The ACLU and others filed the lawsuit Monday on behalf of five homeowners who took out loans from New Century Mortgage Corp., a subprime lender that has since collapsed. Morgan Stanley said the allegations were "completely without merit."
The lawsuit claims Morgan Stanley pushed New Century to make the risky loans because Morgan made its profit at the start of the process and sold the loans before they could go bad.
The investment bank took the subprime loans from New Century and bundled them into mortgage bonds, which were then packaged into other securities and delivered to big investors all over the world.
Because Morgan Stanley bought more of New Century's loans than any other firm did, it "effectively dictated the types of loans that New Century issued," the suit said. It described the loans as destined to fail.
The plaintiffs argue that Morgan Stanley encouraged New Century to make "stated-income" loans, in which borrowers provided no verification of their income when they applied for mortgages. Those loans allowed mortgage brokers to inflate borrowers' income and make them appear more credit-worthy.
Black borrowers in the Detroit area "were more likely to receive these categorically harmful loans than white borrowers," the complaint said. In and around Detroit, a black borrower was 70 per cent more likely to wind up with a high-cost subprime loan from New Century than a white borrower with similar income and financing needs, it said. Roughly a third of the company's mortgages were made in neighbourhoods where blacks and other minorities account for at least 90 per cent of the people.
The lawsuit is the latest against a bank for lending practices during the real estate boom leading up to the 2008 financial crisis.
Last week, the federal government sued Wells Fargo, the country's largest mortgage lender, for hundreds of millions of dollars. The government said Wells falsely claimed that more than 100,000 loans made between 2001 and 2005 were eligible for federal mortgage insurance.
One of the Detroit plaintiffs named in the Morgan Stanley suit, Rubbie McCoy, said her mortgage broker falsified her loan application in 2006 and pressured her into buying the house she was renting. Her landlord had put her in contact with the broker.
She said the broker turned her part-time work into a full-time job on the application and tripled the amount of money she received in weekly child support to $100.
The broker also told her that she had to buy the house within 30 days or she and her six children would be evicted, she said.
To buy a house appraised at $89,000, New Century gave McCoy a $79,200 adjustable-rate mortgage with a starting interest rate of 12.1 per cent.
The initial loan payment amounted to more than half her monthly income and began rising within months. She made her last payment in May 2011, according to the complaint.
Morgan Stanley's own analysis showed that 45 per cent of the loans it bought from New Century had high debt-to-income ratios, the lawsuit said.
In a report on New Century's 2007 collapse, senior executives of the subprime lender told a bankruptcy examiner that New Century judged loans mainly on their appeal to other firms dealing in the mortgage-bond market, not on whether the borrowers could pay them back.
"With this lawsuit, real victims of the subprime lending scandal are stepping forward to hold investment banks like Morgan Stanley accountable for the devastation the banks wrought in their lives and in our economy," ACLU Executive Director Anthony D. Romero said in a statement.
In a statement, Morgan Stanley said: "We believe these allegations are completely without merit and plan to defend ourselves vigorously."
The suit, which seeks class-action status, argues that Morgan Stanley violated both the Fair Housing Act and the Equal Credit Opportunity Act. It was filed in federal court in New York.