Collateralized mortgage obligations: are they suitable for public investors?

• Author: Larson, M. Corinne

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...