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Regulation and Compliance > Federal Regulation > FINRA

Caveat Vendor

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It began with nothing but the best intentions: Financial advisors wanting to reap higher yields for their retail clients — and in the process also earn heftier commissions over typical fixed-income products.

In the end, investing in collateralized mortgage obligations (CMOs) would wreak havoc and, for some, wreck lives. Both the FAs who failed to fully understand these complex investments and sold them improperly, along with their clients, were burned badly. As for those who used the investments to deliberately exploit market-naive clients, they have been prosecuted, their firms shuttered.

The newest development that’s been surfacing, increasingly, as a chief contributor to the mortgage calamity and the ensuing global financial crisis pivots on CMOs — risky, highly volatile bonds with low liquidity. The CMO market is huge — reaching into the trillions of dollars. But the products are so complex; they’re confusing even to many institutional investors. Indeed, CMOs and CDOs — collateralized debt obligations — are largely responsible for today’s financial market mess.

At press time, in February, industry regulator FINRA was conducting a sweep examination of brokerage firms that have sold CMOs. Last December, it intensified the agency’s investigation, begun three months earlier, when it sent a letter to 12 large and small broker-dealers requesting detailed information — including transaction particulars, advisor ID numbers and every customer complaint and claim relating to CMOs. The main focus was suitability and disclosure.

The Securities and Exchange Commission is investigating the troubling CMO situation as well.

“If brokers have been selling CMOs improperly, they have a legal threat looming. People selling these products to the moms and pops of the world — who aren’t sophisticated enough to know what they are getting — will have issues,” says Joyce Wagner, a partner in Arc Analytics, of Boca Raton, Fla., and previously the long-time compliance director of a regional brokerage.

Arc, which creates reports concerning broker-dealer litigation, is analyzing the CMO activity of 100 retail accounts, many belonging to seniors. Issues include disclosure, margin leverage and pricing.

Wagner says that in some accounts, Arc has found “exorbitant” CMO losses. “They exceed the amount of money that was borrowed.” Among the cases are pension funds and municipalities that bought CMOs on FAs’ recommendations even though they were in violation of investment policy statements.

“Basic hocus-pocus about what the securities were worth” has caused the CMO “scandal,” writes noted attorney and economist Ben Stein in The New York Times. He branded CMO losses the industry’s latest breach in fiduciary duty.

During the last few years, CMOs, which Salomon Bros. and First Boston designed and engineered in 1983 for institutional investing, have also been sold to small retail investors, for whom they were wholly unsuitable. Indeed, they were barely comprehensible to them.

The fall-out: Major account losses and billions of dollars in write-downs by big financial services firms after the mortgage-backed securities lost value.

There is already “a tremendous number” of claims, arbitrations and litigation as a result of CMO losses, according to attorney Erwin Shustak of San Diego-based Shustak & Partners, which specializes in securities and corporate law.

“It was CMOs that caused the credit market to dry up. Wall Street was packaging these mortgages into different [classes], but nobody would buy the paper…If there’s no market for what you’re holding, there’s no value.”

CMOs, volatile bonds issued by, among others, Fannie Mae, Freddie Mac and private issuers, are complicated investments of re-packaged mortgages that are sliced and diced into tranches, or classes, then sold separately to investors. They have differing maturity dates and are extremely sensitive to interest-rate changes.

Retail advisors selling CMOs — without elaborate research at their disposal — usually have no clue as to what the underlying collateral, the tranche, consists of. So when they’re sold to, say, elderly retirees on fixed-incomes who are obviously in the dark about how they work, it’s a set-up for disaster.

“The client needs to know about the underlying collateral, the quality and the pay-off rate so they’ll know the average life on their investment. But 90 percent of advisors are [just] selling a coupon and a rating,” says Donald Weidenfeld, senior vice president-private client group, with Raymond James & Associates in Boca Raton, Fla.

Weidenfeld sold CMOs nearly a decade ago, but to institutional accounts only. “It’s a horrendous investment for retail clients. The highest quality collateral goes to the institutional investors,” he says. “After they slice and dice the tranches, the retail investor gets stuck with what’s left. That’s why, when the mortgage market falls apart, as it has, the underlying collateral of their investment diminishes in credit quality.”

Selling to SeniorsEspecially risky are CMOs known as inverse floaters, sales of which have been responsible for much of the widespread losses. Buying these or other questionable CMOs on margin greatly increases their risk.

The NASD, predecessor regulator to FINRA, for years had been telling advisors that CMOs were suitable only for institutional clients or smart, experienced, well-to-do individual investors who understand the product and its risks.

But in a 1996 arbitration suit, Merrill Lynch was directed to pay about $1 million to two elderly sisters who bought CMOs on margin at the wirehouse’s recommendation. The women began investing in the products in 1991; three years later, when they liquidated their account, what once was a $2 million portfolio had plummeted in value to about $950,000.

Today, “FINRA has found that CMOs were being sold to investors for whom they were either unsuitable or who didn’t get a clear explanation of what was involved,” says Wagner. “There wasn’t an in-depth review of the quality of the collateral.” Arc has discovered that, in some cases, the CMO in an account “may not be worth even the debt. So the client ends up upside-down.”

At press time, FINRA was still in the process of gathering intelligence from the 12 firms to which it sent the sweep letter. The agency is concerned, in particular, about the sale of CMOs to seniors, who, it says, need to be protected from financial fraud. In September 2007, FINRA CEO Mary L. Schapiro said that “…there appears to be a significant push to sell these complex and risky products to seniors.”

Brian L. Rubin, a Washington, D.C.-based partner with law firm Sutherland Asbill & Brennan, representing broker-dealers — some of whom received the FINRA letter — looks at what might lie ahead: “If there are indications of issues either with the firms or their registered reps, there will be more formal investigations in which testimony will be taken. If there are violations, FINRA can assess a fine, order restitution, suspend broker licenses” or bar advisors from working in the financial services industry.

Rubin, formerly deputy chief counsel of enforcement at the NASD and before that on staff with the SEC’s enforcement division, stresses that FINRA’s concerns about CMO sales signals that even firms who weren’t sent the sweep letter should assess their CMO policies, practices, procedures and risk disclosures.

“They may get a letter in the future, when FINRA or the SEC periodically examines firms, and it may focus on the same issues that we see in the sweep letter,” he says.

FINRA’s investigation also means that advisors who are not now investing in CMOs should be aware that their sales practices could be under scrutiny. “It’s important for reps to understand CMOs before they try to sell them,” notes Rubin.

Though CMOs are widely considered to be structured products, that description is inaccurate according to Keith Styrcula, chair of the Structured Products Association and principal of Structured Funds Advisors, in New York City. Rather, he says, “a CMO is an asset-backed security. A structured product is much more in the liquid markets and has a lot less risk all the way around.”

Styrcula, who eight years ago noted that CMOs were being marketed to retail clients, says he “never felt comfortable that they were something that should be in the hands of two-legged investors.

“You get a very good coupon for it, but there was the risk that if the housing market fell apart, the value of these things was so opaque you could wind up with real liquidity problems,” he says.

Independent producer Carol Rogers sold CMOs more than 20 years ago when she was an E.F. Hutton advisor. The product worked for certain clients; but now, as a partner in Rogers & Company, which is affiliated with LPL Financial, Rogers avoids the products.

In the 1980s, “they were new enough that the client got a fair shot. The quality was there to support the investment,” says Rogers, based in St. Louis. “Now, there are difficulties knowing what the quality is. The people who put them together have more advantages than the client does. People haven’t done their homework. They’ve let it slide.”

She continues. “We can’t wrap our arms around knowing enough about CMOs to make us feel we’re smarter than the average [client]. That’s no advantage to them. We’ve been suspicious for too long — and now, gratefully so.”

“Don’t Reach for Yield”LPL Financial won’t permit its affiliated advisors to market potentially problematic, highly volatile CMO issues, according to Anthony Valeria, CFA, the broker-dealer’s fixed-income strategist, based in San Diego. But LPL does support the purchase of more conservative Planned Amortization Class (PAC) CMOs and sequential CMOs.

Still, “I would definitely consider them [only] for a buy-and-hold investor, typically someone geared more toward income because CMOs’ liquidity is on the lesser side,” says Valeria. “That’s what a retail investor should watch out for. Don’t reach for yield. You usually give up the extra advantage versus a high-quality bond rather quickly — and we’re seeing a lot of that.”

When interest rates are stable, some CMOs can be profitable investments. They provide a good spread to U.S. Treasury bonds, and commissions are higher than on most fixed-income products, according to Weidenfeld and others. “But there are lots of areas where you can take a bad step,” he says, “and you’re not getting enough yield to compensate for all the unknowns.”

“A CMO is a bond, but it’s not [really] a fixed-income product because the income stream can change, and there’s no fixed maturity date,” adds Weidenfeld.

“When interest rates are down, CMOs can get called and you’ll have to re-invest the principal at a lower rate. That’s the worst time to get your money back. Then when interest rates go up, you want your money back, but this thing won’t give it back to you!”

Yet to come is whether it is money managers or brokerage firms that will be held accountable in the CMO fiasco.

As for the former, Wagner notes that Lehman Bros., one of the largest CMO packagers, announced in January that it was reducing its “resources and capacity in the U.S. residential mortgage origination space in light of the dislocation in the mortgage markets.”

Clearing firms also may not be in the clear. A part of FINRA’s sweep letter specifically addresses pricing and valuation. Says attorney Rubin: If “clearing firms aren’t reacting to the market and keep stale valuations, that could be an issue for them.”

Bob Rex, a partner in the firm Dickenson Murphy Rex & Sloan, in Boca Raton, representing nearly 100 South Florida retirees who have lost $10,000 to $1 million investing in risky CMOs, maintains that pricing is the chief cause of the meltdown. “When you ask people how they price CMOs, the answer you get is so muddy. It’s basically a formula that leads to all kinds of potential abuse depending on who made up the formula and who understands what the formula is.

“CMOs are so complicated,” he says, “that no ordinary retail client could begin to understand the risks associated with them.”

However, with CMOs substantially down in value, now may be a good time to buy them — but only for the right client, says Weidenfeld. “It has to be a sophisticated high-net-worth client and someone who can withstand the volatility as well as the change in duration — a person who just wants the income and doesn’t mind when their principal comes back.”

On the other hand, Keith Styrcula says that now “is not a buying opportunity except for the most aggressive hedge funds. I wouldn’t be increasing even at fire-sale prices. We haven’t seen the end of the falling knife.

“But once we shake out all the upcoming bankruptcies and foreclosures, there’ll be an enormous opportunity in CMOs for those who are savvy,” he says. “These are institutionally driven products that should just be a sliver of a portfolio for family offices only — that is, institutional-like individual investors.”

As the glut of FINRA CMO cases wends through the system, attorney Shustak looks for “the whole business of slicing-and-dicing packaged debt to be moribund for a long, long time.”

The best advice for financial advisors? Says Joyce Wagner, who expects tight constraints to be placed on CMOs, if not a complete elimination of sales to retail investors: “Retail brokers need to be certain that what they’re selling is meant for Mom and Pop and that they understand what they’re selling. Just because a brokerage firm has a product available, doesn’t mean it’s suitable for retail investors.”

CMOs Claim Land Broker, Brokerage Firm and Clearing Firm in Court

Here are two examples of deep trouble that has resulted from the unsuitable sale of collateralized mortgage obligations (CMOs) to retail clients:

This past February, a jury found Florida broker Jamie Solow liable for fraud that caused two brokerages to go out of business and millions of dollars in losses for about 750 mom and pop investors.

The Securities and Exchange Commission wants Solow to return $11 million in commissions, pay a big fine and be barred from continuing to work in the financial services industry.

Downplaying high risk, he sold highly volatile inverse floater CMOs to small investors who had no idea what they were investing in.

About 300 of Solow’s ex-clients filed arbitration cases with FINRA. One couple, ages 89 and 79, whom attorney Bob Rex of Dickenson Murphy Rex & Sloan in Boca Raton, Fla., is representing, are coping with their house in foreclosure and their car in repossession.

Says Rex: “This scheme was masterminded by one single broker who did all the trading; but other novice brokers acted as asset gatherers for him.”

In California, Irvine-based Brookstreet Securities was forced to shut down last year because of big losses in mortgage-backed securities.

Ervin Shustak, of San Diego-based Shustak & Partners, attorneys for both brokers and elderly clients in the case, which is proceeding through the courts, claims that clients who bought CMOs on margin were defrauded not only by Brookstreet but by its clearing firm, National Financial, a unit of Fidelity Investments.

National Financial made heavy markdowns in the value of CMOs held by Brookstreet clients, says Shustak. Consequently, many were forced to meet immediate margin calls or lose their investments.

“National Financial knew that Brookstreet was pooling customer money and pledging it as collateral,” says Shustak. “The issue is how much knowledge it had as to what Brookstreet was doing vis-?-vis its customers’ money. They were co-mingling it and pledging it to the clearing firm to cover the margin liability. National Financial took the money when problems arose and ran out of the game.”

Bob Rex says that since “Brookstreet is wiped out, National Financial is a target because they’re the only ones with any money left. What could be the weak point with National Financial is that they may have held the prices artificially high for a period of time.”

For its part, National Financial says the claims are “without merit. The decision to take margin loans is made by clients and their brokers, not by clearing firms. National Financial had clear margin agreements in place with clients and used reputable third-party firms to price securities held in brokerage accounts,” according to a company spokesperson. — J.W.R.

Freelance writer Jane Wollman Rusoff is a Los Angeles-based contributing editor of Research and is the founder of Family Star Productions.


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