Advertising of Collateralized Mortgage Obligations by NASD Members

EXECUTIVE SUMMARY

The NASD Fixed Income Securities Committee has considered the need for adequate disclosure in advertising relating to collateralized mortgage obligations (CMOs). The committee has determined that such advertising should not include comparisons with other investment products, should include the final maturity date, should describe the initial issue tranche, and should make disclosures regarding the uncertainty of the yield, based on changes in prepayment assumptions and market conditions. The committee recommends that advertising relating to corporate and government CMOs be filed with the NASD Advertising Department for review prior to use. The committee also created a subcommittee to further study concerns about CMO advertising and sales practices.

As interest rates have continued to decline, many NASD members have directed their marketing efforts toward offering products to investors that provide higher yields than could be realized, for example, by certificates of deposit (CDs) or money market funds. One such effort has focused on the offer of collateralized mortgage obligations through print, television, and radio advertising.

These advertisements are subject to the standards, including filing requirements, set forth in Section 8 of the NASD Government Securities Rules if the CMOs advertised are agency issues. If they are corporate securities registered under the Securities Act of 1933, they are subject to the standards set forth in Article III, Section 35 of the NASD Rules of Fair Practice. The standards prohibit false and misleading advertising and are essentially identical in each of the rules.

Generally, the advertisements the NASD has seen members using characterize the CMOs as offering high yields, safety, government guarantees and high liquidity, and frequently compare them with CDs. CMOs are extremely complex and require full and fair disclosure to assist the investor in understanding them. An article in the September 1991 edition of the NASD Regulatory and Compliance Alert outlined some of the important areas of disclosure that should be addressed in members' sales materials and cautioned members about this type of advertising. The text of that article is included in this Notice.

The NASD Advertising Department has since received an increasing number of CMO advertisements for review; there has also been a substantial increase in the number of complaints involving CMOs. Several NASD members have expressed concerns that the complexity and unpredictability of the securities necessitates a closer look at the regulations governing the content of such materials. All CMOs do not have the same characteristics, and it is difficult, if not impossible, to distinguish the differences based on the content of an advertisement. Even though two CMOs may have the same underlying collateral, they may differ greatly in their prepayment predictability or volatility.

The NASD's Fixed Income Securities Committee has reviewed the concerns relating to CMO advertisements, and it concurred that CMOs are complex instruments not easily understood by investors. It also supported efforts to clarify the standards for such advertisements and the information provided in them. The committee made several recommendations designed to prevent the content of CMO advertisements from being deemed misleading, and it directed the staff to notify the membership of its determinations in both this Notice and in comments resulting from the review of advertising.

The committee recommends the following standards to ensure that CMO advertising is not false or misleading:

The committee believed that false and/or misleading CMO advertising could be prevented if the material was filed with the NASD Advertising Department for review prior to use, and urges members to do so. This filing would allow the department to comment on the advertisement's fairness and reasonableness before the public receives the information. Problem advertisements could therefore be identified and withheld from or modified prior to publication.

The committee created a subcommittee to explore additional alternatives to address problems in the area of CMO advertising and sales practices.

In the meantime, members are reminded of their existing obligations to weigh the suitability of investments for each customer. Members must also ensure that adequate disclosures, including risks, are being made to customers and that their compliance and supervisory efforts focus on these important areas.

Questions regarding this Notice may be directed to Clark Hooper, Advertising Department, at (202) 728-8330.

(Reprinted from NASD Regulatory & Compliance Alert, September 1991, All rights reserved.)

NASD ADVERTISING DEPARTMENT NOTES SHORTCOMINGS IN CMO LITERATURE

The NASD's Advertising Department has received member advertising and sales literature promoting collateralized mortgage obligations (CMOs) that did not comply with NASD requirements.

CMOs are bonds backed by a pool or mortgages or mortgage certificates that are issued by either government agencies or private investment banking firms.

Although the collateral backing CMOs is typically issued by a government or government-sponsored entity, only those CMOs issued by a government entity carry a government guarantee.

Advertisements for government agency issues are subject to regulation under Section 8 of the NASD Government Securities Rules, and those for private-issue CMOs fall under Article III, Section 35 of the NASD Rules of Fair Practice. The standards of Section 8 generally match those of Section 35 with one major exception.

Section 8(c)(1) requires NASD members to file government securities advertisements with the Advertising Department within 10 days of first use.

Therefore, if a member publishes or broadcasts an advertisement for a CMO issued by a government agency, the member must submit the piece for review.

Like yields on other mortgage-backed issues, CMO yields are generally quoted as estimated-bond-equivalent yields based on an assumed prepayment rate derived from the Public Securities Association benchmark.

When preparing this type of yield, NASD member firms must use a prepayment rate that is reasonable under the circumstances.

Although the estimated yield lets an investor compare a CMO with conventional bonds, not all investors realize the yield is an estimate and that the actual yield may vary.

Thus, advertisements should identify the yield as an estimate based on an assumed prepayment rate and explain that the investor's actual yield will vary depending on the actual prepayments and market conditions.

The ad should disclose the prepayment assumption. Members should also provide the coupon rate and price of the security used in computing the yield as well as the effective date for calculating the yield. Communications should accurately depict the guarantees associated with CMO securities.

For example, in most cases, it would be misleading to state that CMOs are government-guaranteed securities. Instead, members may characterize government agency issues as "government agency guaranteed." If a private-issue CMO contains a pool of guaranteed securities, this relationship may be described.

For example, an advertisement could state that a Government National Mortgage Association collateralized issue includes securities that carry the full faith and credit guarantee of the U.S. government.

In addition, advertisements should clearly indicate that the guarantees apply only to the timely payment of principal and interest.

Furthermore, when referring to guarantees, communications should state that neither the market value nor the yield of the CMO is guaranteed.

Both Section 8 and Article III, Section 35 prohibit exaggerated and misleading language. Therefore, members should not overstate the relative safety offered by the bonds.

Although CMOs generally offer low credit risk, like all investment securities they are subject to market risk.

In addition, despite the greater predictability of prepayments provided by the CMO structure, the securities remain subject to prepayment risk, and this fact should be made clear.

Members should avoid describing yields for bonds with particularly long maturities (i.e., more than 10 years) as predictable. Any reference to predictability should be balanced by disclosure of the prepayment risks associated with the securities.

Although private issuers frequently obtain credit ratings for their CMO issues, government agencies do not usually seek these ratings because agency securities are considered to have an implied AAA rating.

While the Advertising Department would not object to member firms describing government agency CMOs as having an "implied AAA rating," members should avoid references to "AAA rated" unless such rating has actually been obtained.