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Test case on discriminatory mortgages

The National Law Journal
January 14, 2013

Onn October 15, 2012, a private law firm, the American Civil Liberties Union and the National Consumer Law Center filed a potentially path-breaking class action against Morgan Stanley. The named plaintiffs in Adkins v. Morgan Stanley, minority homeowners in the Detroit metropolitan area, allege that the defendant committed racial discrimination under the Fair Housing Act, the Equal Credit Opportunity Act and Michigan law by "enabl[ing]" the now-defunct New Century Mortgage Co. (N.C.) to originate excessively costly and risky residential mortgages targeted at African-American borrowers. Based on a disparate-impact theory, the Adkins complaint asserts that these toxic loans disproportionately harmed blacks, who were much likelier than whites to receive them. If N.C. had not gone bankrupt, the plaintiffs could have sued the obvious wrongdoer. But as it is, they must surmount the obstacle of forging a persuasive link between their injuries and the behavior of Morgan Stanley, an entity with which they had no dealings.

It is clear that during the housing bubble, N.C. served as one of the main purveyors of subprime (basically, high-cost) loans with a number of high-risk elements. As defined by the Adkins plaintiffs, such "combined-risk" mortgages included at least two of the following features: issuance based on the borrower's stated rather than verified income, a practice conducive to "liars' loans"; a debt-to-income ratio of more than 55 percent, which meant that after normal expenses all income would go to repay debt; a loan-to-value ratio of at least 90 percent; an adjustable interest rate, which shot up after the first few years; "interest only" provisions; negative amortization; a "balloon" payment, unaffordable unless the owner could refinance or sell his property; and prepayment penalties.

Foisted on naive clients — 55 percent of whom actually qualified for prime loans, according to a Wall Street Journal study — such loans ensured that hosts of "reverse redlining" victims would default and lose their homes. Indeed, even controlling for income differences, almost a quarter of blacks (more than twice the number of whites) who took out mortgages from 2004 to 2008 are either seriously delinquent or have been foreclosed on. The widespread dispossession created by predatory lending greatly widened the wealth gap between whites and blacks, which grew from 10-to-1 in 2005 to 20-to-1 in 2009. What was Morgan Stanley's role in this debacle? The plaintiffs say that the defendant furnished a voracious market for such loans, which it "bundled" and sold to unlucky investors as so-called asset-backed securities. Because securitization produced enormous profits for underwriters like Morgan Stanley, the desire to increase the sale of such products drove the defendant to forge an unholy alliance with lenders — especially, N.C. — which provided the needed "inventory." The poisonous aspect of this exotic form of debt was that it severed the relationship between mortgagee and mortgagor. Originators like N.C., which immediately sold the loans they made, had no incentive to adhere to sound banking standards. They got their money up-front from the buyer, as well as hefty fees from the borrower, and thus did not care if the latter defaulted. Securitizers like Morgan Stanley pooled and quickly resold the loans and, thus, too, held no stake in the creditworthiness of the borrower. All they wanted was to package and dump as many of these "assets" as they could. Ultimately, when the music stopped, the homeowner and third parties would be the ones to pay the piper.

The complaint asserts that Morgan Stanley was hardly a run-of-the-mill client. Between 2005 and 2007, it purchased between 34 and 48 percent of the debt that N.C. put out to Wall Street. Also, it set terms for these loans — requiring many of the high-risk factors. Finally, it furnished billions of dollars to N.C. to sustain the mass production of mortgages. These actions, in effect, made Morgan Stanley an aider and abettor of N.C.'s conduct.

Although the relevant statutes cover securitization, previous civil rights cases have cited lenders like Wells Fargo & Co. and Bank of America Corp.'s Countrywide division, not middlemen like the defendant. Public and private suits aimed at underwriters have charged securities violations as opposed to discrimination — again, focusing on institutions with which the aggrieved individuals had contact. Morgan Stanley, moving to dismiss, claims that it cannot be held liable for predatory conduct by N.C. against unknown parties. With respect to the future, the Dodd-Frank Act addresses some of the worst abuses of the bubble era. But as to the past, the fate of Adkins may determine whether at least black borrowers can obtain a measure of redress.