Mortgage-Backed Securities

MBS are debt securities that are created from residential mortgages. The activities of dealers marketing OTC derivatives that are determined to be futures are subject to the Commodity Futures Trading Commission’s (CFTC) oversight. Most OTC derivatives are not considered to be securities or futures by the dealers offering them. Objectives, Scope, and Methodology

To address congressional concerns associated with sales practices for OTC derivatives, MBS, and structured notes, our objectives were to analyze (1) the federal sales practice requirements applicable to these products and the dealers marketing them; (2) the extent of end-user satisfaction with sales practices, product use, and related disputes and the costs of these disputes; (3) the views of end-users and dealers on the nature of their relationship and responsibilities; (4) the actions dealers and end-users have taken to reduce the potential for sales practice disputes; and (5) the actions regulators have taken to address sales practice issues. In addition, we reviewed the sales practice guidance provided by federal bank regulators for their examiners and the dealers they oversee. To analyze the actions that regulators have taken to address sales practice issues, we interviewed federal financial market regulators. Federal Sales Practice Requirements Vary by Product and Dealer

The federal sales practice requirements designed to protect end-users of OTC derivatives vary, depending, in part, on whether the specific product in question is a security, a futures contract, or neither product. State Statutory and Common Law Claims Would Be Asserted in Disputes Involving OTC Derivatives That Are Not Subject to Federal Laws

To the extent that OTC derivatives are not covered by either the federal securities or commodities laws, an end-user alleging sales practice misconduct by a dealer would need to seek relief by asserting primarily state statutory or common law claims, such as fraud or breach of fiduciary duty. MBS and Structured Notes Are Typically Subject to the Securities Laws

MBS and structured notes are typically considered to be securities and subject to the federal securities laws, except when exempted from specific provisions. Securities, futures, and insurance firms typically conduct their nonsecurities and nonfutures OTC derivatives marketing in affiliates not subject to direct federal oversight, although some individual transactions may be subject to oversight. Review of regulatory and other data indicated that cases involving sales practice disputes were not widespread. Most End-Users Were Generally Satisfied With Dealer Sales Practices

According to our 1995 survey of a wide range of U.S. organizations, most end-users were generally satisfied with the sales practices of the dealers that marketed OTC derivatives, MBS, and structured notes to them. 6). However, end-users’ views on counterparty relationships differed from those reflected in voluntary guidance issued by two groups of dealer representatives. In contrast to banking regulators, the regulatory authority of SEC and CFTC does not extend to the unregulated affiliates of the firms they otherwise regulate. 3). Conclusions and Recommendations

		Conclusions

Although OTC derivatives are subject to sales practice requirements that vary, depending on the dealer or specific product involved, our survey found that most end-users of these products were generally satisfied with the sales practices of dealers with whom they did business.
Why GAO Did This Study

Pursuant to a congressional request, GAO reviewed the sales practices for over-the-counter (OTC) derivatives, mortgage-backed securities (MBS), and structured notes, focusing on the: (1) federal sales practice requirements applicable to these products and the dealers marketing them; (2) extent of end-user satisfaction with sales practice, product use, and related disputes and the costs of these disputes; (3) views of end-users and dealers on the nature of their relationship and responsibilities; (4) actions dealers and end-users have taken to reduce the potential for sales practice disputes; and (5) actions regulators have taken to address sales practice issues.

What GAO Found

GAO noted that: (1) the extent to which OTC derivatives are subject to federal sales practice requirements intended to protect end-users varies, depending, in part, on whether they are considered to be securities, futures, or neither; (2) when they are considered to be securities or futures, their sale is covered by the federal securities or commodities laws, and they are regulated by the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), respectively; (3) to the extent that these products are not securities or futures, end-users with sales practice disputes would need to seek redress against a dealer by asserting primarily state statutory or common law claims; (4) in contrast to most OTC derivatives, MBS and structured notes are typically securities and, thereby, subject to the federal securities laws, except when exempted from specific provisions; (5) the extent to which sales practice requirements apply to the dealers marketing OTC derivatives in the United States also varies, depending on whether the dealer offering them is regulated; (6) when OTC derivatives are marketed by banks, they are subject to supervisory guidance issued by federal bank regulators; (7) securities, futures, and insurance firms, unlike banks, typically market OTC derivatives that they consider to be neither securities nor futures from affiliates that are not subject to any direct federal financial regulatory oversight, although some individual transactions may be subject to such oversight; (8) although sales practice requirements vary by product and dealer, according to GAO's survey, most end-users were generally satisfied with the sales practices of the dealers with whom they entered transactions; (9) GAO's survey also found that relatively few organizations reported using OTC derivatives; (10) GAO's review of regulatory and public records, covering 1993 through 1996, indicated that cases involving actual or alleged deficiencies in dealer sales practices were limited in number; (11) however, the dealers and end-users involved in these cases often experienced significant costs; (12) although generally satisfied with dealer sales practices, end-users' views on the nature of counterparty relationships sometimes differed from those of dealers; (13) in addition, bank regulators have taken certain actions to address sales practice issues; and (14) although SEC and CFTC do not directly regulate the affiliates that securities and futures firms use to conduct their OTC derivatives activities, SEC and CFTC worked with the most active of these firms to produce one of two sets of voluntary guidance.