The Securities and Exchange Commission has found that securities firms did not suffer severe losses on interest-only strips, despite record prepayments last summer.
This. however, is no reason to refrain from giving the National Association of Securities Dealers the authority to make suitability and sales practice rules for all government securities. including IO strips issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, the SEC said.
Repeal of language prohibiting the NASD from acting on government securities was contained in House and Senate versions of a bill to extend the Government Securities Act. But a conflict over committee Jurisdiction killed the congressional effort to extend the GSA. which expired a year ago.
"The volatility of these instruments underscores the absurdity of the exemption, in current law, of all government securities, including interest-only strips issued by government-sponsored enterprises, from the NASD's suitability and other sales practice rules," wrote SEC Chairman Richard C. Breeden to Rep. Edward J. Markey, D-Mass., chairman of the Telecommunications and Finance Subcommittee of the House Energy and Commerce Committee. "I look forward to working with you next year to eliminate this exemption, and to enacting the other government securities reforms we have worked towards this year."
For his part, Markey promised to "move quickly in the next session to enact a tough, comprehensive government securities reform bill that includes sales practice regulations, as well as other reforms needed to respond to abuses uncovered in the aftermath of the Salomon Bros. scandal."
The report reviewed IO positions of 16 of the largest U.S. securities firms as of the end of July or August. It found that none had IO positions in excess of 16% of their total MBS position, and most were lower than 10%. Two firms had long IO positions of between $400 million and $600 million; six had long IO positions between $100 million and $250 million and the eight others had long positions of less than $100 million.
Most of the finns did not offer prepayment caps. Those that did offer them did so through affiliates and in amounts that were insignificant compared to their total IO positions.
"Notwithstanding the size of these positions and the substantial decline in value of los during July, the surveyed firms which provided profit and loss figures for their july IO positions did not have significant losses on these positions,' the report said.
It found that three firms had losses of between $9.9 million and $13 million on their combined interest only/ principal only positions; two had losses of approximately $8 million of their 10 positions. Two had losses of about $5 million each on their IO positions. Three had losses on their IO or combined IO/PO positions of less than $500,000. One had a profit of about $150,000 on its combined IO/PO position.
According to the report, the losses were not material to the capital positions of the firms. Five firms did not report profit-and-loss figures for both months or did not separately report losses on their IO or IO/PO positions.
"The generally low level of losses as compared to the substantial decline in value of IOs during July largely reflects the fact that these firms are not holding IOs as long-term investments, but rather are holding them for trading and to provide liquidity for customers," the SEC said.
"In any event. the figures may very well overstate firm losses stemming from a decline in IO values since losses on IO positions can be expected to be offset, in whole or in part, by gains on other positions. This follows from the fact that while lower interest rates would result in a decline in the value of an IO portfolio, lower rates would also have a beneficial effect on the value of certain other securities, including positions in POs, certain other mortgage-hacked securities and longer-term Treasuries and agency debt securities."
This is supported by the fact that 10 of the 11 Firms reporting profit-and-loss figures for their entire MBS portfolios had profits in duly of more than $77.8 million, the report said.
Less is known about the experience of individual investors. Toward that end, the Chicago and New York regional offices of the SEC are examining sales practices of firms engaged in retail sales of IOs, POs and other MBS. In addition, the New York Stock Exchange is reviewing the disclosure, markups, customer suitability standards and sales practices of its firms engaged in retail sales of MBS and their derivatives. Also, the Public Securities Association is conducting such a review, concentrating on training sales persons and increasing investor awareness of the risks of such investments.
