New Appeal in Mortgage-Backed Securities

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New appeal in mortgage-backed securities

Post-tax-reform strategies of banks large and small point to CMOs and other mortgage-backed investments

Since the Tax Reform Act of 1986 became law, banks have realigned the look of their investment portfolios. According to bankers surveyed by ABA Banking Journal, mortgage-backed securities and collateralized mortgage obligations (CMOs) have replaced municipal bonds as the "hot" investment tool for banks.

"The mortgage-related products are the thing that more commercial banks are using in their strategies," says James W. Smith, Jr., senior vice-president at South Carolina National Bank, Columbia, S.C. "They seem to have much more appeal than the traditional Treasury purchases."

Charles Hall, executive vice-president of National City Bank in Cleveland and chairman of the ABA's Funds Management and Financial Markets Division, agrees that the popularity of mortgage-backed securities and CMOs has increased sharply, noting the market will respond to this by designing new products of increased complexity and higher risk.

G.B. Carrier Jr., executive vice-president, First Union National Bank, Charlotte, N.C., says mortgage-backed securities is the type of investment that requires a lot of active management. "But they provide attractive returns for the amount of risk at stake," he adds. Risk-based bonanza? A spokesman for Valley National Bank, Phoenix, Ariz., believes mortgage-backed products will become more popular among bankers as a result of the new risk-based capital guidelines.

"The benefits are clear," says the spokesman. "When you're looking at a decision variable which says: `I can either hold a whole loan with a risk-based weighting of 50% for a mortgage or I can pay 25 basis points--which represents the insurance premium and package into a Fannie Mae or Ginnie Mae pool--and that risk-based weighting drops to between 10% to 20%,' then there's a pretty persuasive argument to hold mortgage-backed securities versus loans."

The risk-based guidelines are welcomed by the bankers surveyed. These guidelines will require banks to have higher levels of capital for higher-risk investments. Risk groups are rated from 0% to 100%, with government securities considered a low risk and commercial loans a high one.

National City's Hall says most banks, especially regional banks, may look better from a capital standpoint under these guidelines. But he feels that money center banks will feel constrained because they have less equity capital proportionally than other banks, and have riskier assets.

"These guidelines will give us some opportunities to compete for business we couldn't in the past," says Smith at South Carolina National, noting the new rules will give his bank the ability to increase its leverage.

The Valley National spokesman echoes Smith's sentiments, saying the guidelines were "long overdue. It will put U.S. banking on a more equal footing with our foreign competition. The Japanese and some of the Europeans were more highly leveraged and were able to generate business at more competitive pricing." Community banks' portfolios. Risk based capital guidelines may encourage the increase of the investment activities of community banks. Community bankers surveyed for this article believe mortgage-backed products would be the best investment tool for their institutions. …