The Subprime Mortgage Mess - A Primer to Assist Investors
Stuart R. Berkowitz1
This article discusses the subprime mortgage crisis from the viewpoint of investors and suggests legal remedies.
I. Introduction
The subprime mortgage meltdown has dominated the news for the past year. Economic concerns grow daily as foreclosures increase, housing prices decrease and fears of a recession increase. Also suffering huge losses are ordinary investors who purchased subprime mortgages in the form of mortgage-backed securities. While many of these securities were bought by pension funds, hedge funds and foreign investors, many billions of dollars’ worth were purchased by ordinary investors, typically through mutual funds, bonds and preferred stock. These investors often had no idea what they had purchased and were often misled as to the safety of these securities. Do they have a legal remedy to recover their losses?
This article will address the basics of mortgage-backed securities and the process by which Wall Street securitized the home mortgage industry. An understanding of this process suggests there are legal remedies for innocent investors who purchased these products.
II. The Basics of Loan Securitization
The seeds of the current crisis stem from the late 1990s, which had seen an unprecedented run-up of the stock market, particularly technology. This bubble collapsed during 2000 and 2001, causing huge losses for many investors. The financial scandals of Enron and MCI Worldcom were followed by New York Attorney General Elliot Spitzer’s investigation of stock manipulation by large Wall Street firms. Investors fled the stock market for safer and more predictable returns from fixed-income products, mortgage-backed securities being one of several asset classes generally considered safe, secure and predictable.
Several factors fueled the growth of mortgage-backed securities or CMOs (collateralized mortgage obligations). First, the Federal Reserve’s successive rate cuts and the demand for mortgage-based securities combined to force home loans to record low rates. As interest rates dropped, however, investors began demanding higher returns. Wall Street responded by ramping up its marketing of private CMOs and by making several substantive changes to traditional CMOs.2 The result was a range of products that became incredibly complex and virtually impossible to analyze for risk.
The early CMO structure was designed by Fannie Mae and Freddie Mac.3 Pools of mortgages were sold to investors as pass-through securities. In other words, principal and interest payments passed directly through to investors. Because Fannie Mae and Freddie Mac guaranteed timely principal and interest payments, irrespective of whether borrowers made their payments, these securities were subject only to interest rate risk and were considered extremely safe and stable.
Early CMOs issued outside government-sponsored entities had no guarantees. They also suffered from prepayment risk, making simple pass-through securities unattractive to many investors. Prepayment risk is the risk that the borrower will pay off his mortgage early. Most homeowners, on average, will own their homes less than 10 years. Falling interest rates will trigger refinancing. In either event, the loan is prepaid. The Federal Reserve’s rate cuts beginning in 2001 set off a wave of refinancing, making these securities less attractive. Holders of CMOs saw a corresponding loss in value of the CMO.
Wall Street figured out that cash flows from a pool of mortgages did not have to be structured on a strictly pro-rata basis via pass-through securities. So long as every dollar of principal and interest was allocated to a security holder, each pool of securities could support a wide variety of complex structured securities. These customized classes of CMOs became known as “tranches,” from the French word for “slice.”
By redistributing prepayment risk within the mortgage pool, Wall Street was able to create Planned Amortization Classes, or PACs, with stable maturities and cash flows. Analogous to skimming the cream off the top, the more protected the PAC at the top, the more concentrated the prepayment risk in the “support” tranches at the bottom.
As the demand grew for these products, Wall Street used the same techniques to package large pools of private mortgages. These mortgage pools quickly came to be dominated by subprime mortgages. Subprime mortgages traditionally had been a niche market focused on borrowers with less than stellar credit. In return for a higher interest rate, the lender would issue a riskier loan. Borrowers were often required to post additional collateral, obtain additional guarantors, and show a higher loan to equity ratio. Investors were able to make reasonably intelligent assessments of risk.
In the current crisis the exact opposite occurred. Subprime mortgages were issued with little or no documentation. These mortgages came to be known in the mortgage industry as No-Doc (for no documentation loans) and Alt-A (for minimal documentation loans.) Initial interest rates were often set at “teaser” levels with preset automatic upward adjustments.
As PACs developed, they became increasingly complex. Moody’s and Standard & Poor’s typically gave CMOs investment grade ratings. Backed by the marketing of the financial services industry, brokers uniformly marketed these products as an investment-grade safe and secure alternative to lower-yielding bank CDs. Stripped of their complexity, however, the subprime mortgage market rested upon the ability of borrowers to repay their loans, a risk that had been grossly underevaluated and understated.
Retail investors did not and could not have known the true risks of the CMOs Wall Street was selling. They were not told that payments depended upon borrowers whose credit risk had never been evaluated or that the normal underwriting rules of the traditional government-sponsored entities had been eliminated. Investment grade ratings from Standard & Poor’s and Moody’s gave investors a false sense of security.
The primary factor fueling the CMO market was continued rising home prices. This factor was critical to the viability of subprime mortgages. When adjustable rates began resetting and housing prices declined, subprime borrowers were either unable or unwilling to continue their monthly payments. The current housing and credit crisis ensued.
As discussed further below, the ability of investors to properly assess risk will be at the heart of any legal remedy. It is not the purpose of this article to evaluate all the causes and/or allocate blame for the current problems in the financial and housing markets, which has spread far beyond subprime mortgages. The above background is presented simply to provide some background and context to anyone seeking to advise a client with subprime mortgage losses.
III. Legal Remedies
Assuming the CMO was purchased through a registered brokerage firm, the client would have been required to sign a customer account agreement. A standard clause within such agreements is a requirement that any disputes be arbitrated before a securities industry self-regulating organization (SRO) such as FINRA (Financial Industry Regulatory Authority), where arbitration clauses are binding and enforceable.4
Until recently the two primary forums for arbitrating customer disputes were the National Association of Securities Dealers - Dispute Resolution (NASD-DR) and the New York Stock Exchange (NYSE). The recent merger of these two forums has resulted in a new entity called the Financial Industry Regulatory Authority (FINRA).
Arbitration claims filed after August 6, 2007 will be governed by the NASD’s Code of Arbitration Procedure.5 A thorough understanding of the code should precede the filing of any claim. While beyond the scope of this article, any practitioner should understand the basics of drafting a statement of claim, the discovery requirements applicable to the case, and the procedure for selecting arbitrators.
A practitioner looking for practice tools regarding a securities arbitration claim will find virtually nothing.6 While arbitration awards decisions can be obtained from several databases,7 these decisions contain no reasoning and have no value as precedent. This utter lack of any published precedent has led to an unwritten set of standards and doctrines that have come to dominate the thinking of the relatively small group of attorneys who regularly litigate and/or defend arbitration claims.
Accordingly, CMO claims will need to fall within the accepted informal framework that has been developed by practitioners over the past 15 years.
The most important legal doctrine that will underpin any CMO case is the doctrine of suitability.8 Almost all customer claims involving the purchase of securities invoke some aspect of the suitability doctrine. This doctrine permeates the relationship between a broker and his customers. The source of the doctrine is NASD Rule 2310. The rule reads as follows:
(a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.9
The rule contains several technical threshold requirements that must be satisfied in every customer case.
The term “recommendation” has no simple definition. The NASD has offered a series of “clarifications” to its first effort to define what is a “recommendation.”10 These “clarifications” only serve to demonstrate that each case is fact-sensitive.
More useful is Exchange Act Rel. No. 27160, where the commission attempted to distinguish brokers as mere order takers as opposed to directly recommending the purchase of a specific security.11
Brokerages often mark their order tickets as “unsolicited” to indicate the transaction was not recommended. If the order ticket is blank, it is assumed the transaction was “solicited.” These terms, however, are not synonymous with “recommendation” and a deeper inquiry into the facts often shows that an unsolicited trade was, in fact, recommended.
The rule states that the client must also be a “customer” of the broker-dealer. The NASD’s Code of Arbitration does not define the term “customer.” Section 2270(b) of the Conduct Rules defines “customer” as “any person who, in the regular course of such member’s business, has cash or securities in the possession of such member.”12
If the client opened an account and purchased the security through the account, he/she is a customer. Other situations are not as clear. In Oppenheimer & Co., Inc. v. Neidhardt, the court held that certain defrauded investors were “customers” under the NASD Code despite never having opened accounts or purchased any securities through the firm.12
In a typical case the client would have opened an account, executed a customer account agreement, and purchased the security through his/her account. Situations where none of the foregoing occurred will need to be carefully examined to see if the erstwhile client met the threshold requirement of being a customer.
The term “security” is defined in the Securities Act of 1933 and includes anything of value purchased on any national securities exchange as well as any interest in any instrument commonly known as a “security.”13
CMOs were normally sold as bonds, which specifically come within the definition of “security” in the 1933 act.
NASD Conduct Rule 2310 (Suitability Rule) establishes an industry duty of care.14 The rule does not create a private cause of action that would be cognizable in a court of law. In securities arbitration, however, arbitrators commonly apply the securities industry’s duty of care to its customers.
Assuming it can be shown that the client is entitled to the duty of care set forth in NASD Conduct Rule 2310, an analysis of a potential claim in light of the opening discussion reveals there are two interrelated suitability claims that should be explored in any case involving a loss in mortgage-backed securities.
The first involves the reasonable grounds of the brokerage firm in recommending securities that contained CMO exposure.
It is apparent that the public was not informed about the subprime mortgage risks of CMOs. They were marketed to investors seeking safety of principal with income. They were often advertised as being as safe as a bank certificate of deposit (CD). Regional and small brokerage firms marketed CMO products wrapped in mutual funds. At no time were customers told that CMOs contained subprime mortgages issued to borrowers with little or no documentation of credit worthiness. Nor were customers told that loans were often made for 100 percent of the value of the collateral or that initial interest rates were set at artificially low teaser rates.
As in any product defect case, the brokerage firms had a non-delegable duty of due diligence regarding the riskiness of CMOs. The riskiness of these products and their complexity suggests a failure to conduct adequate due diligence before recommending these products as safe and conservative.
Inherent in the doctrine of suitability and the customer’s ability to evaluate any recommendation is the riskiness of the investment in relation to potential profit. The markets factor risk into every security but the lack of transparency can sometimes, in effect, fool the markets. CMOs were recommended as low-risk investments. Investors did not know and could not have known that the risks were grossly understated. They were not told that subprime mortgages were included in the tranches of virtually every CMO.
Under the circumstances, a reasonable claim can be made that the selling broker did not have reasonable grounds for recommending CMOs to customers as a safe and secure investment.
Second, the issue of customer suitability must be explored. Client suitability focuses on the customer’s investment objectives and ability to understand the true risk of a CMO. A thorough inquiry into the client’s financial situation and sophistication should be undertaken.
Customer suitability cases focus on the suitability of the customer for the particular security purchased. Education, employment history, net worth, investment experience and investment objectives are relevant factors. Most retail investors purchasing CMOs were retirees seeking stable income. Purchases made in tax qualified accounts, such as an IRA, by investors close to retirement, along with supporting facts, could support a claim of customer suitability.
Retail brokers relied upon information supplied by the brokerage firms that employed them. They were as surprised as anyone to learn that they had been told to market these products as safe and secure when they contained subprime mortgages that were anything but safe and secure. Under these circumstances, the selling broker may be a valuable source of information.
A claim should also be explored under § 409.5-509, RSMo, which entitles a purchaser of a security to sue the seller where there is “an untrue statement of a material fact or an omission to state a material fact. . . .” Under this section, the purchaser can sue for his actual out-of-pocket loss, interest at eight percent from the date of purchase, and “reasonable attorneys’ fees.”15
There is no requirement that the misrepresentation be intentional or that the broker knew or should have known his statements were false.
IV. Conclusion
Representing customers in securities arbitration is a relatively new field that must quickly adapt to a fast-changing financial world. The CMO crisis fits within previous brokerage abuses where suitability claims have been successful. Many investors who have suffered losses in CMOs may, unknowingly, have legal redress.
Footnotes
1. Mr. Berkowitz received his J.D. from Washington University School of Law in 1973 and practices in St. Louis, where he concentrates in representing the victims of investment fraud. He is a member of the Public Investor Arbitration Bar Association and the Missouri and Illinois bars.
2. Private CMOs are not issued by government-sponsored entities such as Fannie Mae and, therefore, have no government-backed guarantees of principal and interest payments.
3. Fannie Mae (Federal Home Loan Mortgage Corporation) and Freddie Mac (The Federal Home Loan Mortgage Corporation) are the largest government-sponsored mortgage companies.
4. See Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987).
5. The NASD Code of Arbitration is available online at www.finra.org/ArbitrationMediation/index.htm.
6. The exception is the Public Investors Arbitration Bar Association (PIABA), a national bar association of approximately 500 attorneys who specialize in representing customers in securities arbitration. PIABA publishes a quarterly journal and maintains searchable research files. See www.piaba.org.
7. The most complete awards database is maintained by PIABA, but access is limited to members.
8. For a detailed review of the suitability doctrine, see Lewis D. Lowenfels & Alan R. Bromberg, Suitability In Securities Transactions, 54 Business Lawyer 1557 (August, 1999).
9. Available at http://finra.complinet.com/finra/index.html
10. See NASD Notice to Members 96-60 and Clarification to Notice to Members 96-60 attempting to clarify Notice to Members 96-32 issued May 9, 1996, available at http://www.finra.org.
11. SEC Announcement of Final Rule on Sales Practice Requirements for Certain Low-Priced Securitites, Release No. 34-27160, 54 Fed. Reg. 35468 (Aug. 28, 1989). The SEC’s Division of Corporate Finance Compliance & Disclosure Interpretations can be found at www.sec.gov/divisions/corpfin/cfguidance.shtml.
12. NASD Conduct Rules available at http://www.finra.org.
13. 15 U.S.C. § 77a (2007).
13. See 56 F.3d 352, 358 (2d Cir. 1995). Fleet Boston Robertson Stephens, Inc. v. Innovex, 264 F.3d 770, 772 (8th Cir. 2001), when the court took a slightly narrower view of the term “customer.”
14. NASD Conduct Rules available at http://www.finra.org.
15. Section 409.5-509(b)(3), RSMo 2007.