Deutsche Bank, through the Deutsche Bank National Trust Company, filed a suit against Morgan Stanley last month.
The German bank says Morgan Stanley knowingly passed on to it mortgages with an original principal balance of $735 million that were in fact toxic, according to a statement from Morgan Stanley.
A New York court has rejected the US bank's attempts to have the suit thrown out, Morgan Stanley said.
Morgan Stanley could incur a loss of up to approximately $292 million, plus pre- and post-judgement interest, fees and costs, it said.