Morgan Stanley Wins Dismissal of Libertas CDO Suit by Virgin Islands Pension

(October 3, 2011) — Morgan Stanley has won the dismissal of a Virgin Islands pension fund’s lawsuit over a collateralized debt obligation (CDO). 

US District Judge Barbara Jones in Manhattan dismissed the investor complaint.

In 2009, the Employees’ Retirement System of the Government of the Virgin Islands claimed that the bank defrauded investors by collaborating with ratings companies to give the CDO an undeserved AAA rating while it was simultaneously short-selling nearly all of the assets underlying the notes. Bloomberg reported. The complaint alleged that the bank was therefore motivated to defraud investors with positive ratings, aware the CDO assets were suffering from an increase in delinquencies and were riskier than the ratings indicated.

Additionally, the lawsuit claimed that the CDOs were backed by securities issued by subprime lenders, including bankrupt New Century Financial Corp. and Option One Mortgage Corp.

The lawsuit by the pension against Morgan Stanley is one of many examples of accusations against financial institutions following the 2008 economic crisis. Last year, the US Securities and Exchange Commission (SEC) accused Goldman Sachs of fraud in failing to disclose conflicts in mortgage securities, which they alleged cost investors more than $1 billion and fueled the worst financial crisis since the Great Depression.

The SEC’s complaint, filed in the US District Court for the Southern District of New York, stated that Goldman failed to disclose that one of its clients — Paulson & Co. — helped create and then bet against subprime mortgage securities that the New York-based firm sold to investors. The suit claimed that Paulson & Co., one of the world’s largest hedge funds run by the billionaire John Paulson, paid Goldman about $15 million for structuring the deals in 2007.

In July 2010, Goldman agreed to pay $550 million to settle charges by the SEC over the Abacus 2007-AC1 CDO.

More recently, the SEC announced in June that JP Morgan will pay $153 million to settle charges of allegedly selling $1.1 billion in mortgage-backed securities that were designed to fail. The US regulator asserted that as the housing market crumbled in March and April 2007, JP Morgan executives urged the marketing of Squared CDO 2007-1, a synthetic CDO linked to a collection of residential mortgages, without informing investors that a hedge fund — Magnetar Capital — helped select the assets in the CDO portfolio and had a short position in more than half of those assets. Consequently, the hedge fund was positioned to benefit if the CDO assets it was selecting for the portfolio defaulted.

“J.P Morgan marketed highly-complex CDO investments to investors with promises that the mortgage assets underlying the CDO would be selected by an independent manager looking out for investor interests,” Robert Khuzami, the SEC’s director of the division of enforcement, said in a statement. “What JP Morgan failed to tell investors was that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection. With today’s settlement, harmed investors receive a full return of the losses they suffered.”

The SEC release stated: “The SEC alleges that by the time the deal closed in May 2007, Magnetar held a $600 million short position that dwarfed its $8.9 million long position. In an internal e-mail, a J.P. Morgan employee noted, ‘We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart.'”