Collateralized mortgage obligations as investment instruments: what is the risk?

• Author: Nadler, James D.

Although CMOs are among the most complex and intricate securities ever created, these exotic new debt instruments can enhance portfolio returns for savvy managers.

As interest rates move to 20-year lows, public investors and pension fund managers who assume certain yields on investments face the prospect of embarrassing results. The apparent high quality and attractive yields of collateralized mortgage obligations (CMOs) are appealing. Indeed, these exotic new derivative debt instruments backed by home mortgages can enhance returns in public fund portfolios for savvy managers who know what they are buying.

CMOs are among the most complex and intricate securities ever created. They were devised by Wall Street's brightest marketeers in an attempt to remove an uncertainty inherent in all mortgage debt: the impact that market conditions will have on mortgage prepayments. CMOs were engineered to deal with that uncertainty.

Billed as having AAA credit quality while offering yields exceeding U.S. Treasury instruments, CMOs constitute a huge market, accounting for about one-half of the $1.2 trillion of mortgage debt issued. Yet they have received their share of bad press. The following sample of headlines illustrates how the media have portrayed the CMO.

* "The CMO Return You See May Not Be What You Get," Wall Street Journal headline, August 3, 1992.

* "Choosing CMO Bond Fraught with Danger," Knight-Ridder News Service, April 1992.

* Of CMOs: ". . .precious few investors realize they have a tiger by the tail," Business Week, January 1992.

* "Insurance Regulators Express Concern Over Safety of Certain Types of CMOs," Wall Street Journal, June 6, 1992.

With this kind of press, it is no mystery that state and local governments are cautious about CMOs.

In a session on investing public funds at the Government Finance Officers Association's 1992 annual conference, attendees were warned against blindly using exotic securities to reach for yield. As an alternative, one speaker suggested CMOs with volatility ratings, or "V-ratings," which assess the safety of individual tranches. A tranche is a security created by dividing a CMO into pieces with different characteristics. Some have predictable price, cash flow and total return, and are stable, while others do not, and are volatile when market conditions vary.

V-ratings, launched by Fitch Investors Service in February 1992, measure volatility of individual tranches on a V1 through V5 scale to gauge market risk in the face of changing interest rates. Other means for measuring or containing the risk of CMOs exist as well. Banks and thrifts must comply with Federal Financial Institutions Examinations Council (FFIEC) codes for CMO safety, dubbed the "pass-fail" test. Separately, insurance regulators are studying various safety measures for CMO investments by that industry. California recently specified V-rated CMOs for its pooled investments as a way of quantifying the risk. Other states, such as South Carolina, are being asked by underwriters to examine the investment merits of rated tranches.

Mortgage-backed Debt

Thrifts and mortgage lenders sell mortgages to federal agencies such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Association (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae). Hundreds of mortgages are pooled to create mortgage obligations which are marketed to investors. Holders are paid from proceeds of...