SUPREME COURT OF THE STATE OF NEW YORK
COUNTY OF NEW YORK
X

PHOENIX LIGHT SF LIMITED, BLUE
HERON FUNDING V LTD., BLUE HERON
FUNDING VI LTD., BLUE HERON
FUNDING VII LTD., SILVER ELMS CDO
PLC, SILVER ELMS CDO II LIMITED and
KLEROS PREFERRED FUNDING V PLC,
Plaintiffs,

vs.

MORGAN STANLEY, MORGAN STANLEY
& CO. LLC, MORGAN STANLEY
MORTGAGE CAPITAL HOLDINGS LLC,
MORGAN STANLEY ABS CAPITAL I,
INC., MORGAN STANLEY CAPITAL I
INC., SAXON CAPITAL, INC., SAXON
FUNDING MANAGEMENT LLC and
SAXON ASSET SECURITIES COMPANY,
Defendants.

EXCERPTS:

440. Contrary to their affirmative representations in the Offering Documents, defendants
knew that the loan originators had, in fact, implemented loan underwriting policies and practices that
were simply designed to extend mortgages to as many borrowers as possible, regardless of whether
those borrowers could actually repay them. These policies and practices included, among other
things:

•  Falsifying borrowers’ incomes and/or coaching borrowers to misstate their income
  on loan applications to qualify them for loans they could not afford to repay, while
  making it appear the loans complied with the stated underwriting guidelines;
•  Coaching borrowers to omit or understate debts and expenses on loan applications to
  qualify them for loans they could not afford to repay, while making it appear the
  loans complied with the stated underwriting guidelines;
•  Steering borrowers to loans that exceeded their borrowing capacity;
•  Approving borrowers based on “teaser rates” for loans, despite knowing that the
  borrowers would not be able to afford the fully indexed rate when the loan rates
  adjusted; and
•  Approving non-qualifying borrowers for loans under “exceptions” to the originators’
  underwriting standards based on purported “compensating factors,” when no such
  compensating factors ever existed.

441. Further, the loan originators and their agents had become so aggressive at improperly
approving and funding mortgage loans that many of the loans at issue herein were made to
borrowers who had either not submitted required documents or had falsely altered the required
documentation. In many instances, required income/employment verifications were improperly
performed because the lenders’ clerical staff either did not have adequate verification skills or did
not care to exercise such skills, and oftentimes verifications were provided by inappropriate contacts
at a borrower’s place of employment (e.g., a friend of the borrower would complete the verification
instead of the human resources department at the borrower’s employer). In this way, many suspect
and false income verifications and loan applications were accepted by the originators at issue herein.

442. In addition, borrowers who submitted “stated income” loan applications were
routinely approved on the basis of stated income levels that were inflated to extreme levels relative
to their stated job titles, in order to give the appearance of compliance with stated underwriting
guidelines. In many cases, the loan originators herein actually coached the borrowers to falsely
inflate their stated incomes in order to qualify under the originators’ underwriting guidelines.
Inflation of stated income was so rampant that a study cited by Mortgage Asset Research Institute
later found that almost all stated income loans exaggerated the borrower’s actual income by 5% or
more, and more than half overstated income by at least 50%.

…

445. The constant pressure appraisers routinely faced from originators such as those at
issue herein was described by Jim Amorin, President of the Appraisal Institute, who stated in his
April 23, 2009 FCIC testimony that “[i]n many cases, appraisers are ordered or severely pressured
to doctor their reports and to convey a particular, higher value for a property, or else never see
work from those parties again. . . . [T]oo often state licensed and certified appraisers are forced
into making a ‘Hobson’s Choice.’” This complete lack of independence by appraisers was also
noted by Alan Hummel, Chair of the Appraisal Institute, in his testimony before the U.S. Senate,
where Hummel noted that the dynamic between lenders and appraisers created a “terrible conflict of
interest” by which appraisers “experience[d] systemic problems with coercion” and were “ordered
to doctor their reports” or else they would never “see work from those parties again” and were
placed on “‘exclusionary appraiser lists.’” Testimony on “Legislative Proposals on Reforming
Mortgage Practices” presented by Alan E. Hummel before the House Committee on Financial
Services, at 5 (Oct. 24, 2007).

446. As a result of such pressures, appraisers routinely provided the originators at issue
herein with falsely inflated appraisals that had no reasonable basis in fact, in direct contravention of
the Offering Documents’ false and misleading representations that the certificates’ underlying loans
had been originated pursuant to underwriting guidelines that required the lenders to evaluate the
adequacy of the mortgaged properties to serve as collateral for the loans. Moreover, the falsely
inflated property values also resulted in artificially understated LTV ratios, which caused the loans
and certificates to appear to plaintiffs to be of much higher credit quality and to be much less risky
than they actually were.

447. Following below are detailed allegations demonstrating that the loan originators for
the offerings at issue herein did not comply with the loan underwriting guidelines stated in the
Offering Documents, thereby rendering the Offering Documents false and misleading. While the
allegations concerning these originators cover most of the offerings, plaintiffs have not provided
such allegations for every originator at issue herein, in an attempt to streamline the allegations.
Nonetheless, on information and belief, plaintiffs allege that all of the loan originators at issue herein
engaged in similar conduct, and that such allegations are factually supported by both the
investigations of the FCIC and the U.S. Senate, each of which concluded, after extensive
investigations, that the breakdown in residential loan underwriting standards alleged herein was
systemic in the lending industry during the relevant time period (2004-2007). See The Financial
Crisis Inquiry Report (“FCIC Report”) at 125 (“Lending standards collapsed, and there was a
significant failure of accountability and responsibility throughout each level of the lending
system.”); Levin-Coburn Report at 12 (One of four major causes of worldwide financial collapse was
that “[l]enders introduced new levels of risk into the U.S. financial system by selling . . . home
loans with . . . poor underwriting.”); id. at 50 (“The Subcommittee investigation indicates that”
there were “a host of financial institutions that knowingly originated, sold, and securitized billions
of dollars in high risk, poor quality home loans.”).

…

451. The systemic abandonment of stated underwriting guidelines by all of the originators
identified herein during the period 2004-2007, which included the originators’ complete failure to
evaluate borrowers’ repayment ability, is further corroborated by the following allegations, which
demonstrate that the abandonment of loan underwriting guidelines was rampant, pervasive and
commonplace in the residential lending industry during 2004-2007.

2. The Offering Documents Misrepresented the New Century
Originators’ Underwriting Guidelines

452. New Century Mortgage Corporation, Home 123 Corporation, and NC Capital
Corporation are three affiliated companies that originated loans for the offerings at issue herein. All
three companies were subsidiaries of New Century Financial Corporation. New Century Mortgage
Corporation and Home123 Corporation originated and/or acquired loans directly and sold them to
the sponsors for the offerings at issue herein. For the offerings at issue herein identifying NC
Capital Corporation as an originator, NC Capital Corporation acquired the loans from New Century
Mortgage Corporation and then transferred the loans to the sponsors for such offerings. Because
New Century Mortgage Corporation, Home 123 Corporation, and NC Capital Corporation all
operated under the dominion and control of New Century Financial Corporation, and because the
loans they contributed to the trusts at issue herein were all products of the same dubious loan
origination practices, these three originators are collectively referred to herein as “New Century.”

453. As detailed supra, defendants’ Offering Documents purported to describe the
underwriting guidelines that were supposedly used by New Century in originating loans underlying
plaintiffs’ certificates. See §V. For the reasons set forth immediately below, these representations
were false and misleading at the time defendants made them. In truth, New Century had completely
abandoned its stated underwriting guidelines and was routinely originating loans without any regard
for the borrowers’ true repayment ability or the actual adequacy of the mortgaged properties to serve
as collateral.

454. The U.S. Senate investigation found that New Century “w[as] known for issuing poor
quality subprime loans,” but “[d]espite [its] reputation[] for poor quality loans, leading investment
banks [such as the Morgan Stanley Defendants] continued to do business with [New Century] and
helped [it and other lenders] sell or securitize hundreds of billions of dollars in home mortgages.”
Levin-Coburn Report at 21.

455. In 2007, New Century went into bankruptcy. An examiner was appointed by the
bankruptcy court to investigate New Century and its collapse. After reviewing “a large volume of
documents” from numerous sources, including New Century, and interviewing over 100 fact
witnesses, the bankruptcy examiner filed a detailed report concerning New Century. See Final
Report of Michael J. Missal, In re: New Century TRS Holdings, Inc., No. 07-10416 (D. Del. Feb. 29,
2008) (“Examiner’s Report”) at 14, 16. The examiner confirmed that New Century routinely failed
to follow its stated underwriting guidelines when originating loans during the relevant time period.
The examiner, after his comprehensive fact-gathering process, “conclude[d] that New Century
engaged in a number of significant improper and imprudent practices related to its loan
originations.” Id. at 2. Among other things, the examiner found that:

•  “New Century had a brazen obsession with increasing loan originations, without
  due regard to the risks associated with that business strategy . . . and trained
  mortgage brokers to originate New Century loans in the aptly named ‘CloseMore
  University.’” Id. at 3.
•  “The increasingly risky nature of New Century’s loan originations created a
  ticking time bomb that detonated in 2007.” Id.
•  “New Century . . . layered the risks of loan products upon the risks of loose
  underwriting standards in its loan originations to high risk borrowers.” Id.
•  A New Century employee had informed the company’s senior management in 2005
  that, under New Century’s underwriting guidelines, “‘we are unable to actually
  determine the borrowers’ ability to afford a loan.’” Id.
•  “New Century also made frequent [unmerited] exceptions to its underwriting
  guidelines for borrowers who might not otherwise qualify for a particular loan,” so
  much so that a senior officer of New Century warned internally that the “‘number
  one issue is exceptions to guidelines.’” Id. at 3-4.
•  New Century’s Chief Credit Officer had noted as early as 2004 that New Century
  had “‘no standard for loan quality.’” Id. at 4 “‘[L]oan quality’” referred to “New
  Century’s loan origination processes, which were supposed to ensure that New
  Century loans met its own internal underwriting guidelines . . . .” Id. at 109.
•  “Instead of focusing on whether borrowers could meet their obligations under the
  terms of the mortgages, a number of members of [New Century’s] Board of
  Directors and Senior Management told the Examiner that their predominant
  standard for loan quality was whether the loans New Century originated could be
  sold or securitized . . . .” Id. at 4.
•  A large number of New Century’s loans did not meet its underwriting guidelines,
  suffering from defects such as “defective appraisals, incorrect credit reports and
  missing documentation.” Id. at 109.
•  From 2003 forward, New Century’s Quality Assurance and Internal Audit
  departments identified “significant flaws in New Century’s loan origination
  processes.” Id. at 110.
•  Notwithstanding all the foregoing facts, New Century’s Board of Directors and
  Senior Management did little to nothing to remedy the company’s abandonment of
  its stated underwriting guidelines. Id.

…

535. These massive downgrades – in many cases, from “safest of the safe” “AAA” ratings
to “junk” (anything below Baa3 or BBB-) – show that, due to defendants’ knowing use of bogus
loan data, the initial ratings for the certificates, as stated in the Offering Documents, were false.
Indeed, the fact that all of the certificates are now rated at “junk” status or below, and more than
64% of the certificates are now in default, is compelling evidence that the initial high ratings touted
by defendants in the Offering Documents were grossly overstated and false.

E. Defendants Materially Misrepresented that Title to the Underlying
Loans Was Properly and Timely Transferred

536. An essential aspect of the mortgage securitization process is that the issuing trust for
each RMBS offering must obtain good title to the mortgage loans comprising the pool for that
offering. This is necessary in order for plaintiffs and the other certificate holders to be legally
entitled to enforce the mortgage and foreclose in case of default. Accordingly, at least two
documents relating to each mortgage loan must be validly transferred to the trust as part of the
securitization process – a promissory note and a security instrument (either a mortgage or a deed of
trust).

537. The rules for these transfers are governed by the law of the state where the property is
located, by the terms of the pooling and servicing agreement (“PSA”) for each securitization, and by
the law governing the issuing trust (with respect to matters of trust law). Generally, state laws and
the PSAs require that the trustee have physical possession of the original, manually signed note in
order for the loan to be enforceable by the trustee against the borrower in case of default.

538. In addition, in order to preserve the bankruptcy-remote status of the issuing trusts in
RMBS transactions, the notes and security instruments are generally not transferred directly from the
mortgage loan originators to the trusts. Rather, the notes and security instruments are generally
initially transferred from the originators to the sponsors of the RMBS offerings. After this initial
transfer to the sponsor, the sponsor in turn transfers the notes and security instruments to the
depositor. The depositor then transfers the notes and security instruments to the issuing trust for the
particular securitization. This is done to protect investors from claims that might be asserted against
a bankrupt originator. Each of these transfers must be valid under applicable state law in order for
the trust to have good title to the mortgage loans.

539. Moreover, the PSAs generally require the transfer of the mortgage loans to the trusts
to be completed within a strict time limit – three months – after formation of the trusts in order to
ensure that the trusts qualify as tax-free real estate mortgage investment conduits (“REMICs”). In
order for the trust to maintain its tax free status, the loans must have been transferred to the trust no
later than three months after the “startup day,” i.e., the day interests in the trust are issued. See
Internal Revenue Code §860D(a)(4). That is, the loans must generally have been transferred to the
trusts within at least three months of the “closing” dates of the offerings. In this action, all of closing
dates occurred in 2005, 2006 or 2007, as the offerings were sold to the public. If loans are
transferred into the trust after the three-month period has elapsed, investors are injured, as the trusts
lose their tax-free REMIC status and investors like plaintiffs may face several adverse draconian tax
consequences, including: (1) the trust’s income becoming subject to corporate “double taxation”; (2)
the income from the late-transferred mortgages being subject to a 100% tax; and (3) if latetransferred
mortgages are received through contribution, the value of the mortgages being subject to
a 100% tax. See Internal Revenue Code §§860D, 860F(a), 860G(d).

540. In addition, applicable state trust law generally requires strict compliance with the
trust documents, including the PSAs, so that failure to strictly comply with the timeliness,
endorsement, physical delivery, and other requirements of the PSAs with respect to the transfers of
the notes and security instruments means the transfers would be void and the trust would not have
good title to the mortgage loans.

541. To this end, all of the Offering Documents relied upon by plaintiffs stated that the
loans would be timely transferred to the trusts. For example, in the MSAC 2006-HE2 Offering
Documents, the Morgan Stanley Defendants represented that “[p]ursuant to the pooling and
servicing agreement, the depositor will sell, without recourse, to the trust, all right, title and interest
in and to each mortgage loan, including all principal outstanding as of, and interest due on or after,
the close of business on the cut-off date.” See MSAC 2006-HE2 Pros. Supp. at S-55. The Offering
Documents for each of the offerings at issue herein contained either the same or very similar
language, uniformly representing that defendants would ensure that the proper transfer of title to the
mortgage loans to the trusts occurred in a timely fashion.

542. However, defendants’ statements were materially false and misleading when made.
Contrary to defendants’ representations that they would legally and properly transfer the promissory
notes and security instruments to the trusts, defendants in fact systematically failed to do so. This
failure was driven by defendants’ desire to complete securitizations as fast as possible and maximize
the fees they would earn on the deals they closed. Because ensuring the proper transfer of the
promissory notes and mortgages hindered and slowed defendants’ securitizations, defendants
deliberately chose to disregard their promises to do so to plaintiffs.

543. Defendants’ failure to ensure proper transfer of the notes and the mortgages to the
trusts at closing has already resulted in damages to investors in securitizations underwritten by
defendants. Trusts are unable to foreclose on loans because they cannot prove they own the
mortgages, due to the fact that defendants never properly transferred title to the mortgages at the
closing of the offerings. Moreover, investors are only now becoming aware that, while they thought
they were purchasing “mortgaged-backed” securities, in fact they were purchasing non-mortgagedbacked
securities.

…