Securities Arbitrations Involving Mortgage-Backed Securities and Collateralized Mortgage Obligations: Suitable for Unsuitability Claims?

Article excerpt

I. Introduction and Background

Over the past two years, the world has witnessed the unfolding of the "subprime mortgage crisis". A steep rise in home foreclosures beginning in late 2006 caused a ripple effect throughout the economy, resulting in a dearth of liquidity across the lending sector. The largest rise in defaults occurred on so-called "subprime"1 and other adjustable rate mortgages (ARMs).2 These types of mortgages were offered initially during a time of rising housing prices, often to unqualified borrowers,3 who thought that they would later have the opportunity to refinance at more favorable terms. As housing prices declined, however, refinancing became more difficult; defaults increased sharply as interest rates reset at higher rates on many of the mortgages.4 These events contributed to approximately 1.3 million foreclosures in 2007, an increase of approximately 75% from 2006.5 Foreclosures increased to 2.3 million in 2008, an increase of approximately 80% from 2007. 6 Some experts have estimated that subprime defaults ultimately will reach between $200 billion and $300 billion before the crisis ends.7

Mortgage lenders and banks - which maintained the mortgages on their balance sheets, and thereby retained the credit risk - suffered the first losses. Other financial institutions avoided large losses, however, by passing along the credit risk to investors through securitization of the mortgages into mortgage-backed securities (MBSs) and collateralized mortgage obligations (CMOs). These investment products, in turn, were purchased by retail and institutional investors, often following a recommendation by a broker-dealer.

MBSs are asset-backed securities having cash flows backed by the principal and interest payments of a pool of mortgage loans.8 Payments are made periodically over the lifetime of the underlying loans.9 CMOs are more complex mortgage-backed securities, comprised of pools of home mortgages backed by government-insured agencies such as Freddie Mac and Fannie Mae.10 There are two streams of income from each pool: one from the aggregate interest payments and the other from the aggregate principal payments made on the mortgages." These income streams are then divided into tranches based on credit quality and sold as separate securities to investors.12 Losses are applied in reverse order of seniority and, therefore, junior tranches offer higher coupons (interest rates) to compensate investors for the added default risk.13 Due to the risk associated with junior tranches, they have been called "toxic waste" by some commentators.14 Because CMOs are backed by government-sponsored agencies, each tranche usually retains a surprisingly high rating, although each has a completely different risk profile.15

CMO derivatives, such as "inverse floaters"16 and "interest-only strips,"17 have become popular among investors in recent years. These derivatives have considerably more risks than normal CMOs. One of the risks associated with CMO derivatives is that their value fluctuates significantly with slight changes in interest rates.18 These products are also illiquid, meaning that investors are often stuck holding the securities even as their value spirals downward.19 A related risk of CMO derivatives is pricing risk. Often CMO derivatives are priced only once a month, using methodologies that may not be readily transparent. As a result, when the time comes to sell the CMO derivatives, investors may find it difficult to arrive at a price.20

MBSs and CMOs gained tremendous popularity with investors in the late 1990s and in the early part of this decade when broker-dealers began recommending them to retail and institutional customers as suitable investment alternatives to treasury securities to hedge against inflation risk while earning a presumably safe return. In Banca Cremi, S.A. v. Alex. Brown & Sons, Inc., the Fourth Circuit summarized the turbulent CMO market of the late-1980s to the mid-1990s: "From 1987 to 1993, U. …