Morgan Stanley executives told a partner in its Rhinebridge structured investment vehicle that mortgages underlying the SIV may cause it to fail, according to e-mails cited by investors who were sold $100 million of the fund’s notes just days after the warning.

Officials from Morgan Stanley met with IKB Deutsche Industriebank AG executives in July 2007 and warned them about the stability of Rhinebridge, which they set up together, according to e-mails unsealed as part of a lawsuit by two institutional investors filed in Manhattan federal court.

“We’ve been in there with IKB this morning to raise the alarm,” Robert Rooney, a Morgan Stanley executive who worked on the deal, told his colleague Stefano Corsi in a July 19, 2007, message. “They acknowledged that this is a serious issue.”

Rhinebridge was set up to borrow from the short-term commercial paper market to fund purchases of asset-backed securities. The notes first went on sale in June 2007. The vehicle defaulted in October of that year as investors abandoned all but the safest debt.

Steve D’Agostino, a Morgan Stanley senior managing director according to the court filing, had been “expressing very strong view” that Rhinebridge’s portfolio of securities, backed by subprime mortgages, could cause it to “hit triggers and unwind quickly,” Rooney wrote in the July 19 e-mail. It isn’t clear from the documents whether D’Agostino was at the meeting with IKB. The plaintiffs’ filing identified D’Agostino as a Morgan Stanley executive involved in the deal.

“There is risk,” the e-mail states. “Perhaps not as ‘totally going to happen’ as Steve is suggesting, but a possibility.”

Washington Suit

King County, Washington, and the Iowa Student Loan Liquidity Corp., which bought $100 million in Rhinebridge notes, sued IKB and Morgan Stanley in October 2009. They want to use the e-mail and other documents to show that New York-based Morgan Stanley built the investment vehicle on flawed mortgage- backed securities and misled them about the quality of the notes they purchased.

Morgan Stanley has rejected those claims. Mary Claire Delaney, a spokeswoman for the bank, said in an e-mailed statement that the bank will fight the litigation.

Subprime Collateral

The investors should have known that the vehicle’s collateral included subprime mortgages because that was disclosed in the offering documents, Morgan Stanley said in an Oct. 10 court filing.

The bank said in court papers that it put $10 million of its $11.8 million in fees into the riskiest part of the Rhinebridge deal. Morgan Stanley cited that investment as evidence it believed in the deal.

The investors alleged in court papers that rating companies Standard & Poor’s, Moody’s Investors Service Inc. and Fitch Group Inc. collaborated in structuring the vehicle and gave it improperly high marks. The rating companies denied the allegations in court filings.

IKB was the investment vehicle’s manager, the investors said. The Dusseldorf, Germany-based bank settled its liability in the case in May on terms that weren’t disclosed publicly.

The plaintiffs have urged U.S. District Judge Shira Scheindlin to reject a request by the remaining defendants to decide the case in their favor without a trial. The judge has yet to rule on the request.

‘Highly Secure’

Morgan Stanley and IKB offered Rhinebridge for sale as a “safe, highly secure investment,” the investors contend. Instead, Rhinebridge defaulted and the entity’s notes were downgraded to junk by October 2007, making it “perhaps the shortest-lived Triple-A fund in the history of corporate finance,” the plaintiffs said.

The investors also point to an Oct. 12, 2007, e-mail from a Morgan Stanley executive who said the bank’s money-market funds were barred from investing in the notes.

In the message, David Ginsburg, a vice president in the fixed-income department, alerted colleague Diane Maurice to a news report about a drop in value in Rhinebridge’s investments.

Maurice asked “how much do we have” in Rhinebridge notes.

Ginsburg replied: “None -- we never approved Rhinebridge for purchase.”

Delaney, the spokeswoman for Morgan Stanley, declined to say whether D’Agostino, Corsi, Rooney or Ginsburg still worked for the bank.

Cheyne Copy

Rhinebridge was set up as a “copycat” of another Morgan Stanley vehicle, Cheyne, King County and Iowa Student Loan said in their Oct. 10 court filings. Investors in Cheyne, including Abu Dhabi Commercial Bank, sued Morgan Stanley, Moody’s and Standard & Poor’s.

Scheindlin, who is overseeing both lawsuits, rejected a move to dismiss the case, ruling in May that the ratings companies must face claims they misled investors about the quality of the Cheyne and Rhinebridge notes.

S&P, the world’s largest provider of credit ratings, is owned by New York-based McGraw-Hill Cos. Moody’s, the No. 2 ratings provider, also is based in New York. The defendants in the Cheyne lawsuit rejected the allegations in that case.

The cases are King County, Washington v. IKB Deutsche Industriebank AG, 09-CV-8387; Abu Dhabi Commercial Bank v. Morgan Stanley & Co., 08-CV-7508, U.S. District Court, Southern District of New York (Manhattan).