Connecting the Dots: First Lawsuit Linking Investment Banks to Racial Discrimination in the Subprime Mortgage Crisis

House for saleOn October 15, a landmark lawsuit was filed in the United States District Court for the Southern District of New York against Morgan Stanley for facilitating the production of risky loans that targeted African-American borrowers. The suit, which was filed by the American Civil Liberties Union (ACLU), the ACLU of Michigan, the National Consumer Law Center, and San Francisco-based law firm Lieff Cabraser Heimann & Bernstein on behalf of five Detroit residents and the nonprofit legal aid organization Michigan Legal Services, is unique for two reasons. First, according to the ACLU, the suit is the first to connect racial discrimination to the bundling of mortgage-backed securities. Second, unlike previous lawsuits where the named defendants were subprime lenders that originated the loans, this is the first lawsuit where victims of the subprime lending crisis have sought to hold an investment firm accountable for its role in providing a subprime lender strong incentives to originate risky mortgages.

Specifically, the three-count suit alleges that Morgan Stanley violated the federal Fair Housing Act (prohibiting discrimination in housing transactions and unfair lending practices), the Equal Credit Opportunity Act (banning discrimination for credit transactions such as mortgages loans), and the Michigan Elliott-Larsen Civil Rights Act (prohibiting discrimination in making or purchasing of loans secured by residential real estate). Plaintiffs contend that Morgan Stanley was the principal financer for the now bankrupt New Century Mortgage Company, providing the funding that enabled New Century to make mortgage loans to borrowers located in Detroit’s African American communities. Morgan Stanley then “dictated” the types of loans that New Century issued by requiring that a substantial percentage of New Century’s loans bear a combination of high-risk terms (e.g., adjustable interest rates that increase significantly after an initial year of low interest rates and prepayment penalties), effectively placing borrowers at an elevated risk of default and foreclosure. Plaintiffs further allege that Morgan Stanley encouraged New Century to abandon standard fair lending practices that focus on whether borrowers can meet their obligations under the terms of the mortgages and, instead, focused solely whether the loans New Century originated could be processed and sold as securities. The complaint also states that an African American borrower was 70% more likely to obtain a high-cost loan from New Century than a white borrower. 

Although the case concerns lending abuses in Detroit, these practices were common among financial institutions and had a disproportionally adverse affect on Latino and African American borrowers across the country. In this past year alone, the Department of Justice has successfully negotiated residential fair lending settlements against Countrywide Financial (now a subsidiary of Bank of America) and Wells Fargo for African American and Hispanic minority borrowers who were steered into subprime mortgages or who paid higher fees and rates than white borrowers because of their race or national origin.

Morgan Stanley has issued a statement that it will defend itself "vigorously" against the lawsuit. If successful, however, this suit could introduce a new avenue of justice aimed at holding investment institutions accountable for their role in helping to craft the lending policies that resulted in the subprime mortgage crisis.

This blog post was coauthored by Stephanie Patterson.

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