Helping law catch up to markets: applying broker-dealer law to subprime mortgages.

Author:Macey, Jonathan R.
  1. INTRODUCTION II. FROM CONSUMPTION TO INVESTMENT: THE TRANSFORMATION OF THE MORTGAGE INDUSTRY A. The Evolution of Mortgages B. Subprime Mortgages III. SEC OVERSIGHT OF SUBPRIME MORTGAGE BROKERS A. Mortgages as Securities B. Mortgage Transactions "In Connection With" Purchases and Sales of Securities IV. SUITABILITY A. Suitability in the Securities Context B. Product vs. Transaction Suitability C. Transaction Form Suitability 1. Suitability in Margin Purchases 2. Suitability in Excessive Trading: Churning 3. Suitability in Commission Structure 4. Distinguishing Transaction Form and Securities Product Suitability D. Previous Mortgage Suitability Proposals V. HOW SUITABILITY MIGHT HAVE SAVED HOMEOWNERS VI. SOME PRACTICAL AND PUBLIC CHOICE CONSIDERATIONS A. Markets Transform Themselves Faster than Law B. The SEC Bureaucracy and Public Choice C. The Plaintiffs' Bar D. Litigation Prospects VII. CONCLUSION "By now everyone knows that reckless and even predatory mortgage lending provoked the financial meltdown."

    Editorial, The New York Times, October 19, 2008 (1)


    In this Article we make two claims. First, we argue that the current subprime mortgage and credit crisis would have been avoided, or at least greatly mitigated, if existing securities laws had been properly applied to subprime mortgage brokers and originators. Second, we argue that under any of what we regard as three reasonable interpretations of the securities laws, many of the problematic mortgage brokers are actually under the SEC's jurisdiction. (2) This tantalizing possibility does not appear to have occurred to anybody in this crisis, at least to this point.

    Katka would have loved this story: According to our current understanding of U.S. law, there is far better consumer protection for people who play the stock market than for people who are duped into buying a house with an exotically structured subprime mortgage, even when the mortgage instrument is immediately packaged and sold as part of a security. (3) We live on a peculiar legal landscape in which homeowners have almost no recourse under consumer protection laws against people who peddled unsuitable mortgages to them, unless the funds generated by the mortgage financing happened to have been used by the homeowner to purchase securities rather than a house.

    The bizarre juxtaposition between the plethora of legal rights afforded participants in the securities markets and the dearth of rights afforded participants in the mortgage market became clear in a lawsuit filed by the SEC on September 29, 2008 against a group of securities brokers in southern California. (4) These broker-dealers persuaded some of their customers to refinance their houses through a related mortgage company and to take the proceeds of the refinancing and use them to buy exotic securities known as variable universal life (VUL) policies, (5) which consist of a combination of a life insurance policy and an investment in equities.

    Consider one of the SEC's allegations in their Complaint. The SEC alleged that Gabriel Paredes, the marketing director of World Group Financial and a branch manager at Ainsworth Mortgage, recommended to Lorenzo Pelayo that Pelayo refinance his home with a negative amortization loan and use the proceeds to buy VUL securities. (6) Pelayo is a 41-year-old truck driver with a weak command of English, four children (ages four, five, seven, and nine), and a combined family income of $15,000. (7) Mr. Pelayo made an upfront payment for the VUL securities of $9000, all of which came from the proceeds of the refinancing. The VUL required monthly premiums in 2006 of $500, which over the course of the year equated to 40% of the Pelayo family's entire yearly household income. Pelayo's subprime mortgage contained a substantial prepayment penalty and the interest payments were variable rather than fixed, two facts that the SEC alleges were not properly disclosed. (8) The SEC alleged that the subprime mortgage was an unsuitable way for Pelayo to purchase securities that themselves were unsuitable for him. (9)

    The SEC's lawsuit is based on the assumption that the securities laws do not apply to these (or any other) mortgages. While mortgages are financial instruments for which the SEC does not claim jurisdiction, the SEC is taking the position that because the proceeds of the negative amortization mortgages were used to finance purchases of other financial instruments over which the SEC does have jurisdiction--the VUL securities--the entire transaction is covered by the securities laws, which ban fraudulent or misleading practices "in connection with" the purchase or sale of securities. (10) If Mr. Pelayo had used the proceeds of his refinancing to buy food or other necessities, the SEC would never have become involved in the case. It was an anomaly--the fact that that the proceeds of the subprime mortgage financing were used to buy securities rather than food, clothing, or shelter--that made the case of interest to the SEC.

    The point of this Article is to explore the different relationships underlying the governance of securities markets and mortgage transactions. We begin with the observation that there is a fiduciary relationship between customers and their brokers underlying securities transactions while caveat emptor governs the mortgage relationship. Legally, the dichotomy in the legal treatment of people who engage in mortgage financing and people who engage in securities transactions is based on two unexamined assumptions. The primary assumption is that mortgages are not securities, and the brokers who sell them are not securities broker-dealers, and therefore customers who deal in mortgages do not qualify for the standard consumer protection scheme available to people who deal in securities. The second assumption is that even where the issuance of a mortgage is part of a securitization process in which the mortgage payments will be bundled together with other mortgage payments and sold as securities the protections of the SEC's catch-all antifraud provision, Rule 10b-5, do not apply. For Rule 10b-5 to apply to a transaction, all that is required is that there be a misrepresentation or omission of a material fact "in connection with the purchase or sale of any security." (11) It seems clear, at least to us, that the issuance of a mortgage as an integral part of a securitization is a transaction "in connection with the purchase or sale of any security." (12)

    We take the view that this distinction, however valid it may have been in the past with respect to mortgage financings, no longer makes sense. Fundamental changes in the mortgage market and in the characteristics of mortgages themselves have transformed mortgage brokers into peddlers of financial instruments that share more than enough characteristics with the financial instruments that we call "securities" to permit people who obtain mortgages to qualify for certain legal protections that are routinely afforded those who transact in securities.

    Part II of this Article describes how the evolution of the mortgage industry has dramatically changed the economic properties of the financial products known as mortgages. We describe the growth of the subprime mortgage industry and the peculiar aspects of these transactions that make them entirely different from standard 30-year prime mortgages. We also briefly discuss the current (inadequate) protections for subprime borrowers. In Part III we give two independent arguments why the legal protections that apply to securities should also apply to protect purchasers of certain mortgage instruments, particularly so-called subprime mortgages. First we explore reasons for treatment of the subprime mortgage instruments as securities. We then make an innovative argument about how securitization has turned mortgages into products created "in connection with the purchase or sale of a security." (13) Under this line of argument the mortgage itself is not a security, but those brokering mortgage deals are responsible for violations of Rule 10b-5. In Part IV we explore why we might want such oversight for subprime mortgage brokers. We introduce one of the basic protections that exist for retail customers who purchase or sell securities, known as suitability. We then discuss previous attempts to introduce suitability into the mortgage industry and distinguish them from our proposal. In Part V we argue that if our approach would have been followed, much of the current economic misery confronting markets worldwide would have been avoided. Finally, in Part VI we speculate about why our suggested approach has not been previously considered, and address the likely fate of legal challenges to an SEC rule adopting our proposal.


    In a mortgage loan, (14) as in most loans, a lender (mortgagee) provides capital to a borrower (mortgagor) in return for the borrower's agreement to provide the lender a stream of payments in the future that pay back the principal amount of the loan plus interest. Because of the long stream of payments involved, a mortgage can be viewed as a type of annuity. The lender receives the payments and has a "long" position in the annuity; the borrower makes the payments and has a "short" position in the annuity. The distinguishing feature of a mortgage is that it involves the pledge of property as security for the mortgage loan. (15)

    1. The Evolution of Mortgages

      Historically, mortgage loans have had 30-year maturities. (16) This long time horizon allows home purchasers to spread the cost out over a large percentage of a working career and avoid the need to have all the money upfront at the time of purchase. In the past, a vast majority of the loans originated were fixed-rate loans on which the charged interest rate remained constant over time. Because market interest rates vary over time, such a loan structure...

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