Morgan Stanley to Pay $2.6 Billion to Settle Mortgage Cases

The accord ends a U.S. Justice Department probe into allegations Morgan Stanley deceived investors by misrepresenting the quality of the home loans the firm packaged into bonds and follows multibillion-dollar pacts the government struck with other big banks.

The agreement also resolves one of the last, and biggest, "legacy" issues that have weighed on the firm, its chief executive, James Gorman , and shareholders since the 2008 crisis. For Morgan Stanley, the price to move on is steep-wiping out a chunk of earnings-though it will be paid retroactively.

In a Wednesday afternoon regulatory filing that disclosed the deal, Morgan Stanley said it increased its legal reserves by about $2.8 billion, accounting for the costs in its 2014 results.

The higher reserves will cut its income from continuing operations by $2.7 billion, or $1.35 a share, more than a third of its 2014 net income.

Last month, Morgan Stanley said it earned $6.2 billion, or $2.96 a share, from continuing operations in 2014.

Large U.S. banks have now paid about $130 billion in settlements, fines and other costs related to the worst economic downturn in decades.

On a January conference call with analysts, Mr. Gorman said his management team had worked hard during the past five years to "put the trouble from the financial crisis clearly in the rearview mirror."

The deal with the Justice Department won't end once and for all of Morgan Stanley's legal headaches.

The New York firm would still have to negotiate with the agency about other settlement terms, including what is included in a statement of facts that it must have to sign off on.

The accord doesn't cover other related probes by state litigators, helping to explain why the Wall Street firm had reserved $200 million above what it agreed to pay federal officials, said a person familiar with the matter.

While Morgan Stanley was expected to settle the government probe, the large size of the penalty was still surprising, Susquehanna Financial Group analyst Doug Sipkin wrote Wednesday in a note to clients.

"Although 2014 results are behind us, we do believe the reduction in earnings and book value clouds the capital story for 2015," Mr. Sipkin said.

The firm reached its agreement in principle with the Justice Department and U.S. Attorney's Office for the Northern District of California, according to the filing.

The $2.6 billion settlement comes in the form of a cash penalty, said people familiar with the matter.

Unlike some of the other bank settlements, Morgan Stanley's deal with the government doesn't include an agreement to provide aid to struggling homeowners, one person said.

Morgan Stanley lawyers held their last round of talks at the Justice Department in Washington last week, according to people familiar with the matter.

During the next few days, the firm's lawyer and Associate Attorney General Stuart Delery hashed out numbers over the phone before the two sides reached an agreement Wednesday.

The firm's executives had faced increasing pressure to strike a deal. In doing so, Morgan Stanley still can account for the additional legal costs in its 2014 results without restating its annual report.

Morgan Stanley has moved closer to hitting its target for reporting an annual return on equity of more than 10%. Starting 2015 in a $2.8 billion hole would make that target all the more difficult this year.

The Morgan Stanley pact was a fraction of the amount paid by other banks in mortgage-related settlements with the Justice Department: Bank of America Corp. paid $16.65 billion, J.P. Morgan Chase & Co. $13 billion and Citigroup Inc. $7 billion.

The Morgan Stanley number was smaller in part because it wasn't a major mortgage lender during the housing boom.

Morgan Stanley's archrival, Goldman Sachs Group Inc., is believed to be next in line with the government to potentially hammer out an agreement.

On Monday, Goldman disclosed in a filing of its own that the U.S. Attorney's Office for the Eastern District of California wrote to the firm in December that the government had "preliminarily concluded" that it had violated federal law in connection the sale of mortgage bonds.

The Morgan Stanley accord comes as the Justice Department prepares for the departure of Attorney General Eric Holder , who is slated to cede his post to Brooklyn U.S. Attorney Loretta Lynch once the Senate confirms her nomination.