International Financial Law Prof Blog

Editor: William Byrnes
Texas A&M University
School of Law

Wednesday, July 30, 2014

Morgan Stanley pays $275 million fine & disgorgement for $2.5 billion of sub-prime backed securities sales

SECThe Securities and Exchange Commission (“Commission”) deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 (“Securities Act”) against Morgan Stanley and Co. LLC (f/k/a Morgan Stanley and Co. Incorporated) (“MS & Co.”), Morgan Stanley ABS Capital I Inc. (“MSAC”), and Morgan Stanley Mortgage Capital Holdings LLC (“MSMCH”).  The Order is excerpted below.

Accordingly, it is hereby ORDERED that:

...Respondents shall, jointly and severally, within ten (10) business days of the entry of this Order, pay disgorgement of $160,627,852, prejudgment interest of $17,995,437, and a civil penalty of $96,376,711 to the Securities and Exchange Commission.

This matter concerns Morgan Stanley’s misleading public disclosures regarding the number
of delinquent loans in two subprime residential mortgage-backed securities (“RMBS”) transactions offered in 2007—Morgan Stanley ABS Capital I Inc. Trust 2007-NC4 (“NC4”) and Morgan Stanley ABS Capital I Inc. Trust 2007-HE7 (“HE7”) (collectively “the transactions”). Morgan Stanley sponsored, issued, and underwrote the transactions, which were collateralized by mortgage loans with an aggregate principal value balance of over $2.5 billion.

The offering documents for the transactions disclosed that less than 1% of each pool’s aggregate principal balance was more than 30 but less than 60 days delinquent as of each transaction’s “cut-off date” (the “current delinquency representation”). With the exception of these loans disclosed as currently delinquent, Morgan Stanley represented that, as of each transaction’s “closing date,” no payment under any other loan had been more than 30 days delinquent at any time since origination (the “historical delinquency representation”).

Notwithstanding the historical delinquency representation, approximately 17% of the
loans collateralizing the HE7 transaction had been delinquent at some point since origination
Further, although Morgan Stanley represented that the number and percentage of currently
delinquent loans included in the HE7 offering materials was as of the transaction’s September 1,
2007 cut-off date, Morgan Stanley actually used payment data as of mid-September to determine
the disclosed delinquencies. By using the later payment data, Morgan Stanley misreported the
number of current delinquencies by 46 loans.

As a result of this conduct, the HE7 trust contains loans that have actual and projected
losses, based on bankruptcies, real estate owned properties (“REOs”), and foreclosures, of
$138,255,564, while the NC4 trust contains loans that have actual and projected losses, based on
bankruptcies, REO’s and foreclosures, of $21,230,863. Investors in these transactions have
incurred losses.

The Securitization Process
Morgan Stanley structured and sold the NC4 and HE7 transactions through the sponsor, depositor and underwriter entities described above. On or about June 20, 2007, MSAC transferred 5,340 loans to the issuing entity Morgan Stanley ABS Capital I Inc. Trust 2007-NC4.

On or about September 28, MSAC transferred approximately 7,670 loans to the issuing trust for
Morgan Stanley ABS Capital I Inc. Trust 2007-HE7. In both instances, MSAC transferred the
loans to the trusts in exchange for certificates representing the RMBS investments. MSAC sold the certificates to MS & Co., the underwriter, which sold them to the public. MS & Co. obtained money through its sales of securities to the public and received underwriting fees in connection with the transactions.

On June 14, Morgan Stanley filed a preliminary Prospectus Supplement offering
$781,761,000 of securities collateralized by approximately 5,340 subprime mortgage loans with a
total principal balance of just over $1 billion as of the cut-off date. The preliminary Prospectus
Supplement included bracketed blanks as placeholders for the specific delinquency values. It
stated that: “[ ] mortgage loans with an aggregate principal balance as of the cut-off date of $[
], which represents no more than approximately 1% of the mortgage loans in the final mortgage
pool, were more than 30 days but less than 60 days Delinquent with respect to their scheduled
monthly payments.” [Emphasis added]

On June 20, 2007, after obtaining the updated remittance data discussed above
Morgan Stanley filed a final Prospectus Supplement including specific delinquency values. Morgan Stanley stated that “41 mortgage loans with an aggregate principal balance as of the cut-off date of $10,501,930.24, which represents approximately 0.9994% of the mortgage loans in the final mortgage loan pool, were more than 30 days but less than 60 days Delinquent with respect to their scheduled payments.”

The updated payment data Morgan Stanley obtained on June 13, 2007, showed that delinquencies as of that date were materially higher than what Morgan Stanley disclosed in
the final Prospectus Supplement as of the May 1 cut-off date. This updated payment information was available to Morgan Stanley a week before the transaction closed.

For the HE7 transaction, Morgan Stanley included at least 1,241 loans that had been historically delinquent. Despite receiving the historical delinquency chart showing that approximately 17% of the HE7 loan pool had been historically delinquent, Morgan Stanley represented in the offering documents that no loans had been more than 30 days delinquent since origination, other than the approximately 1% of loans disclosed as being more than 30 days delinquent. Further, Morgan Stanley used payment data as of September 20, not the stated September 1 cut-off date, as the basis for stating in its offering documents that less than 1% of the aggregate principal balance of the pool was 30 days delinquent.

read the complete Cease & Desist here.

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