NEW YORK (Reuters) - The American Civil Liberties Union sued Morgan Stanley on Monday, accusing the investment bank of racial discrimination in packaging risky subprime mortgage loans into securities.
The lawsuit is the first to directly make allegations against an investment bank, rather than a lender, of violating federal civil rights laws, the group said at a news conference.
Morgan Stanley encouraged a unit of now-bankrupt New Century Financial Corp to disproportionately target black borrowers with overpriced loans that had a strong possibility of going sour, the lawsuit said. The investment bank received significant fees from packaging the loans into securities that were sold to institutional investors, while the borrowers faced high risks of default, the ACLU said.
If successful, the lawsuit could inhibit the lucrative process known as securitization that has long lubricated Wall Street profits but was sidelined until recently by the financial crisis.
Morgan Stanley rejected the allegations and corporate defense lawyers said they are skeptical the litigation can succeed.
The National Consumer Law Center, which helped prepare the suit, hopes to amass evidence against other Wall Street firms, said Stuart Rossman, the group's director of litigation. Morgan Stanley was chosen because evidence gleaned from earlier probes of New Century's practices implicated the investment bank, he said.
Thomas Deutsch, executive director of the American Securitization Forum, a trade group, declined to comment on the suit.
"It is literally the first case of Main Street holding Wall Street accountable" for the financial crisis that led millions of Americans to lose their homes and that devastated the U.S. economy, ACLU Executive Director Anthony Romero said at a news conference.
A Morgan Stanley spokeswoman, Mary Claire Delaney, said: "We believe these allegations are completely without merit and plan to defend ourselves vigorously."
The complaint was filed in U.S. District Court in Manhattan on behalf of five Detroit residents. It said Morgan Stanley went beyond the traditional securitization role of an investment bank by helping to fund loans made by New Century, setting loan volume goals and establishing terms of the loans.
The ACLU asked the court to certify the case as a class action. It said as many as 6,000 black homeowners in the Detroit area may have suffered similar discrimination as a result of being offered loans that many could not afford.
The alleged practice is a twist on claims that banks engaged in "red-lining," or refusing to provide loans and other services in low-income areas.
"It's reverse red-lining. It violates the Fair Housing Act," said Elizabeth Cabraser, a co-counsel for the plaintiffs. "These loans were mass-produced and they were built to order, not to serve homeowners."
Corporate defense lawyers said suing a third party under the Housing Act or the Equal Credit Opportunity Act is a legal stretch. Last year's U.S. Supreme Court decision absolving Wal-Mart of company-wide discrimination policies also makes it more difficult to prove intentional corporate bias.
"If New Century discriminated, then New Century belongs there," said John L. Ropiequet, cohead of the consumer finance practice at Armstein & Lehr in Chicago. "I could see a judge taking a hard look and saying, 'I don't think it's fair.'"
The ACLU said discriminatory practices connected to the securitization process were endemic in the last decade across the financial services industry.
Critics of securitization say the process of packaging loans into securities encourages recklessness in bank credit policies because banks do not hold the loans they originate.
Advocates say that by removing loans from the balance sheets of banks, securitization allows banks to make more loans and stimulate the economy.
Trillions of dollars of mortgage, credit card, automobile and other consumer loans have been securitized and sold to investors. Many of the home loans bought by the banks are insured by agencies such as the Federal Home Loan Mortgage Corp, or Freddie Mac, and the Federal National Mortgage Association, or Fannie Mae.
Some lawyers and economists who work with the securities industry described the lawsuit as "novel" because investment banks are several steps removed from loan origination. Morgan Stanley was chosen because it is among the few remaining "deep pockets" in the financial industry now that so many direct subprime lenders have been shut down, they said.
"If it gains traction and survives a motion to dismiss, 'Whew!,'" said Scott Badami, a corporate defense partner at Fox Rothschild in Blue Bell, Pa. "Certifying the class...will be huge."
Anticipating an argument that the statute of limitations has passed for actions leading up to the financial crisis, the lawsuit says Morgan Stanley's concealment of its role in the loan process and its deviation from "true underwriting standards" for loans it purchased invalidate any legal deadlines.
The ACLU lawsuit follows a spate of new litigation against Wall Street by U.S. federal and state authorities over banks' roles in triggering the financial crisis that began more than four years ago.
JPMorgan Chase & Co was sued last week by New York State Attorney General Eric Schneiderman for alleged subprime mortgage abuses at an investment bank that it purchased during the financial crisis. [ID:nL1E8L2L6Y] The U.S. attorney in Manhattan filed fraud charges against Wells Fargo & Co two weeks ago for a "reckless pattern" of making questionable home loans that allegedly cost the government hundreds of millions of dollars in insurance settlements.
Massachusetts earlier sued Morgan Stanley for securitizing home loans in violation of a state consumer protection law. The ACLU said that case did not address the issue nationwide or link the alleged abusive practices to discriminatory policy.
Plaintiffs in the lawsuit include five borrowers and Michigan Legal Services.
Rubbie McCoy, a municipal swimming teacher in Detroit and one of the plaintiffs, said at the news conference that New Century pressured her to take out a loan that is now higher than the value of the home she purchased.
"In the past 12 months I've been under an enormous amount of stress trying to shield the mortgage situation from my children," McCoy said, choking on tears. "I don't quite understand the situation myself."
The case is Beverly Adkins et al v Morgan Stanley, U.S. District Court for the Southern District of New York, No. 12-7667.
Reporting by Jed Horowitz, additional reporting by Emily Flitter and Tom Hals; Editing by David Gregorio, Matthew Lewis and Grant McCool