Academic journal article ABA Banking Journal

CMOs: Opportunity for the Open-Eyed

Academic journal article ABA Banking Journal

CMOs: Opportunity for the Open-Eyed

Article excerpt

In the hands of a skilled operator, a power saw can make short work of a cutting job. Likewise, in the hands of a banker who understands and uses them properly, collateralized mortgage obligations can prove an extremely useful investment and portfolio management tool.

But in the hands of an untutored user, CMOs, like a power saw, can be a risky proposition.

Bankers, consultants, and others experienced with CMOs agree that they have their place-sometimes a very significant one-in a bank's portfolio. Even bank regulators, who are considering some limits on CMO activity, believe there are varieties that are suitable for banks.

But all these parties also generally agree that CMOs are not instruments bankers can invest in and then forget. They hold out the promise of impressive rewards, but they also hold risks that simpler securities that they resemble don't carry. (See "Some basics about CMOS. )

Appeal of CMOS. In recent years, CMOs have grown more popular with both large and small banks.

As of March 31, banks held a bit more than $60 billion in collateralized mortgage obligations issued by the two dominant players in the market, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp., according to the latest available FDIC statistics. A year earlier, banks held $36.4 billion. (The 1990 figure is based on the first call reports to separately track CMO investments and may not be absolutely accurate.)

What's the appeal? There are several.

The first is the returns available on CM0s.

CMOs are divided up into various segments called "tranches" that resemble Treasury securities and other investments. As rates on Treasury securities have fallen and banks face lower loan demand in many markets, the higher rates available on CMOs prove attractive.

The second is relatively high credit quality. CMOs issued by Fannie Mae and Freddie Mac are generally guaranteed. The underlying mortgage-backed securities are typically also guaranteed. In spite of the controversy in Congress over the safety of "government-sponsored enterprises," as Fannie, Freddie, and others are called, rating agencies and investors who perform their own analyses consider the organizations highly creditworthy.

Additionally, home mortgages-the foundation for CMOs-are considered a strong type of credit.

A third factor is that carefully selected CMO tranches, such as the planned amortization class (PAC), provide a fair degree of certainly that a CMO investment will last for the term the bank investor selected. However, they generally only provide protection within a preset range of prepayment speeds.

Traditional mortgage-backed securities don't provide such certainty. If mortgages in a pool prepay at a faster rate than expected, the bank investor who purchased that security holds an instrument that is behaving differently than when he bought it.

In less volatile times, banks and other investors could match mortgage-backed securities to liabilities with similar maturities and cross their fingers that the two sides would match up. But that won't cut it today, according to Mike McCabe, director of investor marketing at Freddie Mac.

"They can't afford these days to have that mismatch be very great," McCabe explains. Banks that don't feel they can accurately plan for the risk of changes in prepayment speeds on mortgage-backed securities can often obtain some protection through a CMO tranche.

The increased certainty isn't free. The return will typically be higher on a straight mortgage-backed security because CMO investors pay for the management of cash flows that the CMO entails.

To varying degrees, bankers are willing to forgo the extra rate.

For example, John W Logan, executive vice-president for asset-liability management at $6.5 billion-assets First American Corp., Nashville, Tenn. …

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