New brief: Morgan Stanley, rating agencies conspired on 2007 SIV
A few months ago, plaintiffs’ lawyers at Robbins Geller Rudman & Dowd created quite a stir when they filed thousands of pages of deposition transcripts and other juicy discovery in an investors’ fraud case against Morgan Stanley, Standard & Poor’s and Moody’s. The documents — exhibits to the investors’ summary judgment motion — included never-before-seen internal communications between Morgan Stanley and the rating agencies as they worked on a structured investment vehicle known as Cheyne, putting on public display the allegedly half-cocked evaluations that Moody’s and S&P performed in 2005, when they were swamped with subprime mortgage-backed financial instruments to rate.
On Wednesday, the Robbins Geller team, led by Daniel Drosman and Luke Brooks, filed a new brief in a parallel case accusing Morgan Stanley, S&P, Moody’s and Fitch of defrauding two pension funds that invested in an SIV called Rhinebridge, which, in contrast to the Cheyne SIV, was sold in July 2007, as the housing bubble was already collapsing. It’s another must-read for students of the financial crisis.
The Rhinebridge brief, which also references all kinds of evidence from inside the bank and the rating agencies, doesn’t have as many notable quotables as the Cheyne filing. But its allegations are, in a way, even grimmer. According to the brief, which opposes motions for summary judgment by Morgan Stanley and the rating agencies, the defendants all knew the end was near for mortgage-backed securities. Yet (again, according to the brief) Morgan Stanley pushed the agencies to deliver high ratings on the Rhinebridge SIV, even as S&P and Moody’s supposedly questioned the percentage of shaky mortgage loans packed into it. Then, despite internal fears that Rhinebridge was too risky to survive, Morgan Stanley allegedly marketed the SIV to Robbins Geller’s clients, mentioning nothing about its concerns the investment would collapse. Just four months after Rhinebridge launched, and two months after the pension funds bought in, the SIV defaulted, en route to being auctioned off at steep losses for investors.
I should note here that Morgan Stanley and the credit rating agencies have also moved for summary judgment, arguing that the plaintiffs, which are sophisticated investors, haven’t produced evidence that the defendants engaged in fraud or that the funds justifiably relied on the defendants’ representations about Rhinebridge. (Here’s the Morgan Stanley summary judgment brief, filed by its lawyers at Davis Polk & Wardwell; here’s the joint brief on behalf of Moody’s and S&P, which are represented by Satterlee Stephens Burke & Burke and Cahill Gordon & Reindel; and here’s Fitch’s summary judgment brief, filed by Paul, Weiss, Rifkind, Wharton & Garrison.) Representatives for all of the defendants told me the allegations in the investors’ summary judgment brief are meritless, that they behaved properly and that they will eventually prevail in the litigation; S&P spokesman Edward Sweeney said, in particular, that the defense will respond specifically to the plaintiffs’ assertions in a forthcoming brief.
Nevertheless, it’s news when evidence about the credit rating agencies’ role in the financial crisis comes to light. And according to this brief, the agencies were much more concerned about maintaining their lucrative business in rating structured finance products than about the quality of their ratings. In part, that meant conceding to the demands of a client like Morgan Stanley, according to the brief. The Rhinebridge SIV had significantly higher exposure to subprime mortgages than was typical, so, according to the brief, Morgan Stanley had to push S&P and Moody’s to confer top ratings. The filing cites, for instance, a document from Morgan Stanley banker Gregg Drennan to SIV manager IKB Deutsche Industriebank, calling on IKB to “lobby” S&P because the agency “suggested that [it] might not rate the deal!!!”
The bank also allegedly pressed Moody’s and S&P to use an obsolete rating model because it knew that Rhinebridge would otherwise rate poorly. (S&P allegedly admitted that its imminent downgrade of hundreds of mortgage-backed securities didn’t affect its modeling on the Rhinebridge SIV.) And Fitch, according to the brief, had been so wary of the Cheyne SIV that was the model for Rhinebridge that it refused to rate Cheyne in 2005. But by 2006 it was so eager to gain a piece of the market in SIV ratings that it offered to rate Rhinebridge at a discount.
The credit rating agencies ultimately gave the SIV the ratings it needed to attract investors. But meanwhile, according to the Rhinebridge investors, Morgan Stanley and the rating agencies were bracing for the subprime market to collapse. The brief cites, for instance, a 2007 report from the S&P board that predicted disastrous consequences for the agency from a mortgage meltdown. At Moody’s, the team rating Rhinebridge allegedly discussed the “recent high default trend of the US subprime mortgages” and met with IKB in March 2007 “to discuss the sub-prime housing market from the perspective of the rating agencies.”
Morgan Stanley allegedly knew the impact the imploding housing market would have on Rhinebridge. According to the brief, Morgan banker Drennan predicted a low rating from Moody’s and said the SIV deserved it because of its subprime exposure. The brief quoted the SIV’s manager, IKB, telling a Morgan banker in March 2007 that “the whole [Rhinebridge] project is getting the smell of a disaster.” By May 2007, when the SIV was on the verge of launching and underlying assets were rapidly deteriorating, IKB allegedly told a Morgan Stanley trader to “work his magic” when providing prices on 99 of the 101 riskiest home-equity assets transferred into the Rhinebridge SIV. “Morgan Stanley had such grave concerns about the Rhinebridge SIV that — just days before it launched — [the bank] stripped all information identifying [it] as the arranger from the … private placement,” the brief asserted.
Overall, the Rhinebridge investors’ brief, and the internal documents it relies on, serve to reinforce everyone’s most cynical assumptions about the financial crisis. Morgan Stanley and the rating agencies now have an opportunity to explain why the investors are misreading the evidence. I can’t wait to see what they have to say.
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