132 F.3d 1017 (4th Cir. 1997), 97-1315, Banca Cremi, S.A. v. Alex. Brown & Sons, Inc.
|Citation:||132 F.3d 1017|
|Party Name:||BANCA CREMI, S.A., Institucion de Banca Multiple, Grupo Financiero Cremi; Banca Cremi Grand Cayman, Plaintiffs-Appellants, v. ALEX. BROWN & SONS, INCORPORATED; John Isaac Epley, Defendants-Appellees. Securities & Exchange Commission; PSA The Bond Market Trade Association, Amici Curiae.|
|Case Date:||December 30, 1997|
|Court:||United States Courts of Appeals, Court of Appeals for the Fourth Circuit|
Argued Sept. 29, 1997.
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ARGUED: Howard N. Feldman, Dickstein, Shapiro, Morin & Oshinsky, L.L.P., Washington, DC, for Appellants. Susan Sholar McDonald, Senior Litigation Counsel, Securities and Exchange Commission, Washington, DC, for Amicus Curiae SEC. Michael Roger Klein, Wilmer, Cutler & Pickering, Washington, DC, for Appellees. ON BRIEF: Howard Schiffman, Woody N. Peterson, Jennifer Tara Holubar, Dickstein, Shapiro, Morin & Oshinsky, L.L.P., Washington, DC, for Appellants. Richard H. Walker, General Counsel, Jacob H. Stillman, Associate General Counsel, Susan K. Straus, Securities and Exchange Commission, Washington, DC, for Amicus Curiae SEC. Robert F. Hoyt, Adam R. Waldman, Wilmer, Cutler & Pickering, Washington, DC, for Appellees. Peter Buscemi, Lloyd H. Feller, Morgan, Lewis & Bockius, L.L.P., Washington, DC; Robert C. Mendelson, Katherine M. Polk, Morgan, Lewis & Bockius, L.L.P., New York City; Paul Saltzman, Senior Vice President and General Counsel, PSA The Bond Market Trade Association, New York City, for Amicus Curiae Association.
Before LUTTIG and WILLIAMS, Circuit Judges, and MAGILL, Senior Circuit Judge of the United States Court of Appeals for the Eighth Circuit, sitting by designation.
Affirmed by published opinion. Senior Judge MAGILL wrote the opinion, in which Judge LUTTIG and Judge WILLIAMS joined.
MAGILL, Senior Circuit Judge:
Banca Cremi, S.A., Institucion de Banca Multiple, Grupo Financiero Cremi and Banca Cremi Grand Cayman (together, the Bank) purchased a number of collateralized mortgage obligations (CMOs) through John Isaac Epley, a broker with the brokerage firm of Alex. Brown & Sons, Incorporated (Alex. Brown). Although most of its CMO purchases were profitable, the Bank lost money on six CMO purchases after the market in CMOs collapsed in 1994. The Bank brought suit in the district court against Epley and Alex. Brown, alleging that Epley and Alex. Brown had committed securities fraud in violation of § 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, by making material misrepresentations and omissions regarding the CMOs, by selling securities that were unsuitable, and by charging excessive markups. The Bank also alleged Texas state common-law tort claims for fraud, negligence, negligent misrepresentation,
and breach of fiduciary duty, and a claim based on the Maryland Securities Act. The district court granted Epley and Alex. Brown's motion for summary judgment on all of the Bank's claims, 1 and the Bank now appeals. We affirm.
CMOs, first introduced in 1983, are securities derived from pools of private home mortgages backed by U.S. government-sponsored enterprises. 2 From 1987 to 1993, U.S. government-sponsored CMO issuances grew dramatically, from $900 million to $311 billion per year. The market in CMOs largely collapsed in 1994, and in 1995 new issuances fell to $25.4 billion.
Historically, investments in fixed-rate home mortgages have not been attractive to institutional investors. Investors in most fixed-rate securities benefit when interest rates fall. The fixed-rate security then earns interest at a rate higher than decreased prevailing rates. However, unlike other fixed-rate investments such as U.S. treasuries, fixed-rate home mortgages do not benefit from declines in interest rates. Because home mortgages may be freely prepaid, home owners frequently refinance their homes to take advantage of a drop in interest rates. When the mortgage is prepaid, the investor's funds are returned. If the investor seeks to reinvest those funds, as would be the case with most institutional investors, they must be reinvested at the low prevailing rate, rather than earning interest at the higher rate of the original mortgage. This is called the "prepayment risk." If interest rates rise, home mortgages are generally not refinanced, and they lose value just like any other fixed-rate security. Thus, investments in home mortgages perform poorly both when interest rates rise and when they fall.
CMOs concentrate the prepayment risk in some securities in order to reduce that risk in other securities. In so doing, CMOs were designed to make home mortgage investments more attractive to institutional investors, increase the liquidity in the secondary home mortgage market, and reduce the interest costs to consumers buying homes.
A CMO issuer begins with a large pool of home mortgages, often worth billions of dollars. Each pool of home mortgages generates two streams of income. The first income stream is the aggregate of all interest payments made on the underlying mortgages. The second income stream is the aggregate of all principal payments made on the underlying mortgages. These income streams are divided into numerous CMO "tranches," which are the securities sold to investors. To determine what portion of the two income streams are received by an investor in a CMO tranche, each tranche has two unique formulae: one that determines the tranche's interest rate, and the other that determines the tranche's principal repayment priority.
The interest rate on a CMO tranche can be a fixed rate, a floating rate, or a rate that floats inversely to an index rate. Floating interest rates can also be leveraged, meaning that the interest rate shifts more dramatically than the index rate. For example, where a floating rate CMO is leveraged by a multiplier of two, the CMO's interest rate will increase by two percent when the index rate increases by one percent.
The tranche's principal repayment priority determines when the tranche will receive principal payments made on the underlying mortgages. Each principal payment is divided among all of the tranches in a CMO issuance. High priority tranches receive principal payments first. Support tranches receive principal payments last. Because of this, support tranches are the most sensitive to "extension risk." Extension risk is the opposite of prepayment risk: when interest rates rise, the expected maturity of the support tranche CMO increases, often dramatically.
CMO tranches are categorized into classes which have similar properties and risks. The least risky is the planned amortization class (PAC). PACs have little prepayment risk, and appeal to institutional investors for this reason. Two of the riskiest classes of CMOs, inverse floaters and inverse interest-only strips, are at issue in this litigation.
Inverse floaters have a set principal amount and earn interest at a rate that moves inversely to a specified floating index rate. Inverse floaters will often be leveraged, so a small increase in interest rates causes a dramatic decrease in the inverse floating rate. Usually, inverse floaters are also support tranches, so an increase in interest rates causes their maturity date to extend. Inverse floaters earn high returns if interest rates decline or remain constant, but lose substantial value if interest rates increase.
Inverse interest-only strips (inverse IOs) do not receive principal payments. The interest rate for an inverse IO floats inversely to a specified index rate, like an inverse floater. Interest is calculated by reference to the outstanding principal amount of another reference tranche. As the reference tranche is paid off, the principal on which the inverse IO earns interest decreases accordingly. Like an inverse floater, a rate increase reduces the inverse IO's floating rate. According to some investors, a rate increase also reduces prepayment of the reference tranche, extending the maturity of the inverse IO and, ultimately, increasing the total interest payments made on the inverse IO.
Inverse floaters were first introduced in 1986. Inverse IOs were introduced in 1987. Markets for both of these securities remained strong in the environment of decreasing or stable interest rates that predominated between 1986 and the beginning of 1994. On February 4, 1994, the Federal Reserve Board increased short-term interest rates for the first time in five years. Over the next nine months, short-term rates increased by a total of 2.5 percent, from 3 percent to 5.5 percent. In response to the rate increases, a wave of selling hit bond markets and investors in all types of bonds suffered significant losses. 3
CMOs were particularly hard hit, for a variety of reasons. The jump in rates halted mortgage prepayments. This in turn extended the average maturity of all CMOs, including, most dramatically, support tranche CMOs such as inverse floaters. Because of their degree of leverage, certain CMOs were extremely sensitive to the interest rate jumps, and their holders flooded the market after the first interest rate increase. CMO liquidity, which had never been a problem in the stable or declining interest rate environment that had existed since their introduction, dried up as all CMO holders tried to sell. The fear of liquidity problems built on itself, reducing the number of willing purchasers during the critical period after the Federal Reserve Board increased interest rates. In April 1994 an investment fund which primarily invested in CMOs filed for bankruptcy, reporting near total losses of its $600 million CMO...
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