loan is secured by a particular
property. For example, a property valued at $100,000 with a single mortgage of $50,000 has an
LTV of 50%. A similar property with a value of $100,000 with a first mortgage of $50,000 and
a second lien mortgage of $25,000 has an aggregate mortgage balance of $75,000, and a CLTV
of 75%.
52. From an investor’s perspective, a high LTV or CLTV ratio represents a greater
risk of default on the loan. First, borrowers with a small equity position in the underlying
property have “less to lose” in the event of a default. Second, even a slight drop in housing
prices might cause a loan with a high LTV ratio to exceed the value of the underlying collateral,
which might cause the borrower to default and would prevent the issuing trust from recouping
its expected return in the case of foreclosure and subsequent sale of the property.
53. Consequently, the LTV ratios of the loans underlying the RMBS are important to
investors’ assessment of the value of such RMBS. Prospectuses typically provide information
regarding the LTV ratios, and even guarantee certain LTV ratio limits for the loans that will
support the RMBS. Indeed, Morgan Stanley had a stated policy not to securitize loans with a
LTV or CLTV greater than 100%. Each of the prospectus supplements expressly stated, in sum
or substance, that “[n]one of the mortgage loans have loan-to-value ratios at origination, or
with respect to second-lien mortgages, combined loan-to-value ratios at origination, in excess
of 100%.”6 As discussed below, this representation was false because a substantial portion of
the loans purchased and securitized by Morgan Stanley (including nearly one-third of all New
Century loans issued to Massachusetts borrowers between late 2005 through the first half of
2007 and securitized by Morgan Stanley) had LTVs and CLTVs that exceeded 100% as
calculated under independent property valuations obtained by Morgan Stanley. 6 All emphasis added unless otherwise indicated.
21
54. Another important metric when considering a borrower’s ability to repay a loan is
a borrower’s debt-to-income ratio, or DTI, which reflects the increased risk that borrowers
whose debt is relatively high compared to their income will default on their loans. While a
borrower’s current DTI is good measure of his or her capacity to repay a fixed rate mortgage,
other loan products, such as adjustable rate mortgages (“ARMs”), have initial “teaser” rates that
reset at much higher index rates after a certain period. A “fully indexed rate” accounts for this
interest rate reset, and represents the interest rate over the life of the loan, calculated by adding
the index rate at origination and the margin that a lender adds to the index rate after the initial
“teaser” period. For example, if the current index rate is 2.5%, and if the margin on a particular
loan is 3%, the fully indexed rate on that loan is 5.5%. Because the fully indexed rate accounts
for the current value of the interest rate index used by an ARM, it is a better measure of a
borrower’s ability to repay the loan.
55. In 2006, the interagency regulators, responding to the explosive growth of non-
traditional mortgage products, provided revised guidance explicitly addressing how institutions
should calculate a borrower’s DTI. Specifically, the underwriting guidelines state that “[w]hen
an institution offers nontraditional mortgage loan products, underwriting standards should
address the effect of a substantial payment increase on the borrower’s capacity to repay when
loan amortization begins.” Moreover, according to the guidance:
For all nontraditional mortgage loan products, an institution’s analysis of a borrower’s repayment capacity should include an evaluation of their ability to repay the debt by final maturity at the fully indexed rate, assuming a fully amortizing repayment schedule. In addition, for products that permit negative amortization, the repayment analysis should be based upon the initial loan amount plus any balance increase that may accrue from the negative amortization provision.
22
56. The federal guidance thus served to provide assurance to investors that
investments in instruments backed by subprime mortgages could be safe and conservative
products so long as the underlying loans were properly underwritten and scrutinized. Indeed, the
federal guidance made clear that heightened attention to and rigorous compliance with strict
underwriting standards was critical for institutions engaged in subprime lending due to the
unique risks posed by that borrower population. As regulators made clear, in the context of
RMBS such as those purchased by Allstate here, representations concerning underwriting
guidelines, appraisals, LTVs and DTIs were paramount.
V. THE OFFERING MATERIALS MISREPRESENTED THE UNDERWRITING AND QUALITY OF THE LOANS BACKING THE MORGAN STANLEY RMBS
57. Contrary to the statements in the Offering Materials and other communications by
Morgan Stanley used to solicit Allstate’s investment in the Morgan Stanley RMBS, the
originators whose loans served as collateral for Allstate’s investments routinely and egregiously
violated their stated underwriting guidelines. As a result, the mortgages they originated and sold
to Morgan Stanley for securitization presented a materially higher risk to investors than
represented by Morgan Stanley in the Offering Materials.
58. For example, the MSAC 2006-HE8 prospectus supplement described New
Century’s underwriting standards, in relevant part, as follows:
The New Century Underwriting Guidelines are primarily intended to assess the borrower's ability to repay the mortgage loan, to assess the value of the mortgaged property and to evaluate the adequacy of the property as collateral for the mortgage loan. All of the mortgage loans in the mortgage pool were also underwritten with a view toward the resale of the mortgage loans in the secondary mortgage market. While New Century's primary consideration in underwriting a mortgage loan is the value of the mortgaged property, New Century also considers, among other things, a mortgagor's credit history, repayment ability and debt service-to-income ratio, as well as the type and use of the mortgaged property.
23
* * *
The mortgage loans will have been originated in accordance with the New Century Underwriting Guidelines. On a case by case basis, exceptions to the New Century Underwriting Guidelines are made where compensating factors exist. It is expected that a substantial portion of the mortgage loans in the mortgage pool will represent these exceptions.
59. Further, like the other originators whose loans backed the Morgan Stanley RMBS
purchased by Allstate, the Offering Materials described the documentation that New Century
purportedly required prospective borrowers to produce in order to properly obtain a mortgage
loan. For example, the MSAC 2006-HE8 prospectus supplement stated, in relevant part, as
follows:
Each applicant completes an application which includes information with respect to the applicant's liabilities, income, credit history, employment history and personal information. The New Century Underwriting Guidelines require a credit report on each applicant from a credit reporting company. The report typically contains information relating to matters such as credit history with local and national merchants and lenders, installment debt payments and any record of defaults, bankruptcies, repossessions or judgments.
60. The Offering Materials also provided information regarding the appraisal
standards and practices employed by the Morgan Stanley RMBS originators. For example, the
MSAC 2006-HE8 prospectus supplement described New Century’s appraisal practices as
follows:
Mortgaged properties that are to secure mortgage loans are appraised by qualified independent appraisers. These appraisers inspect and appraise the subject property and verify that the property is in acceptable condition. Following each appraisal, the appraiser prepares a report which includes a market value analysis based on recent sales of comparable homes in the area and, when deemed appropriate, replacement cost analysis based on the current cost of constructing a similar home. All appraisals are required to conform to the Uniform Standards of Professional Appraisal
24
Practice adopted by the Appraisal Standards Board of the Appraisal Foundation and are on forms acceptable to Fannie Mae and Freddie Mac.
61. These statements of material fact, and materially similar statements appearing in
all of the Morgan Stanley RMBS Offering Materials, were false and misleading when made
because New Century and the originators discussed below in ¶¶ 62-130 failed to adhere to their
established underwriting standards. Indeed, the reckless practices of New Century and the other
mortgage originators whose loans backed the Morgan Stanley RMBS rendered numerous
statements concerning the originator’s guidelines, the LTV ratios, property appraisal values, the
credit ratings assigned to the RMBS, and the due diligence Morgan Stanley conducted on those
loans, materially false and misleading. As such, the riskiness of the loans underlying the RMBS
purchased by Allstate, and thus the true risk profile of the RMBS was materially misrepresented.
Through Morgan Stanley’s due diligence process, as well as its intimate knowledge of the
originators’ underwriting practices gleaned through its warehouse lending relationships with
some of the most prominent originators that provided the loans backing the Morgan Stanley
RMBS, Morgan Stanley knew of these violations, and concealed them from Allstate.
A. New Century Violated Its Underwriting Guidelines
62. New Century or its affiliates originated an average of over 38% of the loans
contained in four of the six Morgan Stanley RMBS purchased by Allstate, representing over
$2.1 billion in total face value. Before its collapse in the first half of 2007, New Century was
one of the largest subprime lenders in the country, originating over $101 billion in loans from
2005 through September 2006. The Offering Materials relied upon by Allstate in purchasing
the Morgan Stanley MSAC 2007-NC4 RMBS, which was comprised entirely of New Century-
originated loans, contained false and misleading statements of material fact regarding New
Century’s underwriting practices and guidelines. For example, the MSAC 2007-NC4
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prospectus supplement described New Century’s underwriting guidelines, in relevant part, as
follows:
The New Century Underwriting Guidelines are primarily intended to assess the borrower’s ability to repay the related mortgage loan, to assess the value of the mortgaged property and to evaluate the adequacy of the property as collateral for the mortgage loan. All of the mortgage loans were also underwritten with a view toward the resale of the mortgage loans in the secondary mortgage market. While New Century’s primary consideration in underwriting a mortgage loan is the value of the mortgaged property, New Century also considers, among other things, a borrower’s credit history, repayment ability and debt service-to-income ratio, as well as the type and use of the mortgaged property.
* * *
The mortgage loans will have been originated in accordance with the New Century Underwriting Guidelines. On a case-by-case basis, exceptions to the New Century Underwriting Guidelines are made where compensating factors exist. It is expected that a substantial portion of the mortgage loans will represent these exceptions.
* * *
The mortgage loans were originated consistent with and generally conform to the New Century Underwriting Guidelines’ full documentation, limited documentation and stated income documentation residential loan programs. Under each of the programs, New Century reviews the applicant’s source of income, calculates the amount of income from sources indicated on the loan application or similar documentation, reviews the credit history of the applicant, calculates the debt service-to-income ratio to determine the applicant’s ability to repay the loan, reviews the type and use of the property being financed, and reviews the property.
63. The Offering Materials relied upon by Allstate also contained misstatements of
material fact concerning the documentation that New Century’s prospective borrowers were
purportedly required to submit in order to properly obtain a mortgage loan. For example, the
MSAC 2007-NC4 prospectus supplement represented, in relevant part, as follows:
Each applicant completes an application that includes information with respect to the applicant’s liabilities, income,
26
credit history, employment history and personal information. The New Century Underwriting Guidelines require a credit report on each applicant from a credit reporting company. The report typically contains information relating to matters such as credit history with local and national merchants and lenders, installment debt payments and any record of defaults, bankruptcies, repossessions or judgments.
64. These statements were false and misleading when made. In fact, New Century
systematically disregarded a borrower’s ability to pay when originating loans and without
regard to any “compensating factors.” Indeed, an investigation into New Century’s business
practices by the Bankruptcy Examiner assigned to investigate the causes of its collapse
concluded that “New Century had a brazen obsession with increasing loan originations, without
due regard to the risks associated with that business strategy.” As noted in the New Century’s
Bankruptcy Examiner’s investigation (the “Bankruptcy Examiner’s Report”)—which included a
review of a large number of documents and 110 interviews of 85 fact witnesses—numerous
members of New Century’s board of directors and senior management stated that the
predominant standard for loan quality was whether the loan could be sold in the secondary
market to investors like Morgan Stanley, not—as stated in the Morgan Stanley RMBS Offering
Materials—whether a borrower could meet the obligations under the terms of a loan. Indeed,
according to the Bankruptcy Examiner’s Report, New Century’s Chief Credit Officer said that
in 2004 New Century had “no standard for loan quality.”
65. As reported by the Bankruptcy Examiner, reckless origination and underwriting
of New Century loans was rampant. For example:
Certain senior managers at New Century in 2004 were told by a New Century employee that when underwriting stated income loans, “we are unable to actually determine the borrowers’ ability to afford a loan.”
In early 2006, one senior manager at New Century described the performance of a certain loan product as “horrendous.”
27
In 2004, the number and severity of the exceptions to underwriting standards employed by New Century to originate greater volume was described by one Senior Officer as the “number one issue” facing New Century.
By 2004, New Century Senior Management became aware of spiking increases in Early Payment Default (“EPD”) rates—where a borrower fails to make even the first several payments on a loan—suggesting that the loan should never have been originated in the first place. In every month following March 2006, the EPD rate exceeded 10%, reaching to as high as 14.95% by year end.
Up until 2005 New Century used a DOS-based underwriting system which, according to a New Century manager interviewed by the Bankruptcy Examiner, enabled employees to “finagle anything.”
66. New Century’s loan production department trained mortgage brokers at the
aptly-named “CloseMore University,” which provided instruction to New Century employees
on how to originate increasingly risky loans. For example, over 70% of New Century’s loans
had initial “teaser rates” that would increase over the life of the loan; over 40% of New
Century’s loans were underwritten on a “stated income” basis; and New Century originated an
increasingly high percentage of 80/20 loans, which includes a first lien mortgage with a 80%
loan-to-value ratio, with a second lien loan with a 20%-loan-to-value ratio, resulting in a
combined financing of 100% of the mortgaged property. Often, these different risk
characteristics were combined into a single loan, resulting in a “layering” of the risk of the loan.
67. Numerous former New Century employees interviewed by Allstate’s counsel
confirmed the conclusions of the New Century Bankruptcy Examiner and explained that loans
were not originated according to New Century’s stated underwriting guidelines, but were
instead originated without regard to a borrower’s ability to repay the loan. For example,
according to CW 2, a former New Century fraud investigator and senior loan underwriter who
examined numerous New Century mortgage loans from January 1999 until April 2007, New
Century “started to abandon prudent underwriting guidelines” at the end of 2003 in order to
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“push more loans through.” According to CW 2, New Century essentially “stopped
underwriting.”7 As explained by CW 5, a former New Century account manager employed by
New Century from November 2004 until September 2006 in Englewood, Colorado, New
Century was very “loose” with its underwriting rules, routinely waived certain underwriting
conditions, and often ignored its own underwriters’ findings or decisions. CW 5 stated that a lot
of the loans originated were “fraudulent,” and that CW 5 would bring loans with falsified
verifications to the attention of CW 5’s operations and sales manager, but was told to just issue
the loans in order to “make our numbers.” CW 6, a former New Century Vice President and
Regional Manager, employed by New Century from September 1996 until May 2007, explained
that New Century made very low quality and extremely risky loans, noting that: “If you had a
heartbeat, we would give you a loan.”
68. CW 7, another former New Century underwriter and risk manager employed at
New Century from December 2001 until April 2007, explained that exceptions to underwriting
guidelines were endemic and it was “more about quantity than quality,” with the attitude being
7 CW 3, a former New Century Vice President, Corporate Finance, agreed that New Century began to lower credit standards beginning in 2003. At that time, New Century changed its practice with respect to stated income loans, which became to be known in the industry as “liar’s loans.” CW 4, a former New Century senior training development manager employed by New Century from March 2003 until March 2006, explained that underwriters often allowed borrowers to resubmit a rejected full-documentation loan (which had been rejected because the borrower’s income was too low) as a “stated loan” with a new and higher income, which was then approved. CW 4 stated that this practice was “taboo” in the mortgage industry but routinely occurred and was a “running joke” at New Century.
29
“get the volume on; get the volume on.” Indeed, CW 7 reported that nine out of 10 loans that
CW 7 recommended denying were nevertheless approved by management.8
69. CW 10, a former New Century production risk manager employed by New
Century from April 2002 until April 2007 in Woodland Hills, California who performed quality
control audits on funded loans and, after February 2007, on loans claimed for repurchases,
stated New Century’s loans had gotten “riskier and riskier.” According to CW 10, mortgage
underwriters were told not to deny loans and, if they were denied, applications would simply be
re-worked and signed off by operations managers. CW 10 stated that the most “questionable
loans” were those with exceptions required to be signed off on by management and those were
about half of the total volume of loans CW 10 generally reviewed. CW 10 reported that “a lot”
of the time CW 10 recommended denying a loan, but CW 10’s operations manager “constantly”
overrode CW 10—mainly because operations and branch managers received bonuses for the
number of funded loans they pushed through. According to CW 10, a running joke at New
Century was that, “If you could fog a mirror, you can get a loan at New Century.”
70. According to CW 11, a former New Century regional Vice President, employed
by New Century from 1999 until May 2007, the mindset of New Century’s operations division
was that it did not matter if a loan was a good loan or a bad loan—as long as New Century
could sell the loan for securitization into RMBS, it was a good loan. CW 11 explained that New
Century booked “ugly” loans and it was about “volume, volume, volume … pretty reckless
volume.”
8 CW 8, a former New Century Vice President, Regional Manager, employed by New Century from October 1999 until March 2007, stated that starting in 2003 and 2004, roughly half of New Century’s loans contained exceptions. CW 9, a former New Century underwriter employed by New Century from May 2005 to March 2006 in Itasca, Illinois and, previously, from 2000 until 2003 in Cincinnati, Ohio, explained that he could not recall the last loan that he looked at that did not have an exception.
30
71. Facts such as these led the New Century Bankruptcy Examiner to conclude that
statements in New Century’s Securities and Exchange Commission (“SEC”) filings declaring
that “regardless of document type, New Century designed its underwriting standards and quality
assurance standards to make sure that loan quality was consistent and met its guidelines” were
“not supportable.” Rather, the Bankruptcy Examiner concluded that “New Century did not
produce ‘high quality’ loans or have ‘high origination standards.’” Moreover, claims asserted
against New Century for making false or misleading statements of material fact regarding New
Century’s purported prudent underwriting guidelines have already been sustained under Section
10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, and Section 11 of the Securities
Act of 1933. See In re New Century, No. CV 07-00931 DDP (JTLx), ECF No. 333, at 34 (C.D.
Cal. Dec. 3, 2008) (“This Court likewise agrees . . . that Plaintiffs’ Complaint alleges sufficient
facts that the statements were material misrepresentations of New Century’s loan quality and
underwriting practices.”).
72. The statements in the Morgan Stanley RMBS prospectus supplements set forth
above in ¶¶ 62-63 and 73 regarding New Century’s underwriting practices and guidelines,
which represented the New Century-originated mortgage loans as “originated consistent with
and generally conform[ed] to the New Century Underwriting Guidelines’ . . . loan programs,”
parallel the false statements in New Century’s SEC filings and are equally false and misleading.
73. The Offering Materials for the MSAC 2007-NC4 RMBS used to solicit
Allstate’s purchase of Morgan Stanley RMBS backed by New Century-originated loans also
represented that New Century ensured proper appraisals when issuing loans to borrowers. For
example, the MSAC 2007-NC4 prospectus supplement explained that:
Mortgaged properties that are to secure mortgage loans generally are appraised by qualified independent appraisers. These appraisers inspect and appraise the subject property and verify that the
31
property is in acceptable condition. Following each appraisal, the appraiser prepares a report that includes a market value analysis based on recent sales of comparable homes in the area and, when deemed appropriate, replacement cost analysis based on the current cost of constructing a similar home. All appraisals are required to conform to the Uniform Standards of Professional Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal Foundation and are generally on forms acceptable to Fannie Mae and Freddie Mac. The New Century Underwriting Guidelines require a review of the appraisal by a qualified employee of New Century or by an appraiser retained by New Century. New Century uses the value as determined by the review in computing the loan-to-value ratio of the related mortgage loan if the appraised value of a mortgaged property, as determined by a review, is (i) more than 10% greater but less than or equal to 25% lower than the value as determined by the appraisal for mortgage loans having a loan-to-value ratio or a combined loan-to-value ratio of up to 90%, and (ii) more than 5% greater but less than or equal to 25% lower than the value as determined by the appraisal for mortgage loans having a loan-to-value ratio or a combined loan-to-value ratio of between 91-95%. For mortgage loans having a loan-to-value ratio or a combined loan-to-value ratio greater than 95%, the appraised value as determined by the review is used in computing the loan-to-value ratio of the related mortgage loan. If the appraised value of a mortgaged property as determined by a review is 25% or more lower than the value as determined by the appraisal, then New Century obtains a new appraisal and repeats the review process.
74. These statements were false and misleading when made. In order to increase
loan origination volume, New Century routinely hired biased appraisers and used inflated
appraisals as a matter of course to issue loans to borrowers who would not otherwise qualify for
the mortgage.
75. As described in the Bankruptcy Examiner’s Report, in New Century’s wholesale
division—which accounted for the vast majority (approximately 85%) of New Century’s loan
originations—the regional managers who had lending authority could override the internal
appraisers’ decisions. Moreover, the regional managers’ compensation was not tied to loan
32
quality, but was rather based on the volume of loans originated, providing incentive to inflate
appraisal values in order to increase origination of New Century loans.
76. As revealed in a 2005 internal New Century audit disclosed in the Bankruptcy
Examiner’s Report, 18 of 77 (or 23%) of the loans reviewed at one Sacramento fulfillment
center had “exceptions with either the appraisal conducted or the review of the appraisal
submitted with broker-provided loans or the review appraisal conducted by New Century’s
Appraisal Department.” The results of that audit were not an anomaly. According to the
Bankruptcy Examiner, the results of New Century’s own loan quality audits of underwriting
procedures, account manager review/approval, appraisals and funding “were dismal.” As
reported by the Bankruptcy Examiner, of nine branches audited by New Century in 2005, none
were rated satisfactory, seven were rated unsatisfactory and two were rated as needs
improvement.
77. Former New Century employees interviewed by [Plaintiff’s] counsel confirmed
that loans were routinely originated using improperly inflated appraisals. For example, CW 12,
a senior vice president enterprise program manager for New Century in Irvine, California from
July 2005 to April 2006 stated that he could “guarantee” that large appraisers used by New
Century gave New Century “the benefit of the doubt,” i.e., provided an overly optimistic
appraisal, in order to maintain New Century’s business. As but one example, CW 12 stated that
an appraiser might photograph only one side of the house but not the side that was run down
and falling apart in order to justify the inflated valuation. According to CW 12, these appraisal
companies did not “want to piss off New Century” because they were compensated on volume.
78. New Century’s reckless origination practices described above have had a
devastating effect on the average serious delinquency rates of the loans backing the RMBS
purchased by Allstate. For example, over 38% of the loans backing the MSAC 2007-NC4
33
RMBS, which is comprised of loans entirely originated by New Century, stood seriously
delinquent as of May 2011:
Offering 12
Months 24
Months At 36
Months At 48
Months May 2011
MSAC 2007-NC4 39.35 54.02 47.05 N/A 38.20
79. New Century’s statements regarding its “improved underwriting controls and
appraisal review process” have already been held by one court to be false or misleading
statements of material fact. See In re New Century, No. CV 07-00931 DDP (JTLx), ECF No.
333, at 33-34 (C.D. Cal. Dec. 3, 2008) (“The pleadings adequately support a finding that these
statements were false when made.”).
B. WMC Mortgage Corporation Violated Its Underwriting Guidelines
80. WMC Mortgage Corporation (“WMC”) originated over 30% of the loans
contained in two of the six Morgan Stanley RMBS purchased by Allstate representing almost
$1.1 billion in total face value. The prospectus supplement for the MSAC 2006-HE4 RMBS
stated the following about WMC’s underwriting guidelines:
Underwriting Standards. The mortgage loans have been either (i) originated generally in accordance with the underwriting guidelines established by WMC Mortgage Corp. (collectively, the “UNDERWRITING GUIDELINES”) or (ii) purchased by WMC Mortgage Corp. after re-underwriting the mortgage loans generally in accordance with the Underwriting Guidelines. . . . The Underwriting Guidelines are primarily intended to (a) determine that the borrower has the ability to repay the mortgage loan in accordance with its terms and (b) determine that the related mortgaged property will provide sufficient value to recover the investment if the borrower defaults. On a case-by-case basis WMC Mortgage Corp. may determine that, based upon compensating factors, a prospective mortgagor not strictly qualifying under the underwriting risk category or other guidelines described below warrants an underwriting exception. Compensating factors may include, but are not limited to, low debt-to-income ratio (“DEBT RATIO”), good mortgage payment history, an abundance of cash reserves, excess disposable income,
34
stable employment and time in residence at the applicant’s current address. It is expected that a substantial number of the mortgage loans to be included in the trust will represent such underwriting exceptions.
81. These statements were false and misleading when made in that they
misrepresented that WMC: (i) systematically failed to follow its stated underwriting standards;
(ii) allowed pervasive exceptions to its stated underwriting standards in the absence of
compensating factors; (iii) disregarded credit quality in favor of generating increased loan
volume; and (iv) violated its stated appraisal standards and in many instances materially inflated
the values of the underlying mortgage properties in the loan origination and underwriting
process.
82. According to Reuters, WMC was responsible for originating “some of the worst-
performing loans in the . . . $575 billion market for home equity asset-backed securities.” In
2004, WMC, then the sixth-largest subprime lender in the nation, was purchased by General
Electric. In September 2007, General Electric closed WMC’s operations because of its
subprime-related losses, taking a $400 million charge as a result. WMC’s reckless underwriting
standards and practices as described more fully below resulted in a huge amount of foreclosures,
ranking WMC fourth in the Office of the Comptroller of the Currency’s (“OCC”) “Worst Ten of
the Worst Ten” list of subprime lenders presented to the FCIC in April 2010—the ten mortgage
originators with the highest rate of subprime and Alt-A mortgage foreclosures in the ten
metropolitan areas experiencing the highest foreclosure rates from 2005 through 2007.
83. According to a lawsuit filed by PMI Mortgage Insurance Co. in September 2009,
a review of WMC’s mortgage loan files showed that WMC “followed few, if any, objective
standards or criteria in underwriting [mortgage loans] and showed little concern if any, for any
35
borrower’s ability to repay.” PMI Mortgage Ins. Co, v. WMC Mortgage Corp., BC-391072 (Los
Angeles Super. Ct.) (the “PMI Complaint”).
84. According to PMI’s allegations concerning misrepresentations and WMC’s
failure to adhere to its contractual repurchase obligations relating to the securitization of a pool
of mortgage loans, a review by Clayton into a sample of thousands of WMC-originated loans
revealed that WMC “breached various representations and warranties [attesting that,] inter alia,
the loan-to-value ratio at the time of origination was greater than 100%; fraud, errors,
misrepresentations, or gross negligence took place on the part of WMC . . .; the loans did not
comply with WMC’s own underwriting standards at the time of origination; certain documents
were missing; and/or WMC had failed to utilize a methodology in underwriting the loans that
employed objective mathematical principles designed to determine that, at the time of
origination, the borrower had the reasonable ability to make timely payments on the [m]ortgage
[l]oans.” According to the PMI Complaint, the Clayton investigation “demonstrate[d] a systemic
failure by WMC to apply sound underwriting standards and practices which cuts across all of the
[loans in the securitization].” In the defective loans, “Clayton discovered unreasonable stated
income and/or misrepresentations of income and/or employment by the borrower, the large
majority of which could have been discovered by WMC prior to transfer via simple diligence
procedures.” Moreover, nearly a quarter of the loans sampled by Clayton were shown to contain
“misrepresentations of occupancy by the borrower, another factor that could have easily been
verified by WMC.”
85. WMC’s reckless loan originating practices were noticed by regulatory authorities
as well. In June 2008, the Washington State Department of Financial Institutions, Division of
Consumer Services filed a Statement of Charges and Notice of Intention to Enter an Order to
Revoke License, Prohibit From Industry, Impose Fine, Order Restitution and Collect
36
Investigation Fees against WMC Mortgage and its principal owners individually. The Statement
of Charges included a review of 86 loan files, which revealed that at least 76 loans were
defective or otherwise in violation of Washington state law. Among other things, the
investigation uncovered that WMC had originated loans with unlicensed or unregistered
mortgage brokers, understated amounts of finance charges on loans, understated amounts of
payments made to escrow companies, understated annual percentage rates to borrowers and
committed many other violations of Washington State deceptive and unfair practices laws.
86. In January 2009, WMC Mortgage was sued in the United States District Court for
the Eastern District of California for violations of the Truth In Lending Act, 15 U.S.C. § 1601, et
seq. The plaintiff in that action is a mortgage borrower who alleges that, in an effort to
maximize the number of loans sold to consumers and to maximize WMC’s profits, WMC
assured the plaintiff throughout the loan application process that the plaintiff would have low
mortgage payments and failed to disclose the correct payment amounts or finance charges.
87. WMC’s systematic failure to issue mortgage loans in accordance with its stated
underwriting guidelines has caused losses to Allstate. Over 40% of the loans backing the
MSAC 2006-HE4 RMBS that Allstate purchased were seriously delinquent as of May 2011 as
reflected in the chart below. WMC originated almost 45% of the loans in that RMBS.
Offering 12
Months 24
Months At 36
Months At 48
Months May 2011
MSAC 2006-HE4 17.74 42.60 54.12 47.53 40.29
C. Decision One Violated Its Underwriting Guidelines
88. Similar to the New Century and WMC loans that provided the collateral for the
Morgan Stanley RMBS purchased by Allstate, Decision One Mortgage Company LLC’s
(“Decision One”) reckless lending practices caused the OCC to name Decision One as among the
37
“Worst Ten in the Worst Ten.” The OCC recorded that Decision One had approximately 1,267
foreclosures in those ten metropolitan areas alone during that time. Decision One and its
affiliates originated or otherwise provided the underlying mortgage loans that backed an average
of almost 33% of two of the six Morgan Stanley RMBS purchased by Allstate representing
approximately $1.2 billion in total face value. In originating or acquiring the loans that backed
Morgan Stanley RMBS, Decision One abandoned its own underwriting practices by, among
other things, inducing borrowers into and/or approving unsustainable loans to meet the demand
for loans to securitize.
89. Prior to being shutdown in September 2007 by its parent company, British
banking giant HSBC Holdings PLC, Decision One was a major lender specializing in “mortgage
loans that are commonly referred to as Alt-A lending options, and non-conforming or sub-prime
loans.”9 In 2006, Decision One, which operated more than 15 branches in cities nationwide, was
ranked as the 14th largest subprime lender in the U.S., having originated approximately $11.2
billion in subprime loans. Decision One achieved this stature by routinely abandoning sound
underwriting principles to meet the demand for loans to be securitized into RMBS.
90. The Offering Materials relied on by Allstate in purchasing Morgan Stanley
RMBS backed by loans originated or acquired by Decision One contained materially false and
misleading statements of material fact regarding Decision One’s underwriting standards and
other business practices. For example, the prospectus supplement for the MSAC 2006-HE8 deal
described Decision One’s underwriting guidelines, in relevant part, as follows:
The Decision One Underwriting Guidelines are primarily intended to assess the borrower’s ability to repay the mortgage
9 Alt-A loans, otherwise known as alternative documentation loans, are loans to borrowers that are approved based upon the borrower’s credit score, value of property and other factors that did not meet the guidelines established by Fannie Mae or Freddie Mac. Alt-A loans were purportedly of a higher quality than subprime loans if properly underwritten.
38
loan, to assess the value of the mortgaged property and to evaluate the adequacy of the property as collateral for the mortgage loan. All of the mortgage loans in the mortgage loan pool were also underwritten with a view toward the resale of the mortgage loans in the secondary mortgage market. While Decision One’s primary consideration in underwriting a mortgage loan is the value of the mortgaged property, Decision One also considers, among other things, a mortgagor’s credit history, repayment ability and debt service to income ratio, as well as the type and use of the mortgaged property. The mortgage loans will have been originated in accordance with the Decision One Underwriting Guidelines. On a case by case basis, exceptions to the Decision One Underwriting Guidelines are made where compensating factors exist.
91. The RMBS Offering Materials also contained false and misleading statements of
material fact about the level of information that was purportedly required by Decision One to be
included in each prospective borrower’s loan file. For example, the MSAC 2006-HE8
prospectus supplement stated, in relevant part, that:
Each applicant completes an application which includes information with respect to the applicant’s liabilities, income, credit history, employment history and personal information. The Decision One Underwriting Guidelines require a credit report on each applicant from a credit reporting company. The report typically contains information relating to matters such as credit history with local and national merchants and lenders, installment debt payments and any record of defaults, bankruptcies, repossessions or judgments.
92. Further, the Offering Materials relied on by Allstate included false and misleading
statements of material fact with respect to Decision One’s allegedly sound appraisal standards
and practices. For example, the MSAC 2006-HE8 prospectus supplement stated, in relevant
part, that:
Mortgaged properties that are to secure mortgage loans are appraised by qualified independent appraisers. These appraisers inspect and appraise the subject property and verify that the property is in acceptable condition. Following each appraisal, the appraiser prepares a report which includes a market value analysis
39
based on recent sales of comparable homes in the area, and when deemed appropriate, replacement cost analysis based on the current cost of constructing a similar home. All appraisals are required to conform to the Uniform Standards of Professional Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal Foundation and are generally on forms acceptable to Fannie Mae and Freddie Mac.
93. In addition, the Offering Materials relied on by Allstate also contained untrue
statements of material fact concerning the purportedly comprehensive loan verification process
that Decision One performed for each borrower. Significantly, the MSAC 2006-HE8 prospectus
supplement stated, in relevant part, that:
The mortgage loans were originated consistent with and generally conform to the Decision One Underwriting Guidelines’ full documentation, limited documentation and stated income documentation residential loan programs. Under each of the programs, Decision One reviews the applicant’s source of income, calculates the amount of income from sources indicated on the loan application or similar documentation, reviews the credit history of the applicant, calculates the debt service to income ratio to determine the applicant’s ability to repay the loan, reviews the type and use of the property being financed, and reviews the property. The Decision One Underwriting Guidelines require that mortgage loans be underwritten in a standardized procedure which complies with applicable federal and state laws and regulations and requires Decision One’s underwriters to be satisfied that the value of the property being financed, as indicated by an appraisal and a review of the appraisal, currently supports the outstanding loan balance.
* * *
The Decision One Underwriting Guidelines require that the income of each applicant for a mortgage loan be verified.
* * * In evaluating the credit quality of borrowers, Decision One utilizes credit bureau risk scores, or a FICO score, a statistical ranking of likely future credit performance developed by Fair, Isaac & Company and the three national credit data repositories: Equifax, TransUnion and Experian.
40
94. The above statements of material fact were false and misleading when they were
made because, as explained below, they misrepresented that Decision One: (i) systematically
failed to follow its own underwriting guidelines; (ii) allowed pervasive exceptions to its
underwriting standards in the absence of qualifying compensating factors; (iii) disregarded credit
quality to meet the demand for loans to securitize into RMBS; and (iv) violated its stated
appraisal standards, and, in many instances, materially inflated the values of the underlying
mortgaged properties in the loan origination and underwriting process.
95. Former Decision One employees have described Decision One’s lax attitude
towards its own origination and underwriting standards and explained that Decision One had
been approving loans that should have never been issued.10
96. The accounts of these former Decision One employees interviewed by Allstate’s
counsel are corroborated by the allegations supplied by a Senior Underwriter who worked at
Decision One from 2004 through 2007, who is cited in an action styled Federal Home Loan
Bank of Chicago v. Banc of America Funding Corp., 10-cv-45033. According to the Senior
Underwriter, in or around 2006, Decision One conducted an internal audit in which it released
internal deficiency reports reflecting quality issues with tens of millions of dollars worth of
defaulted loans. In conducting this internal audit, “[w]e tore these loans apart and found a lot of
fraud,” said the Senior Underwriter. Nevertheless, many of the practices leading to the quality
issues identified in the internal audit continued at least through the end of 2005 or 2006.
10 According to CW 13, who was employed by Decision One as a senior underwriter, wholesale account executive from February 2004 until December 2006 in Decision One’s Brea, California location, the loans that were being accepted and offered by every single mortgage company, including Decision One, were “absolutely ridiculous” and that “everybody was giving away free money.” According to CW 14, an underwriter at Decision One in Cleveland, Ohio from 2006 to 2007, certain information in Decision One’s loan files were overlooked and the file was just “passed on” and approved regardless of the merits. In other cases, CW 14 would recommend to decline a file that would later be approved by a senior underwriter or branch manager.
41
97. Significantly, according to the Senior Underwriter, Decision One’s internal audit
revealed that Decision One routinely failed to verify borrower income, rental payment history,
and employment status – all of which are critical measures to assess creditworthiness and the
ability of a borrower to repay a loan. As explained by the Senior Underwriter, Decision One
underwriters would “verify” a borrower’s stated income by merely assuming that the highest
management-level tier of any stated field applied to the borrower, rather than determine the most
applicable tier for the borrower. When “verifying” a borrower’s rental payment history and
payment amounts, Decision One underwriters would not even ensure that they were contacting
the borrower’s actual landlord instead of some other unreliable source, said the Senior
Underwriter.
98. Further, the Senior Underwriter explained that Decision One underwriters would
inexplicably “verify” a borrower’s employment status by calling the actual borrower when they
should have contacted the borrower’s employer. In that regard, rather than meaningfully assess
the quality of the loans to be issued by Decision One, and particularly the borrower’s
creditworthiness and ability to repay those loans, Decision One underwriters blatantly cut
corners at every opportunity to issue loans. Given the pressure at Decision One to close deals,
“[t]he loans just closed without verification,” said the Senior Underwriter. Concerns raised
about the verification process “were left by the wayside.”
99. In fact, according to the Senior Underwriter, Decision One’s management would
frequently overturn the decisions made by underwriters to deny loans, and they did so without
regard to the lender’s own underwriting guidelines. Indeed, a manager’s decision to overturn a
loan denial was considered a “business decision,” said the Senior Underwriter, which basically
meant that the loan was intended for a large client whose relationship was important to the
manager. To give a sense of the frequency of these overturned denials, the Senior Underwriter
42
recalled processing approximately six loans per day, and estimated that one out of those loans
was a denial that was subsequently overturned by a manager.
100. Contrary to statements made in the Offering Materials that were relied upon by
Allstate, Decision One also failed to adhere to sound appraisal standards and Decision One’s
property appraisal values were frequently problematic. For example, the Senior Underwriter
recalled seeing a “lot” of inflated values, representing “values that just weren’t there…. We had
some management overrides on appraisal values that were unwarranted.” Among other practices
employed to manipulate the appraisal process, Decision One managers would remove
“derogatory” pictures of properties from the comparables supplied by appraisers, said the Senior
Underwriter.
101. Decision One’s derelict origination practices have had a dramatic impact on the
performance of the loans backing the MSAC 2006-HE8 RMBS that Allstate purchased, with
almost 45% of the loans seriously delinquent as of May 2011 as reflected in the chart below.
Decision One originated almost 27% of the loans contained in the MSAC 2008-HE8 RMBS.
Offering 12
Months 24
Months At 36
Months At 48
Months May 2011
MSAC 2006-HE8 20.96 44.25 57.89 50.44 44.93
D. First NLC Violated Its Underwriting Guidelines
102. First NLC Financial Services LLC (“First NLC”) or its affiliates originated or
acquired an average of almost 17% of the loans contained in two of the six Morgan Stanley
RMBS purchased by Allstate, representing over $380 million of total face value. As one of the
largest sub-prime lenders in the United States during the recent mortgage boom, First NLC
originated approximately $13.4 billion in loans in 2005 and 2006 while serving as the nonprime
mortgage lending-arm for Friedman Billings Ramsey Group, Inc. (n/k/a Arlington Asset
43
Investment Corp.) (“FBR”). FBR sold First NLC to private equity firm Sun Capital Partners,
Inc. in July 2007 and First NLC filed for bankruptcy on January 18, 2008.
103. First NLC-originated loans were the principal ingredient in the MS&Co.-
underwritten MSIX 2006-1 RMBS purchased by Allstate. The Offering Materials for the MSIX
2006-1 RMBS relied upon by Allstate in purchasing the MSIX 2006-1 RMBS contained false
statements of material fact regarding First NLC’s underwriting practices at the time such
statements were made.
104. For example, the Offering Materials for the MSIX 2006-1 RMBS that Allstate
purchased characterized First NLC’s underwriting standards as designed to evaluate the
prospective borrower’s ability to repay the mortgage loan, establishing protocols to verify a
prospective borrower’s income, and allowing purported exceptions to First NLC’s stated
underwriting guidelines on an isolated basis. The MSIX 2006-1 prospectus supplement detailed
First NLC’s underwriting guidelines, in relevant part, as follows:
General. First NLC’s underwriting guidelines are designed to evaluate a borrower’s credit history, his or her capacity, willingness and ability to repay the loan and the value and adequacy of the collateral.
* * *
Quality Control. First NLC reviews its loans for compliance with applicable legal requirements and its underwriting guidelines. . . . Each loan it funds is reviewed for the accuracy of the income documentation, completeness of loan application information and appraisal conformity. Additionally, all loans are reviewed to ensure that prudent underwriting procedures have been followed and sound underwriting judgments have been made. Executed loan packages are reviewed upon return from the closing agent of accuracy and completeness. All loans are subject to a specific post-funding loan test, including high-cost tests, to verify that First NLC’s originations comply with any applicable laws or regulatory requirements. Any significant findings are reported to supervisors and also to members of the First NLC’s senior management team. Any corrective measures that are required are promptly initiated.
44
* * *
Verification of Income. First NLC’s underwriting guidelines require verification of the borrower’s income. First NLC has two primary levels of income documentation requirements, referred to as “full documentation” and “stated income documentation” programs. Under each of these programs, First NLC reviews the loan applicant’s source of income, calculate [sic] the amount of income from sources indicated on the loan application or similar documentation and calculate debt-to-income ratios to determine the applicant’s ability to repay the loan.
* * *
Exceptions and First NLC Underwriting Guidelines. First NLC may make exceptions and upgrades to its underwriting guidelines on a case-by-case basis where compensating factors exist.
105. The Offering Materials for the MSIX 2006-1 RMBS that Allstate purchased also
contained misstatements of material fact concerning the documentation that First NLC’s
prospective borrowers were purportedly required to submit in order to properly obtain a
mortgage loan. For example, the MSIX 2006-1 prospectus supplement stated, in relevant part, as
follows:
Loan Application and Documentation. Each borrower must complete a mortgage loan application that includes information with respect to the applicant’s liabilities, income, credit history, employment history and other personal information. First NLC also requires independent documentation as part of its underwriting process. As part of this process, First NLC will pull its own tri merged credit bureau from one of its approved vendors. First NLC also requires an appraisal, a title commitment, and other income-verification materials.
106. The MSIX 2006-1 Offering Materials also made false representations of material
fact concerning First NLC’s appraisal practices. For example, the MSIX 2006-1 prospectus
supplement stated, in relevant part, as follows:
Appraisals. Appraisals are performed by licensed, third-party, fee-based appraisers who are hired by First NLC or the broker and include, among other things, an inspection of the exterior
45
and interior of the subject property. Appraisals are also required to address neighborhood conditions, site and zoning status and the condition and value of improvements. First NLC does not require its borrowers to use any particular appraiser; however, it maintains a list of appraisers whose appraisals it will not accept. An appraisal may not be more than 120 days old on the day the loan is funded. First NLC requires its underwriters to review all third-party appraisals against an appraisal checklist of qualitative standards, such as square footage, zoning status, comparable property information and improvements. If the underwriters are not satisfied with the accuracy of the third-party appraisal, they will request that a senior credit officer review the appraisal. In addition, First NLC employs in-house state-certified appraisers who review each third-party appraisal that the underwriters are not able to approve because of a failure to meet the qualitative standards. Staff appraisers may require a field review of the property, review additional comparable properties or order a complete second appraisal to verify the accuracy of the original appraisal. In addition to utilizing automated appraisal tools, staff appraisers may work with independent, third-party appraisers to ensure that the appraisals meet First NLC’s qualitative standards.
107. The above statements of material fact in ¶¶ 104-106 were false and misleading
when made because, in truth, First NLC: (i) abandoned its underwriting guidelines, verification
procedures and quality control standards in order to increase loan originations; (ii) allowed
pervasive exceptions to First NLC’s underwriting guidelines in the absence of existing
compensating factors; (iii) consistently failed to properly document prospective borrowers’
ability to repay their mortgage loans; and (iv) systematically disregarded its stated appraisal
standards and in many instances materially inflated the values of the underlying mortgaged
properties in the loan origination and underwriting process.
108. Numerous former First NLC employees interviewed by Allstate’s counsel said
that First NLC originated loans simply because the loans could be sold to loan purchasers for
securitization. As a result, according to CW 15, who served as an underwriter for First NLC in
Deerfield Beach, Florida from April 2004 until November 2006, “every loan had a problem with
46
it. Every loan seemed to have an exception on it.”11 Indeed, between half and three-quarters of
the mortgage loans that were initially denied by CW 15 and other First NLC underwriters were
subsequently approved by First NLC management simply because those loans could be sold.
109. CW 17, who served as a senior underwriter for First NLC in Deerfield Beach,
Florida from August 2004 until September 2005, explained that First NLC made numerous
unwarranted exceptions to its stated underwriting guidelines including appraisal exceptions and
income exceptions. Instead of denying the loan in accordance First NLC’s stated underwriting
guidelines, according to CW 17, employees at First NLC would institute “premium pricing” and
charge the prospective borrower a higher price to compensate for the additional risk of
“overlook[ing] things.” The practice of allowing such pervasive exceptions directly contradicts
the representations regarding First NLC’s underwriting practices represented in the MSIX 2006-
1 prospectus supplement as described above.
110. First NLC also failed to review and verify the prospective borrower’s source of
income, and abdicated its responsibility to determine the prospective borrower’s ability to repay
the mortgage loan in accordance with First NLC’s stated underwriting standards as described
above in ¶¶ 104-106. For example, according to CW 15, if a prospective borrower’s tax return
attached to one of First NLC’s loan applications appeared to be fraudulent and CW 15 sought to
request further documentation to verify the submitted information, the account representatives
would “scream bloody murder.” Regardless, the loan application would eventually be funneled
to and approved by First NLC’s underwriting manager or Vice President of
Operations/Underwriting, who insisted that no further diligence on the loan application was
necessary. In regards to verifying the borrower’s ability to repay the mortgage loan, CW 15 was
11 CW 16, who served as an underwriter for First NLC in Illinois from June 2005 to March 2007, estimated that 30% to 40% of First NLC-originated loans involved exceptions.
47
told by company management that “[w]e don’t need this, so just don’t dig,” and that verifying
borrowers’ income was discouraged, which was considered “digging for problems.”12
111. Indeed, CW 17 believed that 80% of First NLC’s stated income loans contained
inflated income metrics from the prospective borrower. CW 18, who served as a senior
underwriter for First NLC in Anaheim, California from September 2005 to December 2007, and
whose unit was overseen by Charles Bryson, the former CFO of First NLC, recalled one
situation in which a stated loan file lacked a signed income statement. CW 18 alerted Bryson to
the problem and Bryson replied, “make one up.” These improper origination practices are in
direct conflict with First NLC’s purported underwriting standards as described above and as
represented in the MSIX 2006-1 prospectus supplement.
112. First NLC’s reckless origination practices have had a devastating effect on the
delinquency rates for the loans backing the MSIX 2006-1 RMBS, with almost 28% of that
RMBS’ loans issued by First NLC. Indeed, almost 45% of the loans contained in the MSIX
2006-1 RMBS were seriously delinquent as of May 2011:
Offering 12
Months 24
Months At 36
Months At 48
Months May 2011
MSIX 2006-1 17.77 41.81 52.92 50.58 44.60
E. AIG Violated Its Underwriting Guidelines
113. AIG Federal Savings Bank and Wilmington Finance Inc. (collectively, “AIG”)
were subsidiaries of American International Group, Inc. that originated loans contained in two of
the six Morgan Stanley RMBS purchased by Allstate, representing over $487 million in total
12 CW 16 agreed that one of the most serious underwriting flaws at First NLC was management’s failure to deny loans when “it was evident [the borrower’s] income was fraudulent.” Like CW 15, CW 17 discussed instances where underwriters would review pay stubs that CW 17 considered to be clearly fabricated, but management stated “Oh, it’s close enough” and would approve the loan file.
48
face value. Indeed, AIG-originated loans were predominant in the MSHEL 2006-3 RMBS,
accounting for almost 31% of the mortgages backing the RMBS—a percentage substantially
greater than any other mortgage originator’s loans. The Offering Materials for the MSHEL
2006-3 RMBS relied upon by Allstate in purchasing the MSHEL 2006-3 RMBS contained false
and misleading statements of material fact regarding AIG’s underwriting practices at the time
such statements were made.
114. For example, the Offering Materials for the MSHEL 2006-3 RMBS contained
false and misleading statements of material fact relating to AIG’s underwriting procedures and
practices. The prospectus supplement for the MSHEL 2006-3 RMBS described AIG’s
underwriting guidelines in relevant part, as follows:
Underwriting Standards. AIG Bank mortgage loans were generally originated using the following underwriting process. Each mortgage loan originated by AIG Bank was underwritten prior to mortgage loan closing by AIG Bank, in general accordance with AIG Bank’s underwriting guidelines. The AIG Bank underwriting process is intended to assess a mortgage loan applicant’s credit standing and repayment ability and the value and adequacy of the real property security as collateral for the proposed mortgage loan. AIG Bank underwrites non-conforming and subprime mortgage loans with a view toward the resale of the mortgage loans in the secondary mortgage market.
* * *
AIG Bank underwriting guidelines require verification or evaluation of the income of each applicant pursuant to the AIG Bank “Full Documentation” or “Stated Income” programs. Under each of these programs, AIG Bank reviews the mortgage loan applicant’s source of income, calculates the amount of income from sources indicated on the mortgage loan application or similar documentation, and calculates debt service-to-income ratios to determine the applicant’s ability to repay the mortgage loan.
* * *
Exceptions. The mortgage loans have been originated generally in accordance with the underwriting guidelines. On a case-by-case
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basis, AIG Bank makes exceptions to the underwriting guidelines, typically where compensating factors exist, including, but not limited to, reduced LTV, demonstrated pride of ownership, stability of employment, and stability of residence. It is expected that at least some of the mortgage loans in the mortgage loan pool that were originated by AIG Bank will represent these exceptions.
115. The Offering Materials for the MSHEL 2006-3 RMBS that Allstate purchased
also contained false and misleading misstatements of material fact relating to the documentation
that AIG’s prospective borrowers were purportedly required to submit in order to properly obtain
a mortgage loan. For example, the MSHEL 2006-3 prospectus supplement stated, in relevant
part, as follows:
Each prospective mortgagor completed a mortgage loan application that included information with respect to the applicant’s liabilities, income, credit history, employment history and personal information. At least one credit report on each applicant from an independent, nationally recognized credit reporting company was required. The credit report typically contained information relating to such matters as credit history with local and national merchants and lenders, installment debt payments and any record of defaults, bankruptcies, repossessions, or judgments.
116. The MSHEL 2006-3 Offering Materials also made false and misleading
representations of material fact concerning AIG’s appraisal practices. For example, the MSHEL
2006-3 prospectus supplement stated, in relevant part, as follows:
A full appraisal of the property proposed to be pledged as collateral is required in connection with the origination of each mortgage loan. Appraisals are performed by licensed, third-party, fee-based appraisers and include, among other things, an inspection of the exterior and interior of the subject property. Appraisals are also required to address neighborhood conditions, site and zoning status and the condition and value of improvements. Following each appraisal, the appraiser prepares a report which includes a reproduction costs analysis (when appropriate) based on the current cost of constructing a similar home and market value analysis based on recent sales of comparable homes in the area. Appraisals generally conform to
50
the Uniform Standards of Professional Appraisal Practice and were required to be on forms acceptable to Fannie Mae and Freddie Mac. Every appraisal is reviewed by a qualified underwriter before the mortgage loan is closed, and the underwriter may choose to obtain additional property valuation information, including but not limited to obtaining a review appraisal or automated valuation report.
117. The above statements of material fact outlined above in ¶¶ 114-116 were false and
misleading when made because in truth, AIG: (i) abandoned its underwriting guidelines,
verification procedures and quality control standards in order to increase loan originations; (ii)
allowed pervasive exceptions to the company’s underwriting guidelines in the absence of
existing compensating factors; (iii) consistently failed to properly document prospective
borrowers’ ability to repay their mortgage loans; and (iv) systematically disregarded its stated
appraisal standards and in many instances materially inflated the values of the underlying
mortgaged properties in the loan origination and underwriting process.
118. Like the other originators discussed herein, AIG issued loans to borrowers that
were a high default risk. Indeed, the Financial Times reported on May 11, 2007 that AIG’s
lending practices during the period from 2003 through 2006 were the subject of “ongoing
discussions” with the Office of Thrift Supervision (OTS). On June 8, 2007, the OTS announced
the execution of a Supervisory Agreement with AIG for its failure to manage and control its loan
origination services in a safe and sound manner. According to the press release, “[a] $128
million reserve was established to cover costs associated with providing affordable loans to
borrowers whose creditworthiness was not adequately evaluated when their loan was originated
and to reimburse borrowers who paid large broker fees or lender fees at the time of the
origination.” As part of the settlement, AIG set aside $50 million – $15 million of which was
earmarked for not-for-profit organizations to promote financial literacy – and agreed to review
all loans originated from July 2003 to May 2006.
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119. As detailed in the Supervisory Agreement, AIG originated loans for borrowers
whose ability to repay the debt was not properly considered. For example, AIG originated
adjustable-rate mortgages with low “teaser” rates. Once the teaser rates expired and the rates
reset, however, borrowers faced unmanageable payments and the threat of default.
120. Numerous former AIG employees interviewed by Allstate’s counsel stated that
the mortgage lender habitually issued to borrowers loans that violated the company’s stated
underwriting guidelines. CW 19, an underwriter at AIG’s Tampa, Florida wholesale office from
November 2006 to March 2007, stated that AIG’s underwriting practices were “horrid” and that
CW 19 was asked to sign off on fraud while CW 19 was there. According to CW 20, a mortgage
underwriter at AIG’s North Kingstown, Rhode Island office from December 2004 to January
2006, AIG originated these loans based on inflated stated incomes and inadequate documentation
that were, according to CW 20, an “absolute fraud.” Indeed, CW 20 recalled one instance in
which a housekeeper claimed to earn $8,000 a month to obtain a loan for a multifamily
residence. Although CW 20 initially denied the loan, CW 20 was approached by an account
executive about whether the loan could be approved if the borrower claimed $6,000 a month in
stated income instead. CW 20 responded that the loan could not be approved without proper
documentation. Undeterred, the application was resubmitted – this time indicating that the
borrower owned a housekeeping company and earned $5,000 a month in stated income.
Although no business documentation was ever received, the vice president in charge of the office
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approved the loan and “ripped [CW 20] a new one” for refusing to do so. CW 20 estimated that
approximately 50% of bad loans were being pushed through by AIG in this manner.13
121. CW 22, an AIG senior account executive/loan manager in Plymouth Meeting and
Fort Washington, Pennsylvania from September 2003 until September 2007, explained that
exceptions pervaded AIG-originated loans and appraisal values were frequently manipulated.
CW 22 stated that “the level of exceptions that they were starting to allow . . . was just like how
are you getting that approved?” Loan officers would “waive the wand and they let it go.” CW
22 detailed that AIG would often hire the same appraisers because the company knew which
appraisers would artificially inflate the value of the mortgaged property. As such, according to
CW 22, over 50% of AIG’s loans contained appraisal issues.14
122. AIG’s reckless origination practices described above have had a dramatic impact
on the average serious delinquency rates of the loans backing the RMBS purchased by Allstate.
For example, over 35% of the loans backing the MSHEL 2006-3 RMBS stood seriously
delinquent as of May 2011. AIG originated over 30% of the loans comprising the MSHEL
2006-3 RMBS.
Offering 12
Months 24
Months At 36
Months At 48
Months May 2011
MSHEL 2006-3 16.80 43.00 43.76 37.93 35.05
13 CW 21, who AIG employed as an underwriter at the company’s Las Vegas branch from October 2004 to April 2005, agreed that easily 50% of the loans that AIG approved contained overstated income figures. According to CW 21, AIG issued loans to borrowers that CW 21 expected to have submitted inflated income figures and whose income did not correlate with the salary information listed on income verification websites listed for a particular position.
14 CW 23, a wholesale underwriter for AIG at its Tampa, Florida branch from 2004 until October 2007, stated that exceptions to AIG’s established underwriting practices and procedures were rampant at the company and that “from an appraisal standpoint, the values were so inflated.”
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F. The Other Morgan Stanley RMBS Originators Violated Their Underwriting Guidelines
123. The other mortgage originators whose loans were reviewed, purchased and
securitized by Morgan Stanley also repeatedly and regularly violated their stated underwriting
guidelines and issued loans to borrowers who could not repay them.
124. For example, Accredited Home Lenders, Inc. (“Accredited”) or its affiliates
originated or acquired an average of almost 13% of the loans contained in the MSIX 2006-1 and
MSHEL 2006-3 RMBS, representing approximately $290 million in total face value. Claims
asserted against Accredited for making false or misleading statements of material fact regarding
Accredited’s purported prudent underwriting guidelines have already been sustained under
Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. See Atlas v. Accredited
Home Lenders Holding Co., et al., No. 07-cv-488 H (RBB) ECF No. 86, at 13 (S.D. Cal. Jan. 4,
2008) (sustaining allegations that “Defendants’ statements regarding Accredited’s underwriting
practices were allegedly false and misleading because Defendants had caused Accredited to
deviate from its publicly professed standards.”).
125. Allstate’s counsel’s interviews of former employees of Accredited confirm that
Accredited threw its underwriting standards by the wayside. According to CW 24, who served
as a corporate underwriter for Accredited in San Diego, California between May 2002 and
November 2006, underwriters were consistently pressured by upper management to approve
loans “where there was no mitigating value except to get the loan on the books.” CW 24
explained that certain underwriters with problem loan ratios above 45% “were favored [by
upper-level management] because they produced more loans.”
126. According to CW 25, who served as a corporate underwriter at Accredited
between August 2003 and February 2006 in Tampa, Florida, sales-side managers consistently
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overrode underwriters’ rejections of loan files. “The problem with the whole system was the
overrides. The overrides were rampant. . . . If the borrower breathed, he got the loan,” CW 25
explained.
127. CW 26, who served as chief appraiser at Accredited between 2002 and June 2007
in San Diego, California, further explained that Accredited’s misconduct extended to artificial
inflation of property appraisal values. According to CW 26, Accredited established a policy
whereby sales managers had the authority to manipulate a professional appraiser’s final opinion
of market value by utilizing the values of properties that were not comparable to the property
serving as collateral for the loan. CW 26, estimated that “[a]s of June 2006, between 12% and
15% of [Accredited’s] business was being done through management overrides.”
128. Aegis Mortgage Corporation (“Aegis”), another honoree on the Worst Ten in the
Worst Ten List submitted to the FCIC on April 2010, originated almost 20% of the loans
contained in the MSHEL 2006-3 RMBS representing almost $215 million of total face value of
that RMBS. Since its bankruptcy filing in August 2007, Aegis has come under increasing
scrutiny for its misconduct in originating risky, fraudulent and unsound loans—loans that were
funded by the warehouse lines of credit that Morgan Stanley extended to Aegis.
129. Meritage Mortgage Corp. (“Meritage”), a subsidiary of Atlanta-based NetBank,
FSB (“NetBank”), originated almost 20% of the loans contained in the MSHEL 2006-3 and
MSIX 2006-1 RMBS purchased by Allstate. In 2005, Meritage originated approximately $2.6
billion in risky subprime loans before NetBank liquidated and sold the unit in November 2006.
The mortgage loans that Meritage issued led, in large part, to NetBank’s failure, accounting for
over $91 million in net income losses to NetBank in 2005 through 2006. As described by the
Office of Inspector General when investigating the causes of NetBank’s failure,
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[R]ather than monitoring or instituting triggers to curtail its mortgage banking operations when economic conditions warranted such restrictions, NetBank’s strategy continued to emphasize increased loan production, accomplished by lowering underwriting and documentation standards. Products such as “low-doc” and “no-doc” loans allowed borrowers to obtain loans without demonstrating their ability to repay the loan. In addition, underwriters reported to individuals who marketed and sold loans, and sales personnel pressured underwriters to approve loans. Lowered underwriting standards led to poor loan quality, which led to loan repurchases, which led to large losses.
130. The dangerous lending practices of these originators, and the poor quality of the
loans they issued, were either known or recklessly disregarded by Morgan Stanley, and therefore
Morgan Stanley knew that the statements in the Offering Materials regarding these originators
were false and misleading when made. Specifically, Morgan Stanley knew that the
representations contained in the Offering Materials (that were substantially similar among all the
Morgan Stanley RMBS) that loans from the originators above were “underwritten in accordance
with that originator’s underwriting guidelines” were false and misleading because these
originators (i) routinely disregarded their stated underwriting guidelines and originated mortgage
loans without regard to a borrower’s ability to repay; (ii) allowed exceptions to underwriting
guidelines without sufficient compensating factors; and (iii) manipulated the appraisal process in
order to inflate the values of the underlying mortgaged properties to originate and sell as many
loans as possible.
VI. MORGAN STANLEY KNEW THE TRUTH ABOUT THE ORIGINATORS’ LENDING PRACTICES
131. Morgan Stanley, which controlled every aspect of the securitization process,
scrutinized the loans it was purchasing and identified the rampant underwriting deficiencies at
the mortgage originators discussed above. Notwithstanding its knowledge about the real risks of
default those loans presented, it securitized them into the RMBS sold to Allstate.
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A. Morgan Stanley Knew The Loans It Was Securitizing Were Destined To Fail
132. As represented in the Offering Materials, Morgan Stanley obligated itself to
ensure that the subprime mortgage loans it purchased, securitized and sold to investors like
Allstate were originated under appropriate underwriting standards and in compliance with
federal guidelines and relevant laws and regulations. As an institution supervised directly or
indirectly by a number of federal regulators that issued interagency federal guidance on subprime
lending, Morgan Stanley was well aware of these standards and was duty bound to adhere to
them.15
133. One critical metric that Morgan Stanley focused on in evaluating mortgage loans
for purchase was the maximum debt-to-income (“DTIs”) levels that it believed presented an
acceptable credit risk. Morgan Stanley also considered the impact of certain loan features on a
borrower’s DTI ratio, such as adjustable rate mortgages (“ARM”) that had initial “teaser” rate
periods that would reset at a higher rate. An astounding number of New Century mortgage loans
originated in 2005 and 2006 were adjustable rate mortgage loans.16 Because of increases in
interest rates since those mortgage loans were made, New Century’s home borrowers faced large
payment increases once the initial two or three-year fixed “teaser” rate period ended. That was
even more of a problem for interest-only borrowers who also faced higher monthly payments
upon the expiration of the interest-only payment period, two to three years from origination, as
15 Indeed, entities responsible for the supervision of non-federally regulated institutions issued parallel statements incorporating substantially all of the relevant federal interagency guidelines.
16 In 2005, New Century originated $16.6 billion of adjustable rate, interest-only loans, more than twice as much as it had originated in 2004. In addition, 40-year adjustable rate mortgage loans grew from only about six percent (or $3.3 billion) of all loans in 2005 to over 34% (or $15.7 billion) by the end of the third quarter of 2006.
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they would, for the first time, also have to cover the fully-amortizing mortgage loan amount, not
just interest.
134. To account for this risk, Morgan Stanley purportedly set limits on the DTI ratios it
would accept, and considered borrowers with DTI ratios in excess of 55% to be unable to afford
their loans. As alleged by the Massachusetts Attorney General, in 2005, just as the mortgage
boom was swinging into full gear, Morgan Stanley’s fixed income group conducted an internal
analysis that predicted that, at the then-prevailing interest rate environment, borrowers could
expect an increase in the DTI ratio by a factor of 1.36. Under this analysis, a loan with an initial
“teaser”-rate DTI of 41% in 2006 would, upon the interest-rate reset, convert into a DTI of 56%,
and a “teaser”-rate DTI of 43% would convert into a reset DTI of 58%. Moreover, Morgan
Stanley knew that, in accordance with federal guidance, this DTI ratio had to be calculated under
“the fully indexed rate, assuming a fully amortizing repayment schedule.”
135. Contrary to its stated policy, however, Morgan Stanley routinely purchased and
securitized ARM loans that had effective DTI ratios that were well over 55%. As alleged by the
Massachusetts Attorney General, Morgan Stanley knew that New Century qualified borrowers
based on their DTIs calculated using the initial teaser rates, and made no effort to determine
whether a borrower would qualify for the loan at the fully indexed rate. Thus, despite the fact
that Morgan Stanley knew—based on its own internal analysis—that loans with initial “teaser”-
rates DTI ratios greater than 41% would become unaffordable after the interest rate reset, it
purchased such risky loans from New Century and other lenders as a matter of course.
136. In fact, according to the Massachusetts Attorney General, of the New Century
ARM loans originated in Massachusetts that were purchased by Morgan Stanley, a full 41% had
fully indexed DTI ratios that were greater than 55%, and 29% of the loans it purchased had fully
indexed DTI ratios exceeding 60%. In other words, according to Morgan Stanley’s own
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repayment projections for the ARMs it purchased from New Century, a full 41% of the
borrowers whose loans served as collateral for New Century mortgage pools would be unable to
repay their debt unless they could refinance, and a full 45% of the borrowers should have never
have qualified for the loans in the first place. See Assurance of Discontinuance, at ¶20, In re
Morgan Stanley & Co. Inc., Civ. A. No. 10-2538 (Mass. Super. Ct. June 24, 2010).
137. Accordingly, contrary to the explicit representations in the Offering Materials
relied on by Allstate, an astonishing percentage of the loans purchased by Morgan Stanley were
dead on arrival and presumptively failed to comply with state laws requiring lenders to determine
whether borrowers can repay loans according to their terms. Given the importance of this
metric, as well as the fact that the federal interagency guidelines—which, if not followed, could
subject a noncompliant institution to adverse regulatory action—required that all loans be
underwritten according to the borrowers’ ability to repay the debt by final maturity at the fully
indexed rate, such an omission could only have been intentional.
138. The problems of inaccurate DTIs were especially acute in the case of stated
income loans, where the borrower’s income is not independently verified by the lender through,
for example, a review of an employer’s pay stubs or tax returns. Such loans comprised a
substantial percentage the collateral backing the Morgan Stanley RMBS purchased by Allstate.
139. In fact, as alleged by the Massachusetts Attorney General, by 2005, Morgan
Stanley employees were well aware that stated income loans were among the most risky
subprime loan products that Morgan Stanley purchased for securitization. After rejecting one
New Century loan pool that had an exceptionally large number of loans with overstated incomes,
one Morgan Stanley employee described stated income loans as overused to the point of abuse.
As early as October 2005, Morgan Stanley’s due diligence team recognized problems with New
Century’s stated income loans, and in 2006 a Morgan Stanley employee commented that stated
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income credit was not adequately evaluated by New Century. See Assurance of Discontinuance,
at ¶38, In re Morgan Stanley & Co. Inc., Civ. A. No. 10-2538 (Mass. Super. Ct. June 24, 2010).
140. About 36% of the New Century-originated loans reviewed by Clayton were stated
income loans and, on average, the stated income of these borrowers was 42% higher than the
income of fully documented borrowers, with stated income borrowers reporting annual income
of about $115,000. Assuming that the true income of stated income borrowers more closely
approximated those of fully documented borrowers, a substantial number of New Century loans
securitized by Morgan Stanley would have DTIs in excess of 55%, a level that Morgan Stanley
believed meant that the borrower could not repay the loan.
141. CW 27, who worked as a Clayton due diligence underwriter from 2003 through
2007 and conducted due diligence on loans for Morgan Stanley, confirmed that Morgan Stanley
made exceptions on loans with high DTIs, and purchased loans even though borrowers’ DTI
ratios were not based on the fully indexed rate, but on the initial teaser rate. According to CW
27, Morgan Stanley did not consider the borrower’s ability to pay the full rate after the initial
teaser rate expired, and would purchase and securitize interest-only loans in which borrowers
were qualified at the initial start rate. CW 27 said that sometimes a Clayton underwriter would
comment that a particular loan should not be purchased, but then that loan would be purchased
anyway—ultimately, CW 27 said, it was Morgan Stanley’s decision to buy the loan.
142. CW 1, a former Morgan Stanley employee who joined Morgan Stanley in January
2006 as a transaction manager following his previous stint at Clayton, where he conducted due
diligence on the loans purchased by Morgan Stanley, was familiar with Morgan Stanley’s DTI
study. CW 1 confirmed that Morgan Stanley employees were well aware of the poor quality of
loans Morgan Stanley purchased and securitized and said that Morgan Stanley transaction
managers would discuss the impact of DTI levels at weekly meetings. CW 1 also said that
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Morgan Stanley employees agreed that a DTI of 55% basically meant that borrower’s income
was fully allocated to paying debt, after accounting for all of a borrower’s normal expenses. In
addition, according to CW 1, even though Morgan Stanley had a policy not to purchase loans
with DTI ratios higher than 55%, loans with DTIs into the 60s (63, 64, and 65) were purchased
by Morgan Stanley for securitization in violation of that policy.
143. CW 28, who served as a director of risk and compliance at Lydian Trust
Securities (“Lydian”) from June 2003 to October 2005 and as a distressed asset manager at
Morgan Stanley from January 2007 to June 2008, managed pools of mortgage loans while
employed by Morgan Stanley that had already been securitized and were known to be
nonperforming. According to CW 28, all of the loans he looked at had some deficiencies—
including loans originated by New Century and WMC.
144. CW 28 also dealt with Morgan Stanley when CW 28 performed due diligence on
loans at Lydian. According to CW 28, Morgan Stanley had a very clear contract with Lydian
that specified that every underwriting review executed by Lydian could be performed on an
exception basis so that Morgan Stanley could purchase as many loans as possible to securitize
and sell to investors. Indeed, CW 28 said that Morgan Stanley was not concerned with
underwriting compliance because Morgan Stanley knew that the defectively originated loans
could be sold to investors.
145. CW 28 stated that Morgan Stanley executives met with Lydian and made clear to
Lydian that Morgan Stanley wanted loans; Morgan Stanley wanted fulfillment. As such, CW 28
explained that while auditing loans for Morgan Stanley, reporting deficiencies and exceptions on
loans was pointless because Morgan Stanley was willing to accept loans on an exception basis.
CW 28 stated that at least 80% of the loans that CW 28 reviewed contained deficiencies and
should not have been purchased.
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146. According to CW 28, Morgan Stanley’s appetite for deficient loans was so
extraordinary that Lydian was not equipped to handle such a high volume. As such, CW 28
explained, Morgan Stanley likely retained other firms like Lydian to underwrite loans without
regard to the borrowers’ ability to repay the mortgage loans.
147. Morgan Stanley’s own traders have publicly admitted that Morgan Stanley knew
it was purchasing and securitizing defective loans that were bound to fail. In an interview on the
radio program “This American Life,” broadcast by National Public Radio, Mike Francis, who
worked as an executive director on Morgan Stanley’s residential mortgage trading desk at the
height of the mortgage market boom and during its subsequent collapse, said that Morgan
Stanley knew that the loans it purchased from originators like WMC were of poor quality and
never should have been originated in the first place. Reporter Alex Blumberg interviewed a
WMC sales manager who made over a million dollars a year by making loans to “people who
didn’t have a pot to piss in,” that would then be purchased and securitized by Morgan Stanley.
As reported by Blumberg, WMC “didn’t worry about whether the loans were good. That’s
someone else’s problem. And this way of thinking thrived at every step of this mortgage
security chain. A guy like Mike Francis, from Morgan Stanley, he told me he bought loans, lots
of loans, from [WMC], and he knew in his gut they were bad loans.” As Mike Francis told
Blumberg on “This American Life,” Morgan Stanley knew what it was doing was wrong:
No income no asset loans. That’s a liar’s loan. We are telling you to lie to us. We’re hoping you don’t lie. Tell us what you make, tell us what you have in the bank, but we won’t verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened . . . we did it because everyone else was doing it.
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B. Morgan Stanley’s Due Diligence Identified Defects In The Loan Pools Morgan Stanley Purchased For Securitization
148. Not only did Morgan Stanley know that the underwriting practices employed by
the originators whose loans it purchased presented great risks of default, Morgan Stanley
learned, through its due diligence process, that a substantial portion of the loans it securitized
woefully failed to meet the stated underwriting standards of those originators. In fact, Morgan
Stanley’s due diligence process identified a pattern establishing that the loans Morgan Stanley
purchased for securitization—including those included in the Morgan Stanley RMBS purchased
by Allstate—failed to meet the originator’s underwriting guidelines, had other deficiencies,
violated state and federal law, and/or were based on inflated property valuations.
149. As described in transcripts of interviews conducted by the congressional
Financial Crisis Inquiry Commission (“FCIC”) with Tony Peterson, who served as a vice
president of Morgan Stanley’s Boca Raton, Florida-based due diligence department which
oversaw all of Morgan Stanley’s residential mortgage business, Morgan Stanley rejected
Clayton’s credit due diligence findings as a matter of course. Peterson also stated that the
Morgan Stanley traders who put together Morgan Stanley’s RMBS deals had explicit data about
the poor quality of the loans they securitized. Moreover, Peterson testified that major functions
of the due diligence process—including which loans were to be sampled for compliance with
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the originators’ underwriting guidelines—were dictated by Morgan Stanley traders in New
York.17
150. During its review, Clayton would assign each loan a number—1, 2 or 3—to
reflect Clayton’s evaluation of the soundness of the loan. The numbering referred to three
different levels, “1” being the best—i.e., the loan met the originators’ underwriting guidelines—
and a “3” being the worst. CW 1 said that Clayton referred to level 3s as “mission criticals.”
Morgan Stanley was not even supposed to know Clayton’s proprietary “1, 2, or 3” rating
system—Clayton’s job was supposed to be limited to telling Morgan Stanley “yes” or “no” on a
particular loan. However, Morgan Stanley knew the status of particular loans and the grades
Clayton contemplated assigning them.
151. CW 30, who worked as a Clayton due diligence contract underwriter in 2005 and
reviewed loan files that Morgan Stanley considered purchasing, said that while level 1 loans
might have a minor exception, and level 2 loans would have multiple exceptions, level 3 loans
failed to conform to the originators’ underwriting guidelines. Level 3 loans, CW 30 said, could
include loans with really bad collateral, and were not compliant with the underwriting guidelines
17 Several witnesses interviewed by Allstate’s counsel confirmed the involvement of Morgan Stanley’s traders in the due diligence process. For example, CW 1 said that Morgan Stanley traders in New York were indirectly involved in the due diligence process and had the ability to overrule everyone, despite the fact that the traders did not have a mortgage underwriting background and therefore lacked the experience needed to evaluate mortgage underwriting. According to CW 1, traders used that authority to cause Morgan Stanley to purchase loans that should have been rejected. CW 29, who worked as a senior conduit operations manager for Clayton from 2005 to 2007 and exclusively reviewed loans that Morgan Stanley’s conduit operations department in Boca Raton considered purchasing, said that once Clayton determined that a loan fell outside of Morgan Stanley’s guidelines, that loan would be elevated to Morgan Stanley’s team in Boca Raton. Morgan Stanley employees in Boca Raton would then communicate with Morgan Stanley’s trading desk about whether to approve the loan for purchase. While CW 29 said that he could not estimate how many loans Morgan Stanley approved and purchased that Clayton had identified as noncompliant, CW 1 said that there was a steady stream of loans that fell outside of the guidelines on a regular basis, and that these loans were approved on a regular basis and would be included in a securitization.
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at all. CW 30 said that Clayton would send its level 3 findings to Morgan Stanley, and then
Morgan Stanley and the loan seller would negotiate the purchase of level 3 loans.
152. Indeed, as Peterson explained in his testimony before the FCIC, Morgan
Stanley’s own due diligence team undermined the due diligence review conducted by Clayton
by routinely rejecting and re-designating the grades assigned by Clayton:
During the diligence process, if Clayton elevated something as a 3, regardless of the reason …our team would take a look at that and, at their first review of the issues of the overall loan, they could make a decision at that point that it was acceptable and change the grade to a 2W….And then when our process was complete, we sent the reports up to New York indicating which loans were still a 3, which loans we had changed to a 2W. And then that was the end of our diligence process.18
153. As reflected in Peterson’s testimony and through documents Clayton produced to
the FCIC, over one-third of the Morgan Stanley-securitized loans sampled by Clayton during
the height of the mortgage boom (from 2006 to mid-2007) failed to meet the originator’s
underwriting guidelines. Moreover, a Clayton report reveals that, over this same period,
Morgan Stanley overruled Clayton’s findings and “waived” approximately 56% of all such
defective “exception” loans and securitized them into RMBS that were sold to investors like
Allstate.19
154. Extrapolating the results of Morgan Stanley’s 56% “waive in” rate of the loans
Clayton had rejected for failing to meet originator’s guidelines to the entire loan pools backing
the Morgan Stanley RMBS purchased by Allstate reveals the extent to which Morgan Stanley
18 As reflected in FCIC interview notes, former Clayton president Keith Johnson explained that a 2W “was when the client told us to take a 3 and make it into a 2. We wanted to always track that. We wanted to be on record that we originally rated it a three.”
19 The Clayton trending report published by the FCIC reveals that 36% of the sampled loans that Clayton reviewed for Morgan Stanley from the first quarter of 2006 through the second quarter of 2007 failed to meet the relevant underwriting guidelines. Over this same period, Morgan Stanley nevertheless “waived in” these rejected loans 56% of the time.
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knew the loans it had securitized were destined to fail. As the FCIC Report concluded with
regard to the Offering Materials for Morgan Stanley RMBS:
[M]any prospectuses indicated that the loans in the pool either met guidelines outright or had compensating factors, even though Clayton’s records show that only a portion of the loans were sampled, and that of those that were sampled, a substantial percentage of Grade 3 loans were waived in….[O]ne could reasonably expect [the untested loans] to have many of the same deficiencies, at the same rate, as the sampled loans. Prospectuses for the ultimate investors in the mortgage-backed securities did not contain this information, or information on how few of the loans were reviewed, raising the question of whether the disclosures were materially misleading, in violation of the securities laws.
FCIC Report at 167, 170.
155. Morgan Stanley’s astounding 56% “waive in” rate, and the implications for the
quality of the RMBS underwritten by MS&Co., rendered materially false and misleading
numerous statements in the Offering Materials relied on by Allstate in purchasing the Morgan
Stanley RMBS. The Morgan Stanley prospectus supplements represented, for example, that
“[o]n a case-by-case basis WMC may determine that, based upon compensating factors, a
prospective mortgagor not strictly qualifying under the underwriting risk category or other
guidelines described below warrants an underwriting exception” and that “[o]n a case-by-case
basis, exceptions to the New Century Underwriting Guidelines are made where compensating
factors exist.” Morgan Stanley knew that these statements were materially false and misleading
because, through its due diligence process, it had determined that over one-third of the loans it
sampled were exception loans that did not have compensating factors and, in fact, deliberately
included over half of all such exception loans in the loan pools it securitized. Moreover, given
that the loans actually reviewed by Clayton represented only a fraction of the loans Morgan
Stanley actually purchased and securitized—typically only 10% of given loan pool sold by a
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“big” originator such as New Century—Morgan Stanley either knew or recklessly disregarded
that a highly material number of the loans underlying the Morgan Stanley RMBS purchased by
Allstate were not underwritten in compliance with the originator’s guidelines.20
156. The Massachusetts Attorney General’s investigation likewise determined that a
large majority of the New Century loans originated in Massachusetts that were reviewed by
Clayton were identified as having some sort of exception, and most loans had multiple
exceptions. Furthermore, approximately 91% of the loans with material exceptions did not have
sufficient compensating factors to justify their inclusion in the loan pool. Yet, according to the
Massachusetts Attorney General, in the last three quarters of 2006, Morgan Stanley waived over
half of the material exceptions identified by Clayton, and purchased and securitized those loans.
Moreover, loans with certain exceptions—such as high DTI ratios or high LTV or CLTV ratios
that were in excess of the originator’s underwriting guidelines but deemed acceptable by Morgan
Stanley—were not even reviewed for sufficient compensating factors by Clayton, but purchased
and securitized by Morgan Stanley anyway.
157. In addition to reviewing the originator’s loan files and bid tapes, Morgan Stanley
conducted due diligence on the mortgage loans that comprised its RMBS by sending employees
to mortgage originators such as New Century to review the pools of loans that Morgan Stanley
would consider purchasing. Peterson told FCIC investigators that between 2005 and 2007,
Morgan Stanley communicated directly with the loan sellers to coordinate due diligence logistics
and that, more frequently than not, the due diligence review was conducted onsite at the
originator’s location. 20 According to CW 15, Morgan Stanley reviewed approximately 25% of the loans that it purchased from First NLC. Nevertheless, Morgan Stanley purchased the First NLC-originated loans, packaged them into RMBS, which Morgan Stanley then sold to investors like Allstate without disclosing the true risks of the loans that Morgan Stanley’s due diligence process had uncovered. Indeed, CW 15 explained that loan purchasers would buy anything.
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158. New Century was one such loan seller. According to CW 31, who served as a
business analyst in secondary marketing at New Century affiliate NC Capital Corp. from 2003
until 2006, Morgan Stanley placed at least two employees onsite at New Century “full time”
when conducting due diligence on loans it would purchase for securitization.
159. Not only did Morgan Stanley conduct on-site due diligence at one of the lenders
later determined to be one of the “worst of the worst” originators in the country, it was also well
aware of the frequency and level of artificially inflated property valuations underlying New
Century-originated loans. As alleged by the Massachusetts Attorney General, starting in or
around October 2005, Morgan Stanley became aware of problems in the quality of the
appraisals at New Century, problems that persisted throughout 2006 and 2007. Morgan
Stanley’s valuation due diligence process included hiring independent contractors to provide an
opinion concerning the value of a sample of the properties securing New Century-originated
loans. Generally, Morgan Stanley employed so-called “Broker Price Opinions” or “BPOs,” in
which a local broker would evaluate the property and provide an indicated value and some
additional information on a sample of a New Century loan pool.
160. Using the BPO-checked value, rather than the appraisal value provided by New
Century, over 31% of the New Century loans securitized by Morgan Stanley in 2006 and 2007
had CLTVs that were greater than 100%. Moreover, 60% of the New Century loans with
CLTVs based on the BPO-checked values over 100% had ratios greater than 105%, and nearly
20% of such loans had CLTV ratios based on the BPO-checked values that exceeded 120%.
Because many of the loans with BPO-checked values were part of a randomly sampled portion
of a given loan pool reviewed during the due diligence process, there is high likelihood that a
substantial number of additional loans contained in the New Century-originated pools had
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CLTVs exceeding 100%. Indeed, based on Morgan Stanley’s own due diligence on the
property values underlying New Century loans, this eventuality was a near certainty.
161. According to CW 1, Morgan Stanley purchased New Century loans with actual
knowledge that the New Century loans suffered from inflated appraisals. CW 1 explained that
Morgan Stanley would not require New Century to conduct a second appraisal on the
mortgaged property because Morgan Stanley feared that a second appraisal would reflect the
true, un-inflated value of the property and impede the flow of loans for securitization.
162. CW 32, who worked as an underwriter for Clayton from 2005 to 2007 exclusively
on due diligence reviews for Morgan Stanley, stated that the loan files CW 32 reviewed
contained inaccurate and incorrect appraisals, which CW 32 believed were intentionally
inaccurate for purposes of inflating the property’s value. According to CW 32, the due diligence
CW 32 performed frequently identified fraud and missing documentation, and that this
information would be passed along to quality assurance underwriters at Clayton. Clayton would
then review CW 32’s findings and communicate them to Morgan Stanley, which would decide
whether to accept or reject the loans. According to CW 32, Clayton employees regularly
discussed how Morgan Stanley did not listen to Clayton’s recommendations.
C. Morgan Stanley Knowingly Purchased Defective Loans In Order To Keep Its Subprime Profit Machine Running
163. Morgan Stanley’s willingness to unload such toxic securities onto investors was
driven by Morgan Stanley’s desire to keep generating the enormous fees it was deriving from
securitizing loans originated by lenders that flouted the law. When New Century threatened to
take its loan business elsewhere after Morgan Stanley began rejecting the originator’s
“exception” loans, Morgan Stanley lowered its due diligence standards to keep this stream of
profitable business flowing.
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164. As alleged by the Massachusetts Attorney General, in late 2005, Morgan Stanley
was aware of quality problems with New Century loans, and began rejecting them in greater
numbers. When New Century began to complain to Morgan Stanley about its rejection rate,
suggesting to Morgan Stanley that it would begin to shift its business to other buyers, Morgan
Stanley relented in order to maintain its access to a steady flow of New Century mortgages
available for securitization. In April 2006, after Allstate purchased its Morgan Stanley RMBS
backed by New Century loans, officials at Morgan Stanley wrestled with the possibility of losing
New Century’s business and discussed a number of potential responses. As alleged by the
Massachusetts Attorney General, as a result of these discussions, one of Morgan Stanley’s senior
bankers purchased 228 loans that Morgan Stanley’s due diligence team had initially rejected.
Thereafter, Morgan Stanley’s due diligence team became more responsive to New Century’s
desire to include more defective loans in the pools Morgan Stanley purchased from the
originator.
165. CW 1 confirmed that Morgan Stanley’s practice of purchasing defective loans to
preserve lucrative relationships with originators was not unique to New Century. According to
CW 1, Morgan Stanley definitely purchased loans that Clayton had rejected, and CW 1 said that
this happened a lot. According to CW 1, Morgan Stanley internally referred to such situations as
a business decision or BD, which CW 1 described as Morgan Stanley’s funny way of saying,
“Let’s do something that we shouldn’t.” CW 1 said that Morgan Stanley’s use of the term “BD”
indicated to him that Morgan Stanley knew it was doing something wrong because there did not
appear to be any other reason to use such a code.
166. In certain cases, when Clayton had rejected a particular loan, Morgan Stanley
would do a “last look” at a rejected loan when it came from a certain originator with whom
Morgan Stanley had an important business relationship or an originator with whom Morgan
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Stanley was trying to maintain or develop a business relationship. CW 1 explained that a “BD”
to purchase defective loans would happen in situations where a significant business relationship
was at stake. In other words, according to CW 1, Morgan Stanley would purchase defective
loans from its major clients, smother the loans in a loan pool, and sell the resultant RMBS to
investors like Allstate without disclosing the true nature of the RMBS.
167. The New Century Bankruptcy Examiner’s report similarly describes how
investment banks like Morgan Stanley would exploit the due diligence process to negotiate a
better price for the transaction:
In general, a pool of loans would be created and the investor then would have an opportunity to conduct due diligence on the loans in the pool, typically reviewing approximately 25% of the loans offered for sale, with a further review often conducted on a greater percentage of the appraisals. The investor would advise New Century which loans it did not want to purchase - the kickouts - and would typically tell New Century its reasons for rejecting the loans, such as unacceptable deviations from underwriting guidelines, defective appraisals and missing documentation. New Century personnel then would seek to reduce the proposed kickout rate, either by convincing the investor that it was wrong in rejecting certain loans or by fixing some defect that affected a particular loan. Once the precise pool was finalized, New Century and the investor would agree to a price.
168. According to the New Century Bankruptcy Examiner’s Report, loan purchasers
like Morgan Stanley would often enter into agreements with New Century that limited the total
“kickout” rates, further underscoring that the due diligence process was often deliberately limited
to prevent defective loans from being identified.21 According to the Report, “New Century was
able, particularly when the subprime market was strong and housing prices were rising, to
negotiate understandings with certain loan purchasers to limit kickouts to a maximum rate, such
as 2.5%.” According to the Bankruptcy Examiner, New Century’s Head of Loan Production and
21 “Kickouts” refer to loans that were rejected from the loan pool by the purchaser.
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Secondary Marketing Patrick Flanagan, “was explicit in stating to the Examiner that such
understandings were reached.”
169. CW 1 described how Morgan Stanley’s willingness to purchase defective loans
also gave it increased negotiating power when purchasing loans from an originator that routinely
violated its underwriting guidelines. For example, CW 1 stated, an originator might send over a
loan originated under a full documentation program. If Morgan Stanley did not want to buy the
loan at the price offered by the seller, Morgan Stanley would price the loan as a (cheaper) stated
income loan and shred the full documentation. After the transaction had closed, and the seller
realized what had happened and demanded to receive the price of a full documentation loan,
Morgan Stanley would say it was too late. According to CW 1, this was Morgan Stanley’s way
of exploiting the fact that it routinely purchased loans that never should have been originated in
the first place, knowing that it would be able to get the seller to capitulate because it depended on
Morgan Stanley’s willingness to continue doing so.
170. A June 2006 Moody’s ratings methodology document provided to Morgan
Stanley’s due diligence department and reviewed by Allstate’s counsel makes clear that Morgan
Stanley knew that shredding the files of a “full documentation” loan in order to extract a greater
profit off of a “stated income” loan would affect the ratings assigned to the Certificates.
According to the June 2006 Moody’s ratings methodology update, Moody’s states that it
considers the lender’s motivations and rationale for offering a reduced documentation program—
including whether the program is being used to increase market share or otherwise compromise
credit standards—when assigning its ratings. If Moody’s learned of the manipulation of the loan
files, such a fact would have undoubtedly affected its view of the integrity of the pool and its
assessment of the credit risk of the transaction. Given that Morgan Stanley understood the
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importance that Moody’s placed on these criteria, it is clear Morgan Stanley knew its actions
would cause the ratings to be misrepresented in the Offering Materials.
171. CW 33, a lead underwriter at WMC from 2002 through 2007, said that Morgan
Stanley would also use Clayton’s due diligence findings to negotiate a better price for pools
containing defective loans originated by WMC. CW 33 said that in determining whether to fund
a given loan at WMC, WMC would originate a loan so long as it knew it would be able to sell it
to a loan securitizer like Morgan Stanley. According to CW 33, when WMC was attempting to
sell a loan to Morgan Stanley that had already been rejected by Clayton, Morgan Stanley would
go back to WMC to negotiate a lower price for the loan. These negotiations were tricky, CW 33
said, because they would involve a compromise, and would eventually lead to loans being
securitized that never should have been made in the first place.
172. CW 33 said that WMC originated loans outside of its own guidelines because it
knew Morgan Stanley would buy the loans, even if at a discounted rate, because WMC would
still profit off of the transaction. According to CW 33, WMC would not fund a loan unless it
would be sold to a loan securitizer like Morgan Stanley, and that a substantial percentage of the
loans WMC originated should never have been made. CW 33 said that WMC employees knew
they should not be originating the loans they sold, but Morgan Stanley would say “we want
loans, we want loans” because they were making such large commissions on loan securitizations.
173. Morgan Stanley would also routinely attempt to influence or limit Clayton’s due
diligence process to prevent problem loans from being identified. For example, in some cases
where Clayton would ask to review further documentation on a given loan because the
information in the loan file did not fit the description provided by the seller, Morgan Stanley told
Clayton not to worry about performing a more rigorous review because Morgan Stanley could
rely on the seller’s representations and warranties in the loan pool purchase agreement.
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D. Morgan Stanley Dumped Defective Loans Into Securitizations To Reduce Its Exposure To Its Warehouse Lines Of Credit
174. Morgan Stanley also provided warehouse lines of credit to mortgage originators,
including New Century, WMC, Accredited, and Aegis, whose loans Morgan Stanley would then
purchase and securitize. As of 2007, Morgan Stanley had warehouse lending commitments to
subprime lenders totaling $5.2 billion, of which $2.3 billion was funded and fully collateralized,
with a $2.5 billion funded balance at New Century. Of course, before providing such funding,
Morgan Stanley became intimately familiar with the lending practices of these originators
through extensive due diligence on their business operations.22
175. Not only was Morgan Stanley able to profit off of the interest it received on the
billions of dollars in warehouse lending lines it provided and collect fees for arranging such
financing, it also became those originators’ most valued customers. For example, the multi-
billion dollar warehouse lending relationship that Morgan Stanley had with New Century was
so important to Morgan Stanley that the firm’s traders frequently referred to New Century as a
“partner.” Of any warehouse lender, Morgan Stanley’s line of credit was the largest, providing
$3 billion in credit to the originator during 2006 and 2007. The warehouse loans were
continually sold or securitized, the credit line paid off, and the process would repeat.
176. According to notes of an interview published by the FCIC, former Clayton
President Keith Johnson stated that banks like Morgan Stanley were particularly culpable in
disregarding Clayton’s findings and securitizing defective loans:
For every hundred 3’s that we found, forty were still purchased. Some firms would purchase way more (tended to be those that had
22 For example, Morgan Stanley provided $650 million worth of warehouse financing to Accredited in 2006 alone. Morgan Stanley was one of the most enthusiastic purchasers of Accredited-originated loans, purchasing over $1 billion of Accredited’s loans in 2006. Morgan Stanley also had other financial relationships with the originators, including serving as an underwriter of a $50 million offering of New Century preferred stock in August 2006.
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warehouse lines related to them) and some would purchase way less. The ones with the warehouse lines had the highest. I think we actually talked to a law firm that was doing the prospectuses, and we said that they should disclose the due diligence, and they said that they spent 20 pages talking about the underwriting guidelines. I thought that the investors and the rating agencies would be interested in the exceptions.
Memorandum for the Record, Phone Interview with Keith Johnson, former President and COO
of Clayton Holdings, (June 8, 2010).23
177. During his September 2, 2010 testimony before the FCIC, Johnson offered the
following hypothetical to FCIC staff member Bob Hinkley that highlights the conflict of interest
that drove Morgan Stanley to waive in defective loans originated by those sellers to whom it
provided warehouse lines of credit:
[I]f Bob was originating for me as the client and I had a warehouse line to Bob, I think what happened is a conflict of interest. That if I put back [or ‘kicked out’] loans to you, Bob[,] and you don’t have the financial capability to honor those, then I’m kind of caught; right? If I – the present value of the pain, I’m going to take a loss on the warehouse line. And what I do think happened is that maybe those warehouse lines were extended and actually increased and I perhaps bought your production and I shouldn’t have. That the quality wasn’t—and I don’t think any of the prospectuses disclosed the relationship between the warehouse lenders and the securitizers.
FCIC Interview of Keith Johnson (Sept. 2, 2010).
178. This conflict of interest was particularly acute in the case of Morgan Stanley’s
warehouse lending relationship with New Century. As New Century’s loans began defaulting at
alarming rates and the financial condition of the originator came under increasing doubt,
Morgan Stanley, as New Century’s largest warehouse lender, participated in a March 6, 2007 23 See also FCIC Interview of Keith Johnson (Sept. 2, 2010) (“The one area that I think was probably abused and not disclosed correctly was the warehouse lines. So you know, I think our data would show that, you know, we saw bigger exceptions to any client that had warehouse lines.”).
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conference call with several other investment banks that provided similar funding to New
Century, and with New Century’s senior executives regarding New Century’s declining
financial condition. Shortly thereafter, while several investment banks considered New Century
to be in default of its lending agreements, Morgan Stanley agreed to extend New Century a
$265 million loan collateralized by New Century mortgages.
179. Morgan Stanley’s participation in the March 6, 2007 conference call and its
decision to issue a new $265 million loan to New Century backed by New Century-originated
mortgage loans even as other Wall Street banks declared New Century to be in default
highlights the conflict of interest that drove Morgan Stanley to willingly purchase defective
loans from New Century and, when the originator began to falter, employ increasingly
desperate measures in an attempt to ensure that its outstanding warehouse lines of credit would
be repaid. Indeed, Morgan Stanley’s decision to collateralize a new $265 million loan to New
Century with New Century-originated loans rather than fixed assets evidences Morgan
Stanley’s brazen willingness to disregard the risks its securitization activities posed to investors
when they conflicted with Morgan Stanley’s own self-interest.
180. CW 1, who was also involved in Morgan Stanley’s warehouse lending activities,
confirmed that these conflicts of interest permeated Morgan Stanley’s decisions to disregard the
findings of its due diligence team.
181. CW 1 described one such warehouse lending product offered by Morgan Stanley
that posed an especially acute incentive for Morgan Stanley to disregard the quality of the loans
it would purchase from a warehouse lending client. As described by CW 1, under Morgan
Stanley’s early purchase, or “EP,” program, Morgan Stanley would provide originators with a
warehouse line of credit before it would purchase loans from that originator. Essentially, CW 1
said, this was like providing a cash advance. CW 1 said that providing such warehouse lines
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under the “EP” program essentially meant that Morgan Stanley was locked into buying those
loans no matter their quality.
182. For example, CW 1 said, under Morgan Stanley’s EP program, a seller might
attempt to sell $100 million in bulk loans but needed $30 million in warehouse funding in order
to do so. Once Morgan Stanley conducted an initial sampling of the loans and found them
acceptable, it would release $30 million to the seller. CW 1 said Morgan Stanley was giving out
this $30 million before it actually bought a single loan, explaining that this in effect obligated
Morgan Stanley to buy the loans even if it turned out that they were of very suspect and poor
quality, or else risk losing its $30 million.
183. CW 1 said this practice was like playing hot potato, because Morgan Stanley tried
to immediately resell the majority of what it bought. At Morgan Stanley, CW 1 said, decisions
like these were driven by “yield chaser[s],” or employees who knew that they were buying risky
loans but were willing to take on that risk in return for additional yield on the transaction and,
hopefully, unload the loans to investors like Allstate before Morgan Stanley took a hit.
E. Morgan Stanley Unloaded Toxic RMBS Onto Investors Like Allstate To Limit Its Exposure As The Mortgage Crisis Intensified
184. By 2007, borrowers began defaulting on their loans at increasingly alarming rates,
endangering Morgan Stanley’s subprime securitization business. Increasingly, borrowers were
unable to make even the first several payments on their mortgages. In such cases, these early
payment defaults, or “EPDs,” would often require a loan originator, like New Century, to
repurchase the loan after it had been sold to an investment bank like Morgan Stanley. The
pressures on originators of increasing EPD rates were compounded by demands from warehouse
lenders requiring extra fees for providing short-term funding because of a perceived increased
risk of default on their lines of credit. Witnessing an increase in EPDs, warehouse lenders also
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began to exercise their right to require originators to repurchase defectively originated loans,
putting further strain on the originators. Struggling for survival, the originators turned to
desperate tactics.
185. So did Morgan Stanley, which was likewise put at risk by the collapsing subprime
market, exposed to the millions in loans it had purchased for securitization as well as the
outstanding warehouse lines it had with many of the originators whose loans served as the
collateral for the RMBS purchased by Allstate.
186. CW 1 said that one tactic increasingly employed by certain loan sellers in 2007
was to actually provide the first payments on a borrower’s loan so that the loan could be
squeezed into a securitization, even though it should have been rejected by Morgan Stanley as an
EPD that should have been repurchased by the seller. CW 1 said this practice was evident to
Morgan Stanley employees because, whereas the borrower would make the first payment with a
check, the subsequent payments would be by money order. After a couple of payments, enough
time would have passed, and the loan would be securitized, and thereafter immediately go into
EPD.
187. According to CW 1, another practice that Morgan Stanley employed with
increasing frequency as the subprime mortgage market came under increasing stress in May and
June 2007 was to negotiate side agreements with sellers regarding problem loans. For example,
CW 1 said, a loan might require two property appraisals under an underwriter’s guidelines.
Morgan Stanley would fund the deal with one appraisal but would code it as having two
appraisals, and would have an agreement with the seller that it would provide the missing
appraisal at a later date. The second appraisal would then come in drastically lower than the
initial appraisal that was used to price the loan, but Morgan Stanley had already closed on the
transaction. Of course, the new appraisal would affect the true LTV ratio of the loan, which
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would not reflect what had been coded in the loan file. Nevertheless, CW 1 said, such a loan
would go into a securitization so long as it was not currently defaulting.
188. Morgan Stanley even adopted a similar practice in its attempt to limit its exposure
and stave off the risk of default on the warehouse lines of credit it provided to New Century as
the lender slid into bankruptcy. As alleged by the Massachusetts Attorney General, as New
Century moved toward bankruptcy, Morgan Stanley provided “wet-funding” to New Century
borrowers—a practice whereby Morgan Stanley effectively provided cash directly to New
Century borrowers at the closing table. Like certain originators’ practice of supplying the
funding for a borrower’s first several loan payments so that a loan could be securitized before it
defaulted, Morgan Stanley’s wet-funding permitted New Century to close millions of dollars in
subprime loans in March 2007 that were available for Morgan Stanley to securitize and sell.
VII. MORGAN STANLEY KNEW THE CREDIT RATINGS ASSIGNED TO THE MORGAN STANLEY RMBS MATERIALLY MISREPRESENTED THE CREDIT RISK OF THE RMBS
189. To bring its RMBS to market, Morgan Stanley knew that it needed to obtain the
highest “investment grade” ratings possible from the credit rating agencies (“CRAs”)—
Moody’s, S&P and Fitch—that rated Morgan Stanley’s securitizations. Indeed, Morgan Stanley
featured the ratings prominently in the Offering Materials and discussed at length the ratings
received by the different tranches of the RMBS, and the bases for the ratings. Yet, Morgan
Stanley knew that the ratings were not reliable because those ratings were bought and paid for,
and were supported by, false information that Morgan Stanley provided.
190. “Investment grade” products are understood in the marketplace to be stable,
secure and safe. Using S&P’s scale, “investment grade” ratings are AAA, AA, A and BBB, and
represent, high credit quality (AAA), upper-medium credit quality (AA and A) and medium
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credit quality (BBB). Any instrument rated below BBB is considered below investment grade
or “junk bond.”
191. The Offering Materials for the Morgan Stanley RMBS Allstate purchased state
that the issuance of each tranche of the RMBS was conditioned on the assignment of particular
investment-grade ratings, and listed the ratings in a chart. All of the RMBS purchased by
Allstate were AAA-rated tranches. The AAA rating denotes “high credit-quality,” and is the
same rating as those typically assigned to bonds backed by the full faith and credit of the United
States Government, such as Treasury Bills. For example, Morgan Stanley represented in the
MSIX 2006-1 prospectus supplement that:
In order to be issued, the Offered Certificates must be assigned ratings not lower than the following by S&P, Fitch and Moody’s: Class S&P Fitch Moody’s A-fpt AAA AAA Aaa A-1 AAA AAA Aaa A-2 AAA AAA Aaa A-3 AAA AAA Aaa A-4 AAA AAA Aaa M-1 AA+ AA+ Aa1 M-2 AA AA Aa2 M-3 AA- AA- Aa3 M-4 A+ A+ A1 M-5 A A A2 M-6 A- A- A3 B-1 BBB+ BBB+ Baa1 B-2 BBB BBB Baa2 B-3 BBB- BBB- Baa3 A securities rating addresses the likelihood of the receipt by a certificateholder of distributions on the mortgage loans to which they are entitled by the Final Scheduled Distribution Date. The rating takes into consideration the characteristics of the mortgage loans and the structural, legal and tax aspects associated with the certificates.
192. The above statements (and the substantially similar statements appearing in all of
the Morgan Stanley RMBS Offering Materials) regarding the ratings assigned to the Morgan
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Stanley RMBS, as well as the ratings themselves, were materially false and misleading because
Morgan Stanley touted these ratings while knowing that those ratings were based on the
misleading information Morgan Stanley provided to the CRAs, and on Morgan Stanley’s
manipulation of the rating process.
193. As revealed by internal documents released by the U.S. Senate Permanent
Subcommittee on Investigations on April 23, 2010, Morgan Stanley routinely insisted that
CRAs apply more favorable, though outdated and less accurate, ratings models to structure
Morgan Stanley’s deals. In particular, the documents demonstrate that when investment
bankers at Morgan Stanley complained about the use of new and improved rating models,
CRAs made exceptions to ease those standards and/or provided some other form of favorable
treatment to Morgan Stanley. Morgan Stanley sought these exceptions knowing that the
upgraded ratings models would have provided enhanced accuracy to the rating of mortgage-
backed deals.
194. On November 23, 2005, for example, a Morgan Stanley executive sent an email
to S&P expressing concern that Morgan Stanley’s existing mortgage-backed deals and deals
already in the pipeline would be re-tested using S&P’s new and improved Evaluator 3 (E3)
ratings model. The Morgan Stanley executive pressured S&P to apply an outdated and less
accurate ratings model instead, or at the very least to create some sort of disclaimer for investors
about the application of the E3 model. Underscoring the urgency of this request, the banker
highlighted to S&P that his business was on “pause” pending resolution of the matter. The
email stated, in relevant part, as follows:
We are in a bit of a pickle here. My legal staff is not letting me send anything out to any investor on anything with an S&P rating right now. We are waiting for you to tell us … that you approve the disclaimer or are grandfathering [not retesting with E3] our existing and pipeline deals. My business is on ‘pause’ right now.
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195. Morgan Stanley was persistent in pressuring S&P to utilize outdated ratings
models for Morgan Stanley’s deals. After leaving “numerous” messages for an S&P manager,
another Morgan Stanley employee sent an email to an S&P employee on August 1, 2006
insisting that various deals be grandfathered in to S&P’s prior ratings methods. In particular,
the employee expressed outrage with S&P’s application of new recovery rates to structure
Morgan Stanley’s mortgage-backed deals, which he said would cost him “a large amount of
money.” Accordingly, the employee insisted that S&P make an exception for these
transactions. As the email demonstrates, however, an exception made once for Morgan Stanley
was merely precedent for future exceptions. The Morgan Stanley employee’s email states, in
relevant part, as follows:
The position you have put me in is the same as you changing the Accelerator with no notice, no grandfathering, nada. Every day we (and the rest of the Street) show out bids based on our understanding of your methodology. Changes to methodology are a HUGE deal for us. You would never change the Accelerator assumptions on a dime and tell the market to “deal with it”, which is basically what you have done to me. Trades will have been “done”, hedges made, and capital committed - all based on a firm understanding of how you rate. I believe it is unfair to change your methodology on a dime, with no prior notice, and when I am on the hook financially. Do you disagree? I would propose a compromise: for the second trade, we can get a fixed recovery like last time, but for trades beyond the next I will work under the new framework. But changing one day to the next just ruins us. And you have precedent for doing such a compromise: When you went from [model] 2.4 to 3.0, there was a period of time where you would rate on either model. I am asking for a similar “dual option” window for a short period. I do not think this is unreasonable.
196. In this instance, a frustrated S&P manager resisted the banker’s request for the
exception. However, in so doing, he reminded the banker of the frequency at which exceptions
were made for Morgan Stanley. The email stated, in relevant part, as follows:
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You want this [sic] to a commodity relationship and this is EXACTLY what you get. ... How many millions does Morgan Stanley pay us in the greater scheme of things? How many times have I accomodated [sic] you on tight deals?
197. Morgan Stanley also applied pressure to Moody’s to revert to outdated ratings
methods that could be used to structure deals in a more favorable light. For example, in a series
of emails dated October 18 and 19, 2006, a Morgan Stanley vice president expressed concerns
with Moody’s use of key methodology changes, and insisted that Moody’s apply the
methodology that had previously been used to structure Morgan Stanley deals. The employee’s
email stated, in relevant part, as follows:
My concern here is that this is a material change to the Moody’s methodology and nobody has been telling us. We are already out in the market with this deal and have been so for some time. It looks really bad to have to change the capital structure after the fact and gives investors who have provided an IOI the right to put their commitments back to us.
198. In response to Morgan Stanley’s request, Moody’s informed the Morgan Stanley
vice president that the previous methodology was actually just a “temporary concession” and
that “as more people learned that we were willing to look” at the method, “we found that too
many people were creating amortization schedules that were designed to extend hurdles and
game the break even results.” As a result, “[a]s of earlier this year … we decided to remove the
break even concession and give credit to the junior tranches in another way.” Moody’s further
noted that “[y]ou must have had many deals that we’ve looked at since we stopped looking to
the break even [method].” In other words, this was just another attempt by Morgan Stanley to
manipulate the ratings process.
199. Morgan Stanley was often successful in pressuring CRAs to alter the ratings
process to Morgan Stanley’s benefit. As a result, Morgan Stanley RMBS were given
investment grade ratings that did not accurately reflect the true risk of those securities. On May
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2, 2007, for example, an Executive Director of Morgan Stanley sent an email thanking Moody’s
for complying with Morgan Stanley’s request to delay the use of revised ratings models and
grandfather in a list of eighteen different structured finance securities. The email stated, in
relevant part, as follows:
Thanks again for your help (and Mark’s) in getting Morgan Stanley up-to-speed with your new methodology. As we discussed last Friday, please find below a list of transactions with which Morgan Stanley is significantly engaged already (assets in warehouses, some liabilities placed). We appreciate your willingness to grandfather these transactions [under] Moody’s old methodology.
200. CW 1 confirmed that Morgan Stanley regularly exercised its influence to obtain
the best possible ratings on the RMBS it structured, as well as with CDOs and other mortgage-
backed deals. Indeed, CW 1 stated that there were times when Morgan Stanley would hire a
certain CRA and when it did not get the result that it wanted (i.e., a high credit rating), Morgan
Stanley hired a different agency. CW 1 said that, in his role as transaction manager, he would
speak directly with the people at the CRAs who had lost their jobs as a result of conflicts with
Morgan Stanley, as well as the person who was hired instead. CW 1 said that when a CRA
would assign a rating that was lower than what Morgan Stanley desired, someone at Morgan
Stanley would flip his lid, and then representatives from Morgan Stanley and the CRAs would sit
down and figure out how to make Morgan Stanley happy. According to CW 1, Morgan Stanley
employees responsible for structuring RMBS had a lot of interaction with the CRAs on a
securitization. CW 1 also said there were instances where the original rating assigned by the
CRA to a securitization was raised before being sold to investors.
201. As shown by the above examples and witness statements, through repeated
interactions with the CRAs, Morgan Stanley could effectively reverse engineer aspects of the
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ratings models and then modify the structure of a financing to improve its ratings without
actually improving its credit quality.
202. The credit ratings of the RMBS were further compromised by misinformation
provided by Morgan Stanley regarding the abandonment of the originators’ underwriting
standards, rampant use of aggressive exceptions, Morgan Stanley’s knowledge of pervasive
fraud in the stated income loan programs, and the inflated appraisals assigned to the underlying
collateral, as described above. The Defendants knew that the AAA and other investment grade
ratings assigned to the RMBS were false because the originators did not follow their own
underwriting standards and, as such, no reliable estimate could be made concerning the level of
enhancement necessary to ensure that the top tranches purchased by Allstate were of AAA
quality. By including and endorsing these AAA ratings in the Offering Materials, Morgan
Stanley was making a false representation that it actually believed that the AAA ratings were an
accurate reflection of the credit quality of the RMBS.
203. Subsequent downgrades confirm that the investment grade ratings reported in the
Offering Materials were unjustifiably high and misstated the true credit risk of the RMBS
purchased by Allstate. The RMBS purchased by Allstate—all of which were each initially
awarded a triple-A rating—have all been downgraded to junk. The en masse downgrade of
AAA-rated RMBS indicates that the ratings set forth in the Offering Materials were false,
unreliable and inflated.
204. On May 13, 2010, Bloomberg reported that Morgan Stanley, along with seven
other banks, had been subpoenaed by New York Attorney General Andrew Cuomo “to see
whether they misled credit-rating services about mortgage-backed securities … [including]
whether the banks manipulated the companies’ ratings models.” The investigative bodies
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involved in this probe were the New York Attorney General’s office, the SEC and the U.S.
Attorney’s Office in Manhattan.
VIII. DEFENDANTS’ FALSE AND MISLEADING MISSTATEMENTS AND OMISSIONS OF MATERIAL FACT IN THE OFFERING DOCUMENTS
205. As set forth below, the Offering Materials Allstate relied upon in purchasing the
Morgan Stanley RMBS contained numerous misrepresentations of material fact, or omitted to
state material fact necessary to make the statements therein not misleading, regarding: (i) the
originators’ underwriting practices and guidelines by which the loans were originated, including
the prevalence and type of exceptions to those guidelines being applied to the underlying loans,
and the rampant fraud in stated income loans; (ii) the value of the underlying property securing
the loans, in terms of LTV and CLTV ratios and the appraisal standards by which such
mortgaged properties were measured; (iii) the due diligence that Morgan Stanley conducted into
the loan sellers and the mortgage loans backing the RMBS, which identified pervasive defects in
the loans underlying the securitizations; (iv) the credit ratings assigned to the RMBS; and (v) the
true risks of the RMBS.
A. The Offering Materials Misrepresented The Originators’ Underwriting Guidelines.
206. The originators discussed above in ¶¶ 62-130 originated the mortgage loans that
backed the RMBS purchased by Allstate. The Offering Materials for the RMBS all contained
identical or materially similar statements of material fact regarding the originators’ underwriting
guidelines and practices. For example, the MSAC 2006-HE8 prospectus supplement stated that:
Underwriting Standards. The mortgage loans originated or acquired by New Century, referred to in this section as the originator, were done so in accordance with the underwriting guidelines established by it.
* * *
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The New Century Underwriting Guidelines are primarily intended to assess mortgaged property and to evaluate the adequacy of the property as collateral for the mortgage loan. All of the mortgage loans in the mortgage pool were also underwritten with a view toward the resale of the mortgage loans in the secondary mortgage market. While New Century’s primary consideration in underwriting a mortgage loan is the value of the mortgaged property, New Century also considers, among other things, a mortgagor’s credit history, repayment ability and debt service-to-income ratio, as well as the type and use of the mortgaged property.
* * * On a case by case basis, it may be determined that an applicant warrants a debt service-to-income ratio exception, a pricing exception, a loan-to-value ratio exception, an exception from certain requirements of a particular risk category, etc. An exception may be allowed if the application reflects compensating factors . . . Accordingly, a mortgagor may qualify in a more favorable risk category than, in the absence of compensating factors, would satisfy only the criteria of a less favorable risk category. It is expected that a substantial portion of the mortgage loans will represent these kinds of exceptions.
* * *
The mortgage loans were originated consistent with and generally conform to the New Century Underwriting Guidelines’ full documentation, limited documentation and stated income documentation residential loan programs. Under each of the programs, New Century reviews the applicant’s source of income, calculates the amount of income from sources indicated on the loan application or similar documentation, reviews the credit history of the applicant, calculates the debt service-to-income ratio to determine the applicant’s ability to repay the loan, reviews the type and use of the property being financed, and reviews the property. . . . The New Century Underwriting Guidelines require that mortgage loans be underwritten in a standardized procedure which complies with applicable federal and state laws and regulations and requires New Century’s underwriters to be satisfied that the value of the property being financed, as indicated by an appraisal and a review of the appraisal, currently supports the outstanding loan balance.
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207. The above statements of material fact and similar statements regarding the
originators whose loans back the Morgan Stanley RMBS in which Allstate invested, were
materially false and misleading when made because, as explained above, they misrepresented the
true facts, known by Morgan Stanley, that the originators: (i) systematically and flagrantly failed
to follow their stated underwriting guidelines; (ii) allowed pervasive exceptions to their
underwriting standards regardless of existing compensating factors; (iii) disregarded credit
quality to fuel loan originations to sell to loan purchasers such as Morgan Stanley; and (iv)
routinely allowed fraudulent representations of an applicant’s stated income, failed to verify a
prospective borrowers documentation or statements regarding income or assets, and, in many
cases, knowingly falsified the borrower’s stated or documented income or assets.
208. Indeed, As the FCIC Report concluded with regard to the Offering Materials for
Morgan Stanley RMBS:
[M]any prospectuses indicated that the loans in the pool either met guidelines outright or had compensating factors, even though Clayton’s records show that only a portion of the loans were sampled, and that of those that were sampled, a substantial percentage of Grade 3 loans were waived in….[O]ne could reasonably expect [the untested loans] to have many of the same deficiencies, at the same rate, as the sampled loans. Prospectuses for the ultimate investors in the mortgage-backed securities did not contain this information, or information on how few of the loans were reviewed, raising the question of whether the disclosures were materially misleading, in violation of the securities laws.
FCIC Report at 167, 170.
B. The Offering Materials Misrepresented Morgan Stanley Mortgage Capital Inc.’s Loan Purchasing Guidelines
209. Morgan Stanley not only made false and misleading representations regarding the
underwriting procedures and practices of the mortgage lenders that issued the loans backing the
RMBS that Allstate purchased, Morgan Stanley also made false and misleading representations
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concerning Morgan Stanley Mortgage Capital, Inc.’s loan purchasing guidelines as set forth in
three of the RMBS that Allstate purchased. For example, the MSM 2006-10SL RMBS
purchased by Allstate represented Morgan Stanley Mortgage Capital Inc.’s loan purchasing
guidelines as follows:
Based on the data provided in the application and certain verification (if required), a determination is made by the original lender that the mortgagor’s monthly income (if required to be stated) will be sufficient to enable the mortgagor to meet its monthly obligations on the mortgage loan and other expenses related to the property such as property taxes, utility costs, standard hazard insurance and other fixed obligations other than housing expenses.
* * *
Generally, each mortgagor will have been required to complete an application designed to provide to the original lender pertinent credit information concerning the mortgagor. As part of the description of the mortgagor’s financial condition, the mortgagor will have furnished information with respect to its assets, liabilities, income (except as described below), credit history, employment history and personal information, and furnished an authorization to apply for a credit report which summarizes the mortgagor’s credit history with local merchants and lenders and any record of bankruptcy.
* * *
The adequacy of the mortgaged property as security for repayment of the related mortgage loan will generally have been determined by an appraisal in accordance with pre-established appraisal procedure guidelines for appraisals established by or acceptable to the originator. All appraisals conform to the Uniform Standards of Professional Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal Foundation and must be on forms acceptable to FNMA and/or FHLMC. Appraisers may be staff appraisers employed by the originator or independent appraisers selected in accordance with pre-established appraisal procedure guidelines established by the originator. The appraisal procedure guidelines generally will have required the appraiser or an agent on its behalf to personally inspect the property and to verify whether the property was in good condition and that
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construction, if new, had been substantially completed. The appraisal generally will have been based upon a market data analysis of recent sales of comparable properties and, when deemed applicable, an analysis based on income generated from the property or a replacement cost analysis based on the current cost of constructing or purchasing a similar property.
* * *
In addition, on a case-by-case basis, the Seller may determine that, based upon compensating factors, a prospective borrower not strictly qualifying under its loan purchasing guidelines warrants an underwriting exception. Compensating factors may include, but are not limited to, low loan-to-value ratios, low debt-to-income ratios, good credit history, stable employment, financial reserves, and time in residence at the applicant’s current address. A significant number of the Mortgage Loans sold by the Seller to the Issuing Entity may represent underwriting exceptions.
210. The above statements of material fact and similar statements regarding Morgan
Stanley Mortgage Capital Inc.’s loan purchasing guidelines as set forth in the Offering Materials
of the Morgan Stanley RMBS in which Allstate invested, were materially false and misleading
when made because, as explained above, they misrepresented the true facts, known by Morgan
Stanley, that Morgan Stanley Mortgage Capital Inc.: (i) systematically and flagrantly failed to
follow its stated loan purchasing guidelines as demonstrated through the plethora of defective
loans that plague the Morgan Stanley RMBS; (ii) allowed pervasive exceptions to its purchasing
guidelines, regardless of existing compensating factors; (iii) disregarded credit quality to increase
the amount of loans that it could purchase to stuff Morgan Stanley’s RMBS securitization
pipeline; and (iv) routinely purchased loans containing inflated appraisal valuations.
C. The Offering Materials Misrepresented The Appraisals And LTV Ratios Of The Securitized Loans
211. The adequacy of the mortgaged properties as security of the repayment of the
loans was purportedly determined by appraisals. The Offering Materials represented that
independent appraisals were prepared for each mortgaged property and that reports were
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prepared to substantiate these appraisals. For example, as outlined in the MSAC 2006-HE8
prospectus supplement:
Mortgaged properties that are to secure mortgage loans are appraised by qualified independent appraisers. These appraisers inspect and appraise the subject property and verify that the property is in acceptable condition. Following each appraisal, the appraiser prepares a report which includes a market value analysis based on recent sales of comparable homes in the area and, when deemed appropriate, replacement cost analysis based on the current cost of constructing a similar home. All appraisals are required to conform to the Uniform Standards of Professional Appraisal Practice adopted by the Appraisal Standards Board of the Appraisal Foundation and are on forms acceptable to Fannie Mae and Freddie Mac.
212. As discussed above, the representations regarding appraisals and LTV ratios were
materially false and misleading in that they misrepresented that the appraisal process employed
by the originators, including, among others things, the fact that: (i) the appraisers were not
independent from the respective mortgage lenders, which pressured appraisers to value the
mortgaged property at a pre-determined, preconceived, inflated, and false appraisal value; (ii) the
actual LTV ratios for many of the mortgage loans underlying the RMBS would have exceeded
100% if the mortgaged properties had been appraised by an independent appraiser as represented
in the Offering Documents; (iii) sales managers employed by the respective originators had and
utilized the authority to override and inflate an appraiser’s final professional valuation of the
mortgaged property; and, as such, (iv) the appraisals failed to conform to the standards set by
Fannie Mae and Freddie Mac.
D. The Offering Materials Misrepresented Morgan Stanley’s Due Diligence Into The Loan Sellers And The Mortgage Loans Backing The RMBS
213. All of the Morgan Stanley RMBS purchased by Allstate were securitized through
principal securitization whereby investors expect the involvement of a sophisticated investment
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bank such as Morgan Stanley throughout the securitization process to warrant a high degree of
oversight and due diligence conducted into the mortgages being selected for inclusion in the
RMBS. The Offering Materials for the RMBS purchased by Allstate represented as much. For
example, as discussed in the MSAC 2006-HE8 prospectus supplement:
MSMC acquires residential mortgage loans through bulk purchases and also through purchases of single loans through MSMC’s conduit loan purchase program. The mortgage loans purchased through its conduit program generally conform to the conduit origination standards. Prior to acquiring any residential mortgage loans, MSMC conducts a review of the related mortgage loan seller that is based upon the credit quality of the selling institution. MSMC’s review process may include reviewing select financial information for credit and risk assessment and conducting an underwriting guideline review, senior level management discussion and/or background checks. The scope of the mortgage loan due diligence varies based on the credit quality of the mortgage loans. The underwriting guideline review entails a review of the mortgage loan origination processes and systems. In addition, such review may involve a consideration of corporate policy and procedures relating to state and federal predatory lending, origination practices by jurisdiction, historical loan level loss experience, quality control practices, significant litigation and/or material investors.
214. As outlined above, these statements of material fact and similar statements
appearing in the Offering Materials for each of the Certificates were false and misleading when
made because, in truth: (i) Morgan Stanley routinely ignored the pervasive defects that its
internal and external due diligence processes identified in the loans Morgan Stanley had
purchased for securitization; (ii) Morgan Stanley routinely overruled the determinations of its
due diligence providers and purchased defective mortgage loans to be placed in the mortgage
pools backing its RMBS; and (iii) Morgan Stanley used the information developed through its
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due diligence into loans that failed to meet underwriting guidelines to negotiate with the
mortgage originators a lower price for the relevant loan pools at the cost of investors.
E. Defendants Materially Misrepresented The Accuracy Of The Credit Ratings Assigned To The Certificates
215. Defendants represented in the Offering Materials that all of the RMBS purchased
by Allstate were worthy of being rated “AAA,” signifying that the risk of loss was virtually non-
existent.
216. By providing ratings, Defendants represented that they believed that the
information provided to the rating agencies to support these ratings accurately reflected Morgan
Stanley’s underwriting guidelines and practices, and the specific qualities of the underlying
loans. As explained above, this representation was false.
217. Specifically, the Morgan Stanley RMBS prospectus supplements prepared by
Defendants represented, in sum or substance, that:
In order to be issued, the Offered Certificates must be assigned ratings not lower than the following by S&P, Fitch and Moody’s: Class S&P Fitch Moody’s A-fpt AAA AAA Aaa A-1 AAA AAA Aaa A-2 AAA AAA Aaa A-3 AAA AAA Aaa A-4 AAA AAA Aaa M-1 AA+ AA+ Aa1 M-2 AA AA Aa2 M-3 AA- AA- Aa3 M-4 A+ A+ A1 M-5 A A A2 M-6 A- A- A3 B-1 BBB+ BBB+ Baa1 B-2 BBB BBB Baa2 B-3 BBB- BBB- Baa3 A securities rating addresses the likelihood of the receipt by a certificateholder of distributions on the mortgage loans to which they are entitled by the Final Scheduled Distribution Date. The
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rating takes into consideration the characteristics of the mortgage loans and the structural, legal and tax aspects associated with the certificates.
218. These statements regarding the ratings assigned to the RMBS were false and
misleading because Defendants stated the assigned ratings while knowing that misleading
information was provided to the rating agencies by Morgan Stanley to guarantee AAA or
otherwise investment grade ratings were assigned to the RMBS.
F. Defendants’ Purported Warnings Regarding The Risks Of The RMBS Contained False And Misleading Statements And Omissions Of Material Fact
219. Defendants’ representations regarding the risks of the RMBS contained false
statements and omissions of material fact. For example, as stated in the MSAC 2006-HE8
prospectus supplement:
THE LOANS WILL BE UNDERWRITTEN USING VARYING STANDARDS, AND LESS STRINGENT UNDERWRITING STANDARDS AND THE RESULTANT POTENTIAL FOR DELINQUENCIES ON THE LOANS COULD LEAD TO LOSSES ON YOUR SECURITIES.
* * * [T]he underwriting standards used in the origination of the loans held by the trust will generally be less stringent than those of Fannie Mae or Freddie Mac with respect to a borrower’s credit history and in certain other respects. Borrowers on the loans may have an impaired or unsubstantiated credit history. As a result of this less stringent approach to underwriting, the loans purchased by the trust for your series of securities may experience higher rates of delinquencies, defaults and foreclosures than loans underwritten in a manner which is more similar to the Fannie Mae and Freddie Mac guidelines.
* * *
It is expected that a substantial portion of the mortgage loans in the mortgage pool will represent these exceptions.
* * *
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INCREASED USE OF NEW MORTGAGE LOAN PRODUCTS BY BORROWERS MAY RESULT IN DECLINE IN REAL ESTATE VALUES GENERALLY. In recent years, borrowers have increasingly financed their homes with new mortgage loan products, which in many cases have allowed them to purchase homes that they might otherwise have been unable to afford. Many of these new products feature low monthly payments during the initial years of the loan that can increase (in some cases, significantly) over the loan term. There is little historical data with respect to these new mortgage loan products. Consequently, as borrowers face potentially higher monthly payments for the remaining terms of their loans, it is possible that, combined with other economic conditions such as increasing interest rates and deterioration of home values, borrower delinquencies and defaults could exceed anticipated levels. In that event, the securities, and your investment in the securities, may not perform as you anticipate.
* * *
The ratings on your certificates could be reduced or withdrawn. Each rating agency rating the offered certificates may change or withdraw its initial ratings at any time in the future if, in its judgment, circumstances warrant a change. No person is obligated to maintain the ratings at their initial levels. If a rating agency qualifies, reduces or withdraws its rating on one or more classes of the offered certificates, the liquidity and market value of the affected certificates is likely to be reduced.
220. These and similar purported warnings in the Offering Materials were themselves
materially false and misleading because they failed to convey the severity of the investment risk
at the time of the offering because: (i) the stated underwriting standards and practices of the
mortgage originators from which Morgan Stanley purchased the loans that comprised the RMBS
were not merely “less stringent” than Fannie Mae’s and Freddie Mac’s underwriting
guidelines—they were completely disregarded by the mortgage lenders discussed above,
resulting in loans that presented extremely high risks of default; (ii) Morgan Stanley concealed
that the due diligence it conducted on the mortgage loans that comprised the relevant RMBS
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revealed a substantial number of defective loans; (iii) Morgan Stanley materially misrepresented
the originators’ rampant use of exceptions in the absence of existing compensating factors in
order to generate loan volume and profits; (iv) Morgan Stanley concealed that it routinely
purchased loans with LTV and CLTV ratios over 100%, which it would then securitize into
RMBS and sell to investors; (v) Morgan Stanley failed to address the fact that it consistently
purchased loans with DTI ratios over 55%; (vi) Morgan Stanley misrepresented that the loans
underlying its RMBS were issued pursuant to inflated appraisals; (vii) Morgan Stanley
misrepresented that the loans comprising the RMBS were issued to borrowers regardless of the
borrowers’ ability to repay the mortgage loan; and (viii) Morgan Stanley intentionally provided
misleading information to the rating agencies to guarantee AAA or otherwise investment grade
ratings were assigned to the RMBS, such that the initial ratings assigned to the RMBS were
never justified and faced an extremely high risk of severe downgrades.
221. Moreover, Defendants’ purported warnings about the financial distress of the
mortgage lenders that originated the loans underlying the relevant RMBS, including statements
regarding New Century in certain of the RMBS Offering Materials, were false and misleading
when made because the purported warnings misrepresented that Morgan Stanley: (i) had
performed due diligence on the loans backing the Morgan Stanley RMBS that revealed they were
not underwritten according to the originators’ stated guidelines or with regard to a borrower’s
ability to repay the loan; (ii) knew that these originators had, with increasing frequency, engaged
in practices to make it appear as though defaulting loans were actually performing so they could
be securitized; and (iii) in certain cases actively participated in these attempts in order to protect
its own warehouse lines of credit that were put at risk by these originators’ precarious financial
condition. Indeed, the fact that Morgan Stanley secured AAA ratings for the RMBS backed by
New Century loans and touted its due diligence of those loans even while purportedly warning of
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the particular risks relating to the mortgages originated by New Century conveyed to investors
like Allstate that Morgan Stanley had verified that the loans conformed to the originators’ stated
underwriting guidelines.
222. By purporting to warn RMBS investors like Allstate of matters that Morgan
Stanley already knew, or recklessly disregarded, to exist at the time the RMBS were issued,
Morgan Stanley misled Allstate to believe that these risks were mere potentialities and not
circumstances that already existed when the RMBS were issued.
IX. ALLSTATE’S INVESTMENT IN THE RMBS AND RELIANCE ON MORGAN STANLEY’S MISREPRESENTATIONS
223. The Morgan Stanley RMBS for all offerings were issued pursuant to the Offering
Materials, which contained the false and misleading statements set forth above. These
documents also generally explained the structure and provided an overview of the RMBS.
Morgan Stanley ABS Capital I Inc. and Morgan Stanley Capital I Inc. prepared the Offering
Materials.
224. The Offering Materials contained detailed descriptions of the mortgage pools
underlying the RMBS and provided the specific terms of the particular RMBS offering. The
Offering Materials included tabular data concerning the loans underlying the RMBS, including
(but not limited to) the type of loans; the number of loans; the mortgage rate and net mortgage
rate (the mortgage rate net of the premium for any lender paid mortgage insurance less the sum
of the master servicing fee and the trustee fee on the mortgage loan); the aggregate scheduled
principal balance of the loans; the weighted average original combined LTV ratio; occupancy
rates; credit enhancement; and the geographic concentration of the mortgaged properties. The
Offering Materials also contained a summary of the originators’ underwriting and appraisal
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standards, guidelines and practices. The registration statements incorporated by reference the
subsequently filed prospectuses and prospectus supplements.
225. In deciding to purchase the RMBS, Allstate relied on the Defendants’ false
representations and omissions of material fact regarding their underwriting standards and the
characteristics of the mortgage loans underlying the RMBS in the Offering Materials. But for
the Defendants’ fraudulent representations and omissions, Allstate would not have purchased
the RMBS.
226. Allstate reasonably relied upon the Defendants’ representations in the Offering
Materials regarding loan quality and Morgan Stanley’s reputation. Allstate did not know at the
time they purchased the RMBS, and could not have known, that the originators were not
following their stated underwriting guidelines, leading to a drastic increase in the origination of
risky loans, nor did Allstate know that the property appraisals secured by the originators were
not independent and resulted in false appraisal values. Allstate also did not know that the
originators knowingly or recklessly accepted false information about material fact such as
borrowers’ stated income, which caused the Defendants’ representations to be false. Allstate
did not know that Morgan Stanley’s due diligence had identified significant problems with the
originators’ loans or that Morgan Stanley’s own internal analyses had concluded that the vast
majority of the loans underlying the RMBS would not be able to be repaid. If Allstate had
known these and other material facts regarding the Morgan Stanley’s fraudulent
misrepresentations and omissions of material fact contained in the Offering Materials, Allstate
would not have purchased the RMBS.
227. Morgan Stanley’s misrepresentations and omissions of material fact caused
Allstate to suffer losses on the RMBS, because the RMBS were far riskier—and their rate of
default far higher—than the Offering Materials represented them to be. The mortgage loans
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underlying the RMBS experienced defaults and delinquencies at a much higher rate due to the
originators’ abandonment of their loan-origination guidelines.
228. Allstate purchased each Morgan Stanley RMBS in reliance on the information
contained in the applicable Offering Materials. In connection with the offers and sales of the
RMBS to Allstate, Morgan Stanley provided directly or indirectly to Allstate’s investment
personnel or managers the Offering Materials. Similar information was sent to and analyzed by
Allstate’s investment personnel and managers if the RMBS was sold to them in the secondary
market.
229. Allstate reviewed and analyzed the Offering Materials provided directly or
indirectly by Morgan Stanley and Defendants with respect to each offering of RMBS and
performed various analyses of the RMBS-specific data for each offering before deciding to
purchase RMBS in the offering. The analyses conducted by Allstate before deciding to
purchase a RMBS included various credit analyses based on the information provided by
Morgan Stanley and Defendants with respect to both the credit characteristics of the mortgage
loan pool (including, for example, geographic concentration; weighted average life; fixed- or
floating-rate loans; full-, low-, or no-documentation “stated income” loans; and owner-
occupied, second home, or investment properties), and the structure of the securitization with
respect to the seniority and risk characteristics of the particular tranche of RMBS (including, for
example, position in the payment “waterfall”).
230. Thus, Allstate justifiably relied on the Offering Materials provided directly or
indirectly by Morgan Stanley and Defendants for each offering of the RMBS. These documents
contained numerous statements of material fact about the RMBS, including statements
concerning: (i) the mortgage originators’ underwriting guidelines that were purportedly applied
to evaluate the ability of the borrowers to repay the loans underlying the RMBS; (ii) the
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appraisal guidelines that were purportedly applied to evaluate the value and adequacy of the
mortgaged properties as collateral; (iii) the LTV ratios and debt to income ratios; (iv) Morgan
Stanley’s and Defendants’ due diligence of the loans and the originators’ underwriting
practices; (v) various forms of credit enhancement applicable to certain tranches of RMBS; and
(vi) the ratings assigned to the RMBS.
231. These statements of material fact were untrue because: (i) the originators
violated their stated underwriting guidelines and did not originate loans based on the borrowers’
ability to repay; and (ii) inflated appraisals caused the listed LTV ratios and levels of credit
enhancement to be untrue. In addition, metrics such as debt-to-income ratios were untrue as a
result of the other mortgage originators’ acceptance of untrue information from mortgage
applicants. For example, Morgan Stanley and the other mortgage originators allowed applicants
for “stated income” loans to provide untrue income information and did not verify the
applicants’ purported income. In addition, the credit ratings on which Allstate relied were
materially misleading, did not reflect the true credit quality of the RMBS and were the result of
intentional manipulation.
X. BECAUSE OF DEFENDANTS’ FRAUDULENT CONDUCT, ALLSTATE SUFFERED LOSSES ON ITS PURCHASES OF RMBS
232. The ratings on virtually all of the RMBS have since been downgraded and they
are no longer marketable or salable at the prices paid for them by Allstate. All of the RMBS in
which Allstate purchased interests were rated “AAA” at issuance and have since been
downgraded to junk.
233. Further, the delinquency, bank ownership and foreclosure rates on the underlying
mortgages have soared since issuance. The average percentage of loans that are currently 60
days or more delinquent, in foreclosure, or bank-owned approaches 36%. Moreover, these
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current performance numbers do not reflect the number of loans which have been foreclosed
since issuance and which are no longer included within the loan pools. A substantial number of
the original loans contained in the loan pools have been removed from the pools, largely due to
either foreclosure or early payout, negatively impacting the income payable to certificate-
holders.
234. Other parties’ reviews of Morgan Stanley’s full loan files have revealed even
greater deviations. Third parties with access to the complete loan files for certain Morgan
Stanley’s securitizations have performed additional analysis of the mortgage loans underlying
certain of Morgan Stanley’s offerings. These include MBIA’s analyses of one Morgan Stanley
securitization that showed that 96.6% of the loans underlying the securitization contained one or
more breaches of the mortgage loan purchase agreement, including DTI ratios, CLTV ratios,
credit scores, unreasonable stated incomes, inaccurate appraisals and other problems revealing
that the loans drastically deviated from the underwriting guidelines Morgan Stanley represented
that it would follow. MBIA’s claim for fraudulent inducement against Morgan Stanley arising
out of this transaction was recently sustained. See MBIA Ins. Corp. v. Morgan Stanley et al.,
Index No. 29951/10 (N.Y. Sup. Ct. Westchester Cnty. May 26, 2011). These facts provide
additional strong evidence that essential characteristics of the mortgage loans underlying
Morgan Stanley MBS were misrepresented and omitted material information.
FIRST CAUSE OF ACTION
(Common Law Fraud Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley Mortgage
Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC)
235. Allstate repeats and realleges the allegations set forth in the preceding
paragraphs, as if fully set forth herein.
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236. As alleged above, in the Offering Materials and in their public statements,
Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan
Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage
Capital Holdings LLC (the “Defendants”) made fraudulent and false statements of material fact,
and omitted material facts necessary in order to make their statements, in light of the
circumstances under which the statements were made, not misleading.
237. As a corporate parent, Morgan Stanley directed the activities of Morgan Stanley
& Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley
Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC.
238. Defendants knew at the time they sold and marketed each of the RMBS that the
foregoing statements were false or, at the very least, made recklessly, without any belief in the
truth of the statements.
239. Defendants made these materially false and misleading statements and omissions
for the purpose of inducing Allstate to purchase the RMBS. Furthermore, these statements
related to these Defendants’ own acts and omissions.
240. Defendants knew or recklessly disregarded that investors like Allstate were
relying on their expertise, and they encouraged such reliance through the Offering Materials and
their public representations, as described herein. Defendants knew or recklessly disregarded
that investors like Allstate would rely upon their representations in connection their decision to
purchase the RMBS. Defendants were in a position of unique and superior knowledge
regarding the true facts concerning the foregoing material misrepresentations and omissions.
241. It was only by making such representations that Defendants were able to induce
Allstate to buy the RMBS. Allstate would not have purchased or otherwise acquired the RMBS
but for Defendants’ fraudulent representations and omissions about the quality of the RMBS.
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242. Allstate justifiably, reasonably and foreseeably relied upon Defendants’
representations and false statements regarding the quality of the RMBS.
243. As a result of the false and misleading statements and omissions, as alleged
herein, Allstate has suffered substantial damages.
SECOND CAUSE OF ACTION
(Fraudulent Inducement Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley Mortgage
Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC)
244. Allstate repeats and realleges the allegations set forth in the preceding
paragraphs, as if fully set forth herein.
245. As alleged above, in the Offering Materials and in other communications to
Allstate, Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc.,
Morgan Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley
Mortgage Capital Holdings LLC (the “Defendants”) made fraudulent and false statements of
material fact, and omitted material facts necessary in order to make their statements, in light of
the circumstances under which the statements were made, not misleading.
246. This is a claim for fraudulent inducement against Defendants. As a corporate
parent, Morgan Stanley directed the activities of Morgan Stanley & Co., Inc., Morgan Stanley
ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and
Morgan Stanley Mortgage Capital Holdings LLC.
247. Defendants knew at the time they sold and marketed each of the RMBS that the
foregoing statements were false or, at the very least, made recklessly, without any belief in the
truth of the statements.
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248. Defendants made these materially misleading statements and omissions for the
purpose of inducing Allstate to purchase the RMBS. Furthermore, these statements related to
these Defendants’ own acts and omissions.
249. Defendants knew or recklessly disregarded that investors like Allstate were
relying on their expertise, and they encouraged such reliance through the Offering Materials and
their public representations, as described herein. Defendants knew or recklessly disregarded
that investors like Allstate would rely upon their representations in connection with their
decision to purchase the RMBS. Defendants were in a position of unique and superior
knowledge regarding the true facts concerning the foregoing material misrepresentations and
omissions.
250. It was only by making such representations that Defendants were able to induce
Allstate to buy the RMBS. Allstate would not have purchased or otherwise acquired the RMBS
but for Defendants’ fraudulent representations and omissions about the quality of the RMBS.
251. Allstate justifiably, reasonably and foreseeably relied upon Defendants’
representations and false statements regarding the quality of the RMBS.
252. By virtue of Defendants’ false and misleading statements and omissions, as
alleged herein, Allstate has suffered substantial damages and are also entitled to a rescission of
the sale of the RMBS.
THIRD CAUSE OF ACTION
(Aiding And Abetting Fraud Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley
Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC)
253. Allstate repeats and realleges the allegations set forth in the preceding
paragraphs, as if fully set forth herein.
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254. This is a claim against the above-named Defendants for aiding and abetting the
fraud by Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc.,
Morgan Stanley Capital I Inc., Morgan Stanley Mortgage Capital Inc., and Morgan Stanley
Mortgage Capital Holdings LLC (the “Defendants”). Each of these Defendants aided and
abetted the fraud committed by and among all of the other Defendants.
255. The above-named Defendants knew of the fraud perpetrated by Morgan Stanley,
Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc.,
Morgan Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC
on Allstate. As alleged in detail above, each of the above-named Defendants knew that the
RMBS were not backed by high quality loans and were not underwritten according to the
originators’ underwriting standards, conducted due diligence on the loan pools securitized into
the Morgan Stanley RMBS purchased by Allstate that identified the originators’ deviations from
loan underwriting and appraisal standards, participated in those violations and had actual
knowledge of their own acts, or participated in or had actual knowledge of Defendants’ reckless
or intentional dissemination of false and misleading information to the CRAs.
256. Furthermore, the above-named Defendants provided Morgan Stanley, Morgan
Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan
Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC with
substantial assistance in advancing the commission of the fraud. As alleged in detail above,
each of the above-named Defendants participated in the violations of concealing the originators’
deviations from their stated mortgage loan underwriting and appraisal standards, made false
statements about the originators’ mortgage loan underwriting and appraisal standards and
Morgan Stanley’s own underwriting guidelines, provided false information about the mortgage
loans underlying the Certificates to the credit rating agencies, provided false information for use
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in the Offering Materials, or participated in the failure to properly endorse and deliver the
mortgage notes and security documents to the issuing trusts.
257. It was foreseeable to the above-named Defendants at the time they actively
assisted in the commission of the fraud that Allstate would be harmed as a result of their
assistance.
258. As a direct and natural result of the fraud committed by Morgan Stanley, Morgan
Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan
Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC and the
above-named Defendants’ knowing and active participation therein, Allstate has suffered
substantial damages.
FOURTH CAUSE OF ACTION
(Negligent Misrepresentation Against Morgan Stanley, Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley
Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC)
259. Allstate repeats and realleges each and every allegation set forth in the preceding
paragraphs above as if fully set forth herein, except any allegations that Defendants made any
untrue statements and omissions intentionally or recklessly. For the purposes of this Count,
Allstate expressly disclaims any claim of fraud or intentional misconduct.
260. This is a claim for negligent misrepresentation against Morgan Stanley, Morgan
Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan
Stanley Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC (the
“Defendants”). As a corporate parent, Morgan Stanley directed the activities of Morgan Stanley
& Co., Inc., Morgan Stanley ABS Capital I Inc., Morgan Stanley Capital I Inc., Morgan Stanley
Mortgage Capital Inc., and Morgan Stanley Mortgage Capital Holdings LLC.
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261. Allstate made 17 separate investments in six Offerings of RMBS that Defendants
securitized and sold.
262. Because Defendants originated or acquired, or underwrote all of the underlying
mortgage loans, they had unique and special knowledge about the loans in the Offerings. In
particular, Defendants had unique and special knowledge and expertise regarding the quality of
the underwriting of those loans.
263. Because Allstate could not evaluate the loan files for the mortgage loans
underlying their RMBS, and because Allstate could not examine the underwriting quality of the
mortgage loans in the securitizations on a loan-by-loan basis, it was heavily reliant on
Defendants’ unique and special knowledge regarding the underlying mortgage loans when
determining whether to make each investment of RMBS. Allstate was entirely reliant on
Defendants to provide accurate information regarding the loans in engaging in that analysis.
Accordingly, Defendants were uniquely situated to evaluate the economics of each RMBS.
264. Over the course of almost two years, for 17 separate investments, Allstate relied
on Defendants’ unique and special knowledge regarding the quality of the underlying mortgage
loans and their underwriting when determining whether to invest in the Offerings. This
longstanding relationship, coupled with Defendants’ unique and special knowledge about the
underlying loans, created a special relationship of trust, confidence, and dependence between
Defendants and Allstate.
265. Defendants were aware that Allstate relied on their unique and special expertise
and experience and depended upon them for accurate and truthful information. Defendants also
knew that the facts regarding Morgan Stanley’s compliance with its underwriting standards
were exclusively within their knowledge.
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266. Based on their expertise, superior knowledge, and relationship with Allstate,
Defendants owed a duty to Allstate to provide complete, accurate, and timely information
regarding the mortgage loans and the RMBS. Defendants breached their duty to provide such
information to Allstate.
267. Defendants likewise made misrepresentations which they knew, or were
negligent in not knowing at the time to be false, in order to induce Allstate’s investment in the
RMBS. Defendants provided the Offering Materials to Allstate in connection with the RMBS,
for the purpose of informing Allstate of material facts necessary to make an informed judgment
about whether to purchase the RMBS in the Offerings. In providing these documents,
Defendants knew that the information contained and incorporated therein would be used for a
serious purpose, and that Allstate, like other reasonably prudent investors, intended to rely on
the information.
268. As alleged above, the Offering Materials contained materially false and
misleading information.
269. Defendants should have known that the information in the Offering Materials
was materially false and misleading.
270. Unaware that the Offering Materials contained materially false and misleading
statements, Allstate reasonably relied on those false and misleading statements when deciding
to purchase the non-secondary RMBS in the Offerings.
271. Allstate purchased RMBS from Morgan Stanley ABS Capital I Inc., Morgan
Stanley Capital I Inc., and from Morgan Stanley & Co., Inc. in the RMBS offerings, and are
therefore in privity with Morgan Stanley & Co., Inc., Morgan Stanley ABS Capital I Inc., and
Morgan Stanley Capital I Inc.
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272. Based on Defendants’ expertise and specialized knowledge, and in light of the
false and misleading representations in the Offering Materials, Defendants owed Allstate a duty
to provide it with complete, accurate, and timely information regarding the quality of the
RMBS, and breached their duty to provide such information to Allstate.
273. Allstate reasonably relied on the information provided by Defendants and have
suffered substantial damages as a result of their misrepresentations.
PRAYER FOR RELIEF
WHEREFORE, Plaintiffs pray for relief and judgment, as follows:
(a) Awarding compensatory and/or rescissionary damages in favor of Plaintiffs
against all Defendants, jointly and severally, for all damages sustained as a result of
Defendants’ wrongdoing, in an amount to be proven at trial, including interest thereon;
(b) Awarding Plaintiffs their reasonable costs and expenses incurred in this action,
including counsel fees and expert fees; and
(c) Such other relief as the Court may deem just and proper.
JURY DEMAND
Plaintiffs demand a trial by jury on all claims so triable.
Dated: July 5, 2011 BERNSTEIN LITOWITZ BERGER & GROSSMANN LLP
Gerald H. Silk
Avi Josefson Lauren A. McMillen Michael D. Blatchley Ross Shikowitz 1285 Avenue of the Americas, 38th Floor New York, NY 10019 Tel: (212) 554-1400 Fax: (212) 554-1444 [email protected] [email protected] [email protected] [email protected]
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[email protected] -and- Blair Nicholas 12481 High Bluff Drive, Suite 300 San Diego, CA 92130 Tel: (858) 793-0070 Fax: (858) 793-0323 [email protected]
Counsel for Plaintiffs
