Morgan Stanley could be to blame for Detroit’s blight: N.Y. judge

July 26, 2013

In 2012, five African-American Detroit homeowners and a Michigan legal services group asserted a notably creative legal theory in a class action against Morgan Stanley. Their lawyers at Lieff Cabraser Heimann & Bernstein and the American Civil Liberties Union acknowledged that Morgan Stanley didn’t write the supposedly predatory mortgages that victimized African-American borrowers in Detroit. Those housing-bubble mortgages were originated by New Century, a notorious subprime lender that went under in 2007. But the suit argued that New Century was writing loans to feed Morgan Stanley’s securitization machine. Because Morgan Stanley wanted to bundle certain types of subprime loans into its mortgage-backed securities, the theory went, its policies guided New Century’s predatory practices. So according to the homeowners’ suit, Morgan Stanley was actually responsible for the disparate impact of New Century’s discriminatory lending.

Morgan Stanley seemed downright incredulous at the audacity of the suit. Its lawyers at Wilmer Cutler Pickering Hale and Dorr moved to dismiss the class action, stacking up argument after argument about flaws in the homeowners’ legal theory. They’re pretty good arguments, too. The overarching theme of the bank’s defense is that New Century, not Morgan Stanley, is responsible for the loans it wrote. Morgan Stanley didn’t even buy the mortgages of four of the five homeowners who are name plaintiffs in the suit, the motion says, so how can its securitization policies be to blame?

The bank goes on to assert all sorts of technical deficiencies in the plaintiffs’ claims. The homeowners don’t have standing, the Morgan Stanley brief says, because they can’t show they would have qualified for loans on better terms absent discrimination. The plaintiffs waited too long to assert claims, it said, because the statute of limitations under the Fair Housing Act is two years (and under the Equal Credit Opportunity Act, three years), yet the most recent mortgage in the case dates back to 2006. Anti-housing discrimination laws, the bank said, apply to mortgage lenders but not securitizers. And even putting aside all of those arguments, the brief said, the plaintiffs cannot show that Morgan Stanley policies produced a disparate impact on African-Americans in Detroit. Morgan Stanley’s securitization policies were nationwide, not targeted to any racial group in any geographic area, the bank contends, so plaintiffs lawyers improperly cherry-picked Detroit. They also erred in analyzing all New Century lending in Detroit because not all of New Century’s subprime loans were purchased by Morgan Stanley, according to the brief. And finally, any disparate impact from New Century lending, the bank said, is the result of New Century practices that cannot be tied to a specific Morgan Stanley policy.

Before another judge, or at another moment in time, those arguments might have prevailed. But not before U.S. District Judge Harold Baer – who’s known for issuing certification orders that direct class action firms to include minority lawyers on their teams – and not as the plight of Detroit’s residents grows ever more dire. On Thursday, Judge Baer agreed to toss the Equal Credit Opportunity and Michigan state-law claims against Morgan Stanley on timeliness grounds. But he rejected all of the bank’s arguments for dismissing the homeowners’ Fair Housing Act claims, giving a stamp of judicial approval to the plaintiffs’ theory that “by creating the conditions under which New Century originated toxic loans, Morgan Stanley caused African-American borrowers to fall prey to those loans at a disproportionate rate, or put another way, to make this homeowner nightmare come true.”

In fact, Baer tied Morgan Stanley – which he described as “this alleged icon of the free enterprise system” – to Detroit’s economic downfall. Citing the complaint’s argument that New Century mortgages to African-Americans that were subsequently purchased by Morgan Stanley suffered unusually high foreclosure rates, Baer said that the city’s bankruptcy filing “only emphasizes the broader consequences of predatory lending and the foreclosures that inevitably result.” He also mentioned the report of Detroit’s emergency manager and a Rolling Stone article on the city’s spate of foreclosures, which he quite obviously took to heart. “As residents flee the city,” Baer wrote, “Detroit’s shrinking ratepayer base renders its financial outlook even bleaker. Given these conditions, it is not difficult to conclude that Detroit’s current predicament, at least in part, is an outgrowth of the predatory lending at issue here.”

Baer went on to explain that Detroit homeowners have standing regardless of whether they could have qualified for mortgages on better terms because the toxic loans they were issued “subject (them) to higher mortgage payments and fees over a longer period of time than they would have been had they not been targeted.” The complaint adequately alleged a link between those injuries and the requirements that Morgan Stanley placed on New Century as part of their “lucrative business relationship,” Baer said, so homeowners have a right to seek money relief from the bank. (The name plaintiffs are seeking damages for themselves and disgorgement on behalf of a larger class of African-American borrowers.) The judge also said that because homeowners didn’t know about the Morgan Stanley policies that allegedly led to New Century’s discriminatory lending practices, the statute of limitations on their Fair Housing claims didn’t begin until 2012.

As for Morgan Stanley’s argument that the plaintiffs’ disparate impact theory is fatally flawed, Baer said the bank will have a chance to show why later in the case. At this early juncture, the homeowners had shown enough evidence that “the terms and conditions governing Morgan Stanley’s loan purchases directly resulted in a disparate impact when they caused New Century to issue toxic loans to plaintiffs,” the judge wrote. “Plaintiffs’ allegations that Morgan Stanley ‘required’ New Century to issue discriminatory loans are more than sufficient to make plaintiffs’ claims plausible. Further, whether Morgan Stanley ultimately purchased all of the toxic loans that New Century issued is not relevant at the pleading stage. Instead, Plaintiffs allege a simpler theory: Morgan Stanley’s policies were the cause of all the toxic loans that New Century issued. Nothing more is needed to support plaintiffs’ claims at this stage.”

If I were Morgan Stanley, I’d be very worried about Judge Baer’s liberal use of the word “toxic.” This is one judge who seems willing to break new legal ground if that’s what it takes to hold banks accountable for the harm inflicted by the securitization crisis.

Wilmer partner Noah Levine declined to comment on the ruling.

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