Collateralized mortgage obligations: are they suitable for public investors?

As an investor of public funds, you need to be aware of the effect of rising interest rates on the value of collateralized mortgage obligations or CMOs. These securities can experience more volatility than plain vanilla security types like Treasury notes and bonds. Investors holding CMOs in their portfolios may be in for a bumpy ride. CMOs can be complex and difficult to understand for investors who are accustomed to purchasing fixed-income securities with stated maturity dates. This article will describe what CMOs are and how they are issued, what makes these securities unique, and how to evaluate the various risks associated with CMOs.

WHAT ARE CMOs AND HOW ARE THEY ISSUED?

CMOs were first introduced in June 1983 by the Federal Home Loan Mortgage Corporation to provide investors with a mortgage-backed security that would come in a variety of investment time frames and offer more cash-flow certainty. CMOs became popular with the passage of the Tax Reform Act of 1986 that allowed these securities to be issued in the form of real estate mortgage investment conduits, which offer tax advantages to institutional investors. Almost all CMOs issued today are in the form of real estate mortgage investment conduits. According to The Bond Market Association, the total volume of outstanding CMOs as of June 30, 2002, was $892.2 billion. (1)

Mortgage pass-through securities are created from pooling mortgage loans. These securities are commonly referred to as mortgage-backed securities or participation certificates. Investors in such securities have a direct ownership interest in the pool of mortgage loans. CMOs are created by packaging mortgage pass-through securities (or in some cases mortgage loans themselves) into a multi-class security offering, using the underlying pool of mortgages as collateral.

Issuers of CMOs. Common issuers of CMOs include the Government National Mortgage Association (Ginnie Mae) and government-sponsored enterprises such as the Federal Home Loan Mortgage Association (Freddie Mac) and the Federal National Mortgage Association (Fannie Mae). Private entities such as financial institutions, investment banks, and homebuilders also issue CMOs. These are known as private labels and are the sole obligation of the issuer.

Ratings. The guarantees of CMOs differ according to the type of organization each issuer represents. Ginnie Mae, a government agency, guarantees the timely payment of principal and interest and is backed by the full faith and credit of the U.S. government. Because Fannie Mae and Freddie Mac are government-sponsored enterprises, they do not carry the U.S. government guarantee; however, they do guarantee the timely payment of both principal and interest. CMOs issued by government-sponsored enterprises generally carry a triple-A credit rating. CMOs issued by private institutions may be backed by pools of mortgages, letters of credit, or other types of credit enhancement, and may also carry a triple-A credit rating. Investors should verify the credit ratings before investing in these securities.

WHAT MAKES A CMO UNIQUE?

CMOs differ from other fixed income securities in that principal and interest payments depend on the homeowners' mortgage payments. One distinguishing characteristic of CMOs is that they are described in terms of their average lives rather than stated maturity dates. The security matures when the mortgage is paid off. Investors receive principal and interest payments in varying amounts over the life of the security. Another unique characteristic of CMOs is that interest is paid monthly or quarterly, not semiannually like most bonds. As a result, investors have use of their interest income sooner than bond investors. Because of this, yields on CMOs are discussed in terms of bond equivalent yields, which are based on the actual CMO yield adjusted to account for the present value of more frequent interest payments.

Prepayment Speeds, Yields, and Interest Rate Changes. The average life of a CMO is estimated based on prepayment speeds. When interest rates are falling, homeowners tend to pay off their mortgages early (usually by refinancing at a lower rate), causing the prepayment speed to be faster than expected. When interest rates are rising, homeowners tend to hold on to their original mortgages and prepayment speeds slow down. When evaluating a CMO, investors should keep in mind that the average life of a security is an estimate and will vary based on the actual prepayment speed of the underlying mortgage.

Depending on the type of CMO, these prepayment speeds will have a significant impact on how the investor receives principal and interest payments. Keep in mind that prepayment assumptions are simply estimates based on historic prepayment rates. The offering price, yield, and market value of a CMO factor in the particular mortgage type and how it will react under various economic conditions in different geographic areas. The Bond Market Association has developed a model based on the assumption that new mortgage loans are less likely to be prepaid than older loans. Under this model, projected and historical prepayment rates are expressed as a percentage of prepayment speed assumptions. (2)

Because of the uncertainty of prepayment speeds. CMOs will have a higher yield than comparable fixed income securities. Many investors interpret this higher yield as a better value than a plain vanilla security. However, investors should keep in mind that the higher yield is compensating them for the uncertainty of the life of the security. The estimated yield on a CMO is based on its estimated average life. If actual prepayments are faster or slower than expected, the investor will realize a yield that differs from the quoted yield at the time of purchase. For example, securities purchased at a discount to face value will experience an increase in the yield to maturity if prepayment speeds are faster than expected and will experience a decrease in yield to maturity if prepayment speeds are slower than expected. Conversely, securities purchased at a premium will have a lower yield to maturity when prepayment speeds are faster and a higher yield to maturity when prepayment speeds are slower than expected.

Types of CMOs. CMOs come in different classes called "tranches," which comes from a French word meaning to slice. Cash flows in the form of principal and interest payments from the underlying mortgages are directed to each tranche in a prescribed manner. Generally, each tranche receives an interest payment on a stated payment date. Principal payments are then allocated to the different tranches based on a priority schedule determined at the time the CMO offering was created. The order of principal payments is specified in the CMO prospectus or offering circular. Each tranche has an estimated first payment date and an estimated last principal payment date. The tranche receiving principal repayments is referred to as "active" or "currently paying." The period before principal repayments begin is known as the "lock-out" period and the period during which principal repayments are expected to occur is called the "window." (3) The principal payment dates will vary depending on the actual prepayments of the underlying mortgages.

The most basic type of CMO is the "plain vanilla," "clean," or "sequential pay" offering. With this structure, the tranches pay in strict sequential order and each tranche receives regular interest payments. Principal payments are allocated to the first tranche until it is completely paid off and then payments are allocated to subsequent tranches until they are retired. Exhibit 1 illustrates how the payment sequence works.

Each tranche of a sequential pay CMO has a different average life. The first tranche typically has an average life of two to three years, the second tranche five to seven years, the third tranche 10 to 12 years, and subsequent tranches even longer lives. Some CMO issues can have more than 50 tranches with varying structures and can be quite complex. Common types of CMO tranches include:

* Planned Amortization Class tranches establish a fixed principal payment schedule by using a PAC tranche and a companion tranche to smooth out the effects of prepayments, whether they are slower than expected or faster than expected. The PAC receives the scheduled principal payment and the companion tranche receives excess payments, particularly when prepayments are heavy. If prepayments are minimal, the PAC tranche will be paid off first and the companion tranche will receive payments later. Within this class of CMOs there are Type I tranches that maintain their schedules over a wide range of prepayment speeds, and Type II and Type 111 tranches that function as companion tranches to higher priority tranches. According to The Bond Market Association, PACs represent over 50 percent of the new-issue market. PACs are usually offered at a lower yield than other types of tranches because of their high degree of cash-flow certainty.

* Targeted Amortization Class tranches also provide some cash-flow certainty and a fixed principal payment schedule. However, if prepayment speeds are higher or lower than expected, the actual performance of the TAC tranche will be affected, depending on its priority in the CMO structure and whether a PAC tranche is also present. If a PAC tranche exists, the TAC tranche will have leas cash-flow certainty. The yields on TAC tranches typically will be higher than PAC tranches but lower than companion tranches.

* Companion tranches exist in every CMO that has PAC and TAC tranches and are sometimes referred to as support bonds. Once the principal is paid to a PAC or TAC tranche, the companion tranche will receive the excess or shortfall in payments. The average life of a companion tranche may vary widely, increasing when interest rates rise and decreasing when interest rates fall. Companion tranches may offer a higher initial yield to compensate the investor for the uncertainty of principal repayment.

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