Morgan Stanley has been sued by a Virgin Islands pension fund that accused the Wall Street bank of defrauding investors by marketing $1.2 billion of risky mortgage-related notes that it expected to fail.

The lawsuit filed December 24 in Manhattan federal court said Morgan Stanley collaborated with credit rating agencies Moody's Investors Service and Standard & Poor's to obtain triple-A ratings for notes marketed in 2007 as part of a collateralized debt obligation (CDO) known as Libertas.

According to the complaint, the CDO was backed by low-quality assets, including securities issued by subprime lenders New Century Financial Corp, which quickly went bankrupt, and Option One Mortgage Corp, then owned by H&R Block Inc .

The complaint alleged Morgan Stanley knew the CDO's assets were far riskier than the ratings suggested, but was highly motivated to defraud investors with pristine ratings because it was simultaneously shorting almost all the assets. This was a bet that their value would fall, which they did in 2008.

Morgan Stanley was betting the entire investment it was promoting would fail, according to the complaint, which was made available on Tuesday. The firm achieved its objective.

Alyson Barnes, a Morgan Stanley spokeswoman, declined to comment. S&P spokesman Frank Briamonte had no immediate comment. Moody's did not immediately return a call seeking comment. Moody's, a unit of Moody's Corp , and S&P, a unit of McGraw-Hill Cos , were not named as defendants.

Many banks face lawsuits from investors who say they were misled into investing in securities they believed were safe but which were in fact tied to risky subprime mortgages.

Morgan Stanley is also a defendant in a closely watched case in the same Manhattan court that concerns whether rating agencies deserve free speech protection for their opinions.

The December 24 complaint said Morgan Stanley knew securities in the Libertas CDO were suffering a dramatic rise in delinquencies, but provided a misleading risk factor in a prospectus that rising delinquencies may hurt values in the $1 trillion residential mortgage-backed securities market.

It called this representation analogous to Captain Smith's telling passengers of the Titanic that some ships have 'recently sunk' in the Atlantic and therefore 'our ship may sink,' without mentioning the facts that his ship struck an iceberg, had a hole in it, and was filling with water.

The lawsuit seeks class-action status, and also seeks compensatory and punitive damages, among other remedies. It was filed by Coughlin Stoia Geller Rudman & Robbins LLP, a law firm specializing in securities class-action lawsuits.

Morgan Stanley shares were up 22 cents at $29.51 in afternoon trading on the New York Stock Exchange.

The case is Employees' Retirement System of the Government of the Virgin Islands v. Morgan Stanley & Co et al, U.S. District Court, Southern District of New York, No. 09-10532.

(Reporting by Jonathan Stempel, editing by Matthew Lewis)

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