Regulators Broaden Mortgage Probe: Were Retail Investors Playing with IO Strips?

Both the Wall Street Journal and Bloomberg reported Friday morning that the Financial Industry Regulatory Authority — FINRA for short — is investigating securities brokerage firms’ marketing and sale of collateralized mortgage obligations.

HW readers may recall coverage of Orange County, Calif.-based Brookstreet Securities Corp., which went belly-up in June over bad CMO bets.

In letters sent in mid-December, the Wall Street Journal reports that FINRA asked firms for marketing materials, a list of supervisory policies and procedures, and descriptions of how collateralized mortgage obligations were valued.

FINRA is the largest non-governmental regulator for all securities firms doing business in the United States.

From the Journal:

The letters, dated Dec. 14, were sent from Finra’s enforcement division in what has been described as a “sweep” investigation, which is a broad look at industrywide practices that doesn’t necessarily result in an enforcement action. The letter asks for PowerPoint presentations, sales scripts and detailed customer-account information from June 30, 2006, through July 31, 2007. Firms have until Tuesday to respond.

Bloomberg reports that FINRA’s concern is over the suitability of CMOs, with one lawyer interviewed characterizing the securities as “potentially risky and complicated products.”

I have all sort of comments here, harking back to discussions over Brookstreet’s failing.

First, and I’m far from the first to note this, most CMOs are of the plain-vanilla REMIC variety that currently dominates the market for FNMA and FHLMC pass-throughs (read this to get some background on REMICS and CMOs, if you aren’t familiar).

Tanta over at Calculated Risk has said that “the bond market is certainly going to change pretty radically if we declare that REMICs–as such–are too toxic for retail investors.” These are, after all and literally, your grandmother’s securities.

Which is precisely why I don’t think we’re talking about REMICs here, although neither the WSJ nor Bloomberg appear to have bothered with this important distinction.

Rather, I think we’re talking about IO strips here, part of what’s known as the stripped mortgage-backed securities (SMBS) market — by IO, I mean interest-only.

To put it lightly, IOs represent one of the riskiest fixed-income assets available. Allowing retail investors to dabble in this space would, IMHO, absolutely become an issue of suitability on behalf of any yahoo that actually went ahead and sold it to an investor (or even marketed it, put it into a PowerPoint — you get the idea).

What the FINRA investigation suggests here is that more securities brokerages than just Brookstreet decided to get into this complex game. Which is absolutely stunning.

This story gets extra credit if one of the as-of-yet-unnamed brokerages ends up being something other than a local shop.