Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Thursday, September 4, 2008

FINRA Disciplines Brokers for Unsuitable Sales of CMOs

FINRAhas barred two brokers from the Boca Raton branch office of the now defunct brokerage firm, SAMCO Financial Services, Inc. - and suspended a third broker for two years - for misconduct in connection with selling complex mortgage-backed securities called Collateralized Mortgage Obligations (CMOs) to retail customers.  In making the announcement, FINRA emphasized that these are its first enforcement actions arising from ongoing investigations into abuses in the marketing and sales of mortgage-backed securities such as CMOs to retail customers. The brokers here failed to fulfill their suitability obligations when they recommended 'inverse floaters' to retail customers with little or no investment experience.

A CMO is a security that pools together mortgages and issues shares - called "tranches" - with various characteristics and risks. The underlying mortgages serve as the collateral for the CMO and provide principal and interest payments to shareholders.  One of the most volatile and risky CMO tranches is the "inverse floater CMO," a thinly traded mortgage-backed security which is typically highly leveraged and vulnerable to a high degree of price volatility. Rising interest rates reduce the interest earned and also may decrease the principal payments to the investor. The reduction in the repayment of principal extends the maturity date, potentially for as much as 30 years. Furthermore, since each inverse floater is uniquely structured and thinly traded, prices used for valuation purposes are determined using theoretical pricing models. These prices are strictly best estimates of value and can vary substantially from prices obtained through actual bidding or market offerings. As a result, buying inverse floaters on margin further heightens the risk of investing in the product.

Since 1993, FINRA (formerly NASD) has published warnings that inverse floaters are suitable only for sophisticated investors willing to take on high levels of risk.

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