Academic journal article ABA Banking Journal

Rates Prompt Change in CMO Strategies

Academic journal article ABA Banking Journal

Rates Prompt Change in CMO Strategies

Article excerpt

The runup in mortgage prepayments brought on by refinancings has focused bank investor attention on collateralized mortgage obligations (CMOs) and other mortgage-backed securities. The subject was much discussed at ABA's recent National Conference for Bank Portfolio Managers and Bank Broker/Dealers.

* Changing flavors-In early February, fixed mortgage rates were rising into the high 8s but prepayments were coming on stream on loans refinanced when rates were in the low 8s. As a result, many collateralized mortgage obligation planned amortization classes (PACs) had exceeded their protected range of prepayments.

Thus, many PACs in 9.5% CMOs were metamorphosing into "vanilla" CMO classes, according to Shelly Orjuela, a vice-president at J.P. Morgan Securities, Inc., who spoke at the conference. Regular vanilla classes, also called sequentials, are paid off strictly according to maturity and prepayment speed. They are the most basic CMO "tranche."

Orjuela explained that "support" and "companion" tranches typically protect PAC classes from prepayment risk. However, once the protection the specialized classes provide erodes, PACs are impacted.

Orjuela predicted that CMO issuers would have to structure more support and companion classes into future deals. She said PAC investors, having been through the current environment, would demand broader protection. She doubted that overall demand for CMOs would fall, but said all investors, including banks, will be more selective. " She expected investors to focus on securities backed by lower-rate loans--those in the range of 8%-which would enjoy greater protection from prepayments once market rates reach higher levels. …

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