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

29 Pages Posted: 23 Aug 2009  

Bradley J. Bondi

Cahill Gordon & Reindel LLP; Georgetown University Law Center; George Mason University - School of Law

Date Written: August 22, 2009


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' and other adjustable rate mortgages (ARMs). These types of mortgages were offered initially during a time of rising housing prices, often to unqualified borrowers, 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. These events contributed to approximately 1.3 million foreclosures in 2007, an increase of approximately 75% from 2006. Foreclosures increased to 2.3 million in 2008, an increase of approximately 80% from 2007. Some experts have estimated that subprime defaults ultimately will reach between $200 billion and $300 billion before the crisis ends.

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 recom-mendation 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. Payments are made periodically over the lifetime of the underlying loans. 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. 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. 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. Due to the risk associated with junior tranches, they have been called 'toxic waste' by some commentators. Because CMOs are backed by government-sponsored agencies, each tranche usually retains a surprisingly high rating, although each has a completely different risk profile.

CMO derivatives, such as 'inverse floaters' and 'interest-only strips,' 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. These products are also illiquid, meaning that investors are often stuck holding the securi-ties even as their value spirals downward. A related risk of CMO de-rivatives 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.

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.S. government-sponsored CMO issuances grew dramatically, from $900 million to $311 billion per year. The market in CMOs collapsed in 1994; new issuances fell to $25.4 billion in 1995.'

In the late 1990s, the country witnessed a resurgence in the mortgage-backed securities market as mortgage rates dropped and home sales increased. In 2000, the MBS market overtook the market for U.S. treasury securities. At its height, the total market value of all out-standing U.S. MBSs was approximately $6.1 trillion. '[A]lmost $2 trillion [of that amount consisted of] riskier nonagency securities that are not insured by the federal government or by Fannie Mae or Freddie Mac.'

When the subprime mortgage crisis hit the U.S. economy in late 2006, many investors holding MBSs or CMOs that were purchased before 2006 suffered significant losses because the values of the underlying assets sharply declined. These investors included retail customers, corporations, and institutions such as pension funds, university endowments, municipalities, and even the investment banks themselves. The fact that so many investment banks purchased MBSs and CMOs is a significant difference from the crash in 1994. As one commentator described, 'Wall Street drank its own Kool-Aid. Big investment banks like Bear Stearns Cos., Citigroup and others not only sold the CDOs - they also bought them.'

The losses have been enormous. As of May 2008, Citigroup had suffered a staggering $40.7 billion in subprime losses - the most of any bank - and had been forced to cut 9,000 jobs. Other subprime losses as of that date include: $38 billion at UBS, $31.7 billion at Merrill Lynch, $14.9 billion at Bank of America, $12.6 billion at Morgan Stanley, $12.4 billion at HSBC, $12 billion at Royal Bank of Scotland, $9.7 billion at JP Morgan Chase, $8.3 billion at Washington Mutual, $7.5 billion at Deutsche Bank, $7.3 billion at Wachovia, and $6.3 billion at Credit Suisse.

Several financial services firms have been forced out of business due to their dealings in MBSs and CMOs, leaving investors with significant losses. Most commentators blame the demise of Bear Stearns, Wall Street’s fifth largest investment bank, on the subprime crisis. Available credit virtually dried up as banks became less willing to lend to each other after they suffered large losses on subprime mortgages and related financial products.

Even smaller firms have suffered as a result of their activity in sub-prime mortgage products. Brookstreet Securities of Irvine, California, one of the top 25 independent broker-dealer firms, went out of business in June 2007 when a large number of institutional and retail customer accounts received margin calls from Brookstreet’s clearing firm, National Financial Services, a division of Fidelity Investments. The margin calls were sparked by a sudden decline in value of investments in CMOs, including CMO derivatives. By June 22, 2007, Brookstreet had exhausted its entire net capital of $12 million to meet a margin call and yet still had a margin balance of $70 million against securities worth $85 million, and that value was declining. Ultimately, Brookstreet became insolvent.

As losses continue to stack up for investors of MBSs and CMOs, it is inevitable that investors will seek legal recourse against the broker-dealers from which they purchased the securities. One claim that undoubtedly will be advanced by investors is that the MBSs and CMOs were 'unsuitable' investments. A broker-dealer has an obligation under the governing rules of self-regulatory organizations (SROs), as well as federal and state securities laws, to recommend only 'suitable' investments and trading strategies. A claim for unsuitability typically arises when a representative of a broker-dealer recommends to a customer an investment that he knows, or should have known, is inappropriate for that customer based on the customer’s investment objectives. An allegation of unsuitability is among the most common claims brought in securities arbitration. In 1998, unsuitability claims accounted for 95% of filings under the errors and omissions insurance policies of the National Association of Securities Dealers (the NASD) members. Unsuitability claims currently account for a large portion of the claims asserted by customers during FINRA arbitration proceedings.

Mandatory arbitration clauses in the customer agreements at virtually every broker-dealer firm mean that claims asserted by investors will be heard in arbitration unless both parties elect to have the case heard in court. Supreme Court precedent has made it nearly impossible for investors unilaterally to challenge a mandatory arbitration clause.

The shift in forum from courts to arbitration panels has had a significant effect on jurisprudence of unsuitability claims. In federal courts, unsuitability claims are brought under the antifraud provisions of the federal securities laws, primarily Section 10(b) of the Exchange Act and Rule 10b-5, which together require a showing of intent to defraud or recklessness.

By contrast, unsuitability claims in arbitration are brought under the more amorphous rules of the self-regulatory organizations, which do not necessarily require proof of fraud but instead are rooted in notions of fairness and equity. Although the vast majority of courts hold that there is no private right of action for violations of SRO rules, certain rules, such as the FINRA suitability rules, set forth the standard of care to which registered representatives and broker-dealers are judged in arbitration. A violation of FINRA rules may arise from intent, reck-lessness, or negligence. To recover in arbitration, a customer asserting a claim must prove, at a minimum, that the SRO rule (e.g., suitability) sets forth the standard of care and that there was a breach of that standard of care that proximately caused damages.

This short Article explores the unsuitability claim from its inception to its modern application. It then discusses unsuitability claims in the context of MBSs and CMOs and in the forum of arbitration. Finally, this Article briefly highlights some of the basic considerations of whether a safe harbor for recommendations of brokers to certain institutional customers would be appropriate to consider.

Keywords: securities law, subprime, sub-prime, mortgage-back securities, MBS, CDO, CMO

JEL Classification: K22, K41

Suggested Citation

Bondi, Bradley J., Securities Arbitrations Involving Mortgage-Backed Securities and Collateralized Mortgage Obligations: Suitable for Unsuitability Claims (August 22, 2009). Fordham Journal of Corporate and Financial Law, Vol. 14, p. 251-279, 2009. Available at SSRN:

Bradley Joseph Bondi (Contact Author)

Cahill Gordon & Reindel LLP ( email )

Washington, D.C.
New York, New York
United States
202-862-8910 (Phone)

HOME PAGE: http://

Georgetown University Law Center ( email )

600 New Jersey Avenue, NW
Washington, DC

George Mason University - School of Law

3301 Fairfax Drive
Arlington, VA 22201
United States

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