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Notice To Members 93-73

Members' Obligations to Customers When Selling Collateralized Mortgage Obligations (CMOs)

Published Date:


Senior Management
Government Securities
Legal & Compliance

Executive Summary

As part of its comprehensive program to monitor and enhance member sales practices, the NASD is publishing this Notice to remind members of their obligations under the Rules of Fair Practice when recommending CMOs to their customers. In light of the complexity and the varying risk characteristics of CMOs, Article III, Sections 1 and 2 of the Rules of Fair Practice, require that members must be conversant in all of the characteristics of CMOs to assess adequately the suitability of CMOs for their customers. Moreover, members must ensure that their customers understand the characteristics and risks associated with CMOs.


With the decline in interest rates over the last several years, investors have sought alternatives to the ever-lower yields of certificates of deposit (CDs), money market funds, and government securities. The desire to maximize returns while maintaining a high degree of credit safety has significantly enhanced interest in asset-backed securities, particularly collateralized mortgage obligations.

In recognition of the potential problems and in response to an increase in complaints related to CMO sales practices and advertising in the last few years, the NASD has taken a number of steps to address the issues relating to CMO sales practices. Among others, the initiatives taken by the NASD include the adoption of Guidelines Regarding Communications with the Public About Collateralized Mortgage Obligations (CMOs) that were published in Notice to Members 93-18 and the enactment of a pre-use filing requirement for CMO advertising as published in Notice to Members 92-59. These advertising-related initiatives are having a positive effect in achieving the desired compliance results.

In continuing these efforts to oversee and enhance CMO sales practices, the NASD is reminding members of their obligations under the Rules of Fair Practice when recommending CMOs to their customers. In light of the complexity and the varying risk characteristics of CMOs, under Article III, Sections 1 and 2 of the Rules of Fair Practice, members and their associated persons must be conversant in all of the characteristics of CMOs to assess adequately the suitability of CMOs for their customers. Moreover, they must ensure that their customers understand the characteristics and risks of CMOs. Further, adequate supervisory procedures must be in place to monitor CMO activity within each NASD member firm.

Among the matters members and representatives selling CMOs should be acquainted with are:

General Characteristics

Although CMOs entitle investors to payments of principal and interest, they differ from CDs, corporate bonds, and Treasury securities in significant ways. CDs, corporate bonds, and Treasuries are issued with stated maturities and fixed interest rates. When a CD or bond matures or is called, the issuer returns the face value to the investor in a single principal payment. In contrast, while CMOs have stated final maturity dates at which all principal must be returned, they can make principal payments throughout the life of the security. In addition, the timing of these payments may vary significantly depending on interest rate changes.

Principal payments on CMOs arise from both the regular amortization of the underlying mortgages and from prepayments of those mortgages due to sales or refinancings. As recent history shows, when interest rates decline substantially, many homeowners choose to refinance their mortgages. This activity can result in CMOs paying off principal more rapidly than had been anticipated. Thus, a CMO investor may be faced with reinvesting his or her principal at a current lower rate. In a rising interest rate environment, homeowners may not refinance or sell their houses as quickly; thus, CMO investors may face holding their investment for longer than anticipated. While principal payments may be quite predictable for certain tranches or classes of a given CMO, other tranches of the same issue may be significantly less predictable.

In addition, certain tranches may be structured in such a way that, depending on interest rates and prepayments, investors are at substantial risk and may lose all or a substantial portion of their principal. The risks associated with these less predictable tranches may make them unsuitable for many retail investors. Members must evaluate the suitability of such high-risk tranches for each individual investor based on the investor's sophistication and high-risk profile, and must ensure that the investor is aware of the risks and characteristics of the tranche.

Maturity/Return of Principal/ Prepayment Assumptions

As discussed above, investors have to know that CMOs are not the same as conventional debt securities or CDs and that time to maturity may vary as well as the amount of principal returned. Further, investors need to know that prepayment assumptions—estimates based on historic prepayment rates for each particular type of mortgage loan under various economic conditions from various geographic areas—are factored into the offering price, yield, and market value of a CMO. Explaining prepayment assumptions is important because the realization of the average-life and- yield estimates depends on their accuracy.

Condition of the Secondary Market/Liquidity

While there is a sizable secondary market for CMOs generally, there is less of a market for the more risky and complex tranches. CMOs are less uniform than traditional mortgage-backed securities and more expensive to trade. It is also harder to obtain current pricing information. Matching up buyers and sellers is often difficult, especially for the more esoteric tranches. Members should remind investors that, by selling their CMOs rather than waiting for the final principal payment, the securities may be worth more or less than their original face value. In addition, members should clearly inform investors of extra costs or commissions associated with CMO transactions.

Impact of Purchasing at a Premium or a Discount

While the principles of purchasing CMOs at a discount or a premium are similar to those of Treasuries, members should inform investors of the consequences of such purchases. Members need to advise investors of the factors and pricing assumptions of the discount or premium. In particular, for securities purchased at a premium, it should be clear that any guarantees on the securities only apply to the par value of the security and not to any premium paid.

Interest-Only, Principal-Only, and Floater Tranches, Including Inverse Floaters

Principal-Only (PO) Securities

Some tranches are structured so that investors receive only principal payments generated by the underlying collateral. POs usually sell at a deep discount from face value on the assumption that the purchaser will ultimately receive the entire face value through scheduled payments and prepayments; however, the market values of POs are extremely sensitive to prepayment rates, which, in turn, vary with interest rate changes. If interest rates are falling and prepayments accelerate, the value of the PO will increase. On the other hand, if rates rise and prepayments slow, the value of the PO will drop.

Interest-Only (IO) Securities

These securities result from the creation of POs; thus, CMOs with PO tranches also have IO tranches. IO securities sell at a deep discount to their "notional" principal amount, namely the principal balance used to calculate the amount of interest due. They have no face or par value and, as the notional principal amortizes and prepays, the IO cash-flow declines.

Unlike POs, IOs increase in value when interest rates rise and prepayment rates slow; consequently they are often used to "hedge" portfolios against interest rate risk. IO investors should be mindful that if prepayment rates are high, they may actually receive less cash back than they initially invested. Because of these risks, a member may sell IOs only to a sophisticated investor maintaining a high-risk profile. The member should make sure the investor is aware of the risks and characteristics of IOs.

Floating-Rate Tranches

Floating-rate tranches or "floaters" carry interest rates tied to a variable interest rate index, such as the London Interbank Offered Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of Funds Index (COFI), subject to an upper limit or cap and sometimes to a lower limit or "floor." The performance of these investments also depends on the way interest rate movements affect prepayment rates and average lives.

Inverse Floaters (IFs)

Inverse floaters are structured to offset floating-rate tranches. Interest payments on IFs vary inversely with an index. Because IFs are more leveraged than other tranches, they have high price volatility as interest rates move. As the rate of the index drops, the interest rate on the IF rises at an accelerated pace. Conversely, rising rates cause an IF's interest payments to drop dramatically. At worst, rising rates will lower interest payments and extend return of principal beyond the anticipated average life. As with other high-risk tranches, IFs are only suitable for sophisticated investors with a high-risk profile and the investor must be made aware of the risks and characteristics of IF being purchased.

Accrual Bonds or Z-Tranches

The final tranche of a CMO is often structured as a Z-tranche or an accrual bond. Z-tranche holders receive no cash payments for an extended period of time. During the time that the earlier tranches are outstanding, a Z-tranche receives "accrued interest" which is credit for periodic interest payments that increase the face amount of the security at a compounded rate but are not actually paid out to investors. After all previous tranches are retired, the Z-tranche holders start receiving cash payments that include both principal and continuing interest.

While the presence of a Z-tranche can stabilize the cash flow in other tranches, the market value of Z-tranches can fluctuate widely, and their average life depends on other aspects of the offering. Because the interest on these securities is taxable when credited, even though the investor receives no actual payment, Z-tranches are often suggested as investments for tax-deferred retirement accounts. Thus, the wide variability of risk associated with Z-tranches requires member's suitability evaluations based on the combination of the Z-tranche with other investments as well as on the investor's sophistication and risk profile. The member must make the investor aware of the tranche's risks and characteristics.


The educational and regulatory initiatives discussed in this Notice will help members meet their obligations to investors under the Rules of Fair Practice and should prevent investor misunderstanding that could lead not only to dissatisfaction with CMOs as an investment, but also to potential violations of NASD rules and regulations. If you have any questions concerning this Notice, please contact Walter Robertson, Director, Compliance Department at (202) 728-8221.