Both sides have withdrawn lawsuits against each other as part of the agreement.
Morgan Stanley had bought insurance protection from MBIA on commercial mortgage-backed securities it owns. After the settlement, the New York investment bank is writing down the value of the entire investment, which will result in a $1.8 billion pre-tax charge to its fourth quarter earnings.
The settlement is the result of lawsuits MBIA filed against several banks. The company said it was misled about the quality of home and commercial property loans that were written prior to the financial crisis.
MBIA provided insurance and sold guarantees on the bonds that were based on those faulty real estate loans. When the market for homes and commercial property went bust, defaults spiked, leaving MBIA on the hook for large claims that threatened to put the company out of business.
In 2009, MBIA said it would separate its relatively safe municipal bond insurance business from the more complex mortgage-backed securities insurance business. Morgan Stanley and 17 other banks sued MBIA to challenge its restructuring plan. The banks said the bond insurer's mortgage insurance division would be unable to pay the banks on the insurance they bought.
Morgan Stanley says the settlement significantly cut its risky assets and helped increase a key capital measure, helping the bank better comply with new international regulatory standards.
Morgan Stanley's stock dropped 21 cents, or 1.4 percent, to close at $15.17. MBIA shares added 8 cents to $11.48.
MBIA has settled disputes with other banks this year. Last month it reached a deal with HSBC Holdings. The New York State Financial Services Department, which regulates the insurer, says it is working closely with the remaining financial firms to reach resolutions.