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."
