FINRA Press Release: Inverse Floating Rate CMOs

FINRA Fines HSBC $375,000 for Unsuitable Sales of Inverse Floating Rate CMOs to Retail Customers and Related Supervisory Failures

The Financial Industry Regulatory Authority (FINRA) issued a press release today announcing that

"it has fined HSBC Securities (USA) Inc. $375,000 for recommending unsuitable sales of inverse floating rate Collateralized Mortgage Obligations (CMOs) to retail customers. HSBC failed to adequately supervise the suitability of the CMO sales and fully explain the risks of an inverse floating rate or other risky CMO investment to its customers."

The settlement is detailed in the FINRA AWC No. 2007010582702.

FINRA found that HSBC failed to maintain adequate supervision on the sale of inverse floating rate CMOs. Supported by the recommendation of HSBC, 6 brokers sold 43 of these CMOs when such complex, high-risk securities were not suitable to customers who were considered unsophisticated, low-risk investors.

A mortgage backed security (MBS) is a debt security whose cash flows come from, and are backed by, the principal and interest payments of borrowers on the mortgage loans. The pooling of mortgages into a debt security is called securitization and is performed by a trust. Mortgages are originated by public and private agencies, they are then securitized into MBS by a trust, and then the MBS is issued to public investors by the trust. A collateralized mortgage obligation (CMO) is a type of MBS and is highly sensitive to interest rate changes - for example, in 1994 significant interest rate increases caused CMOs to fall in value.

SLCG has written a paper describing the market and history of CMOs in the wake of the collapse of Brookstreet Securities and two Bear Stearns hedge funds.