On Thursday, Morgan Stanley (MS) agreed to pay $103 million to settle a lawsuit brought against it by the state of Massachusetts, alleging the company of backed subprime lending, which was too risky.
Under the terms of the settlement, Morgan Stanley will be required to pay $23.4 million to an independent fund, which will then cover the losses incurred by two Massachusetts pension funds – the Massachusetts Pension Reserves Investment Trust and the Massachusetts Municipal Depository Trust funds.
Morgan Stanley will also pay $58 million to more than 1,000 affected Massachusetts borrowers who will be getting a 35% reduction on their principal amount. The state’s taxpayers will receive $19.5 million from the company and a non-profit group working for the victims of subprime foreclosure in the state will also get $2 million.
Though Morgan Stanley neither accepted nor rebuffed the charges, Massachusetts Attorney General Martha Coakley charged the company of giving billions of dollars to New Century Financial Corp., a subprime lender. New Century used these funds to influence the low income group into buying loans, which were beyond their repaying capacity. Morgan Stanley was accused of then repackaging these loans and selling them to other investors, which also included two Massachusetts pension funds mentioned above.
In 2006 and 2007, when the subprime market began to encounter problems, Morgan Stanley agreed to pay $3 billion to New Century in funding. However, the company rejected a number of loans that it had decided to buy from New Century to bundle them into bonds as result of non compliance of underwriting guidelines. However, Morgan Stanley started to include an extensive range of New Century loans when it was threatened by New Century to pull its business. In April 2007, New Century filed for bankruptcy.
The suit also alleged that Morgan Stanley continued to do business with New Century even when some of the loans defied the set parameters and lending laws in Massachusetts.
According to the complaint filed, New Century had considered the debt to income ratio at a teaser rate that adjusted to a higher rate after a trial period. Had the loans been calculated with the fully indexed rate, only 60% of the borrowers would have qualified to Morgan Stanley’s underwriting standards. Apart from this, a large number borrowers did not provide any documentation that was required to ensure that they could afford such loans, as these mortgaged loans were based on “stated” income.
According to Coakley, this caused harm to the individual borrowers as well as the larger economy, as unfair lending policy began to inflate the housing market, which led to an overwhelming financial crisis. These risky practices hurt the Massachusetts loan granters and are being probed by state and federal regulators.
Besides Morgan Stanley, in February 2010, State Street Corp. (STT) agreed to pay investors over $300 million to settle allegations by federal and state regulators over misleading investors about its investments in subprime mortgages at the beginning of the credit crisis. Over a year ago, Goldman Sachs Group Inc. (GS) also resolved a similar lawsuit by agreeing to pay $60 million to end an inquiry.
Recently, Goldman and some of its top officers and directors have been charged with securities fraud, and a class action lawsuit has already been filed. The Securities and Exchange Commission (SEC) is looking into allegations against Goldman, while the role of Morgan Stanley and other U.S. banks such as Bank of America Corp. (BAC), Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM) also are under scrutiny.
Going forward, such civil-fraud allegations and legal suits could harshly hit Morgan Stanley’s operating capacity in an industry that is largely based on goodwill and trust. Moreover, such financial and anti-trust regulatory scrutiny may not only spread negative publicity but also shake investors’ confidence in the industry’s most renowned and reliable giants.
All these apprehensions are reflected in the current Zacks #5 Rank (‘Strong Sell’) for Morgan Stanley, with an expectation that the stock would underperform the broader U.S. equity market over the next one to three months. Morgan Stanley’s growth has been negatively impacted by the after-effects of the financial crisis. As a result, the company is facing major headwinds in order to keep pace with its peers and maintain its industry leading position. Hence, we maintain our Underperform recommendation on the stock.
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