Ins and Outs of CMO Investing

Ever since interest rates on certificates of deposit and Treasury bills fell into the basement, investors have been looking for safe, higher-yielding alternatives. And that’s led many people to collateralized mortgage obligations, better known as CMOs.

Some brokers will tell you that investing in CMOs is almost as simple as buying a CD, but buying a CMO is actually much more like buying a car. There are all sorts of makes, models and prices. Some are terrific deals and some are lemons. You’ve got to shop carefully, with an eye for what’s under the hood.

That requires a bit of knowledge about financial mechanics. So we’ll start with CMO-101.

A CMO starts life as a mortgage. John and Jane Doe buy a house and finance it with a $100,000 loan. Their bank then sells the Does’ mortgage to a third-party--usually one of several quasi-governmental agencies such as the Government National Mortgage Assn. (Ginnie Mae), the Federal National Mortgage Assn. (Fannie Mae) or the Federal Home Loan Mortgage Corp. (Freddie Mac).

Ginnie, Freddie or Fannie, which, despite the cutesy names, are major corporations that have some U.S. government backing, take the Does’ mortgage and put it into a “pool” of similar mortgages that pay like amounts of interest and expect to pay off at the same time.

They then sell interests in this pool of mortgages to investors. What investors get is a bond that pays somewhat less than what the Does are paying on their mortgage. (If the Does pay 9%, for example, the investors may get 8%. The 1% difference is eaten up in fees and charges.) Investors also get a guarantee from Fannie, Freddie or Ginnie that says these organizations will make up investor losses if the Does default on their payments.

Ginnies, Freddies and Fannies are generically referred to as mortgage-backed securities. And as far as investors are concerned, the only problem with these securities is the Does.

When interest rates fall, the Does refinance their mortgage. So instead of getting comparatively high rates of interest for 30 years, investors get back their principal. In market parlance, that’s called prepayment risk.

When rates rise, the Does hang onto their lower-rate mortgage and investors are stuck with comparatively low-yielding securities for 30 years. That’s interest rate risk.

Investment bankers can’t force the Does to do what they want them to do. But they can find ways to rejigger Fannies, Freddies and Ginnies to shift some of the interest rate risk and prepayment risk around. And that’s precisely what they’ve done with CMOs.

They take a mortgage-backed security and slice it into pieces. Each piece represents a part of the Does’ mortgage.

One piece may give the CMO investor rights to a third of the Does’ interest payments, plus the first repayment of principal. The second piece may get the next principal payoff, plus interest. And a third category may be structured like a zero coupon bond, where the investor doesn’t get anything until the bond matures.

Investors in the first category may have the greatest risk of prepayment, while those in the final category may bear most of the interest rate risk. Investment bankers estimate values for these risks and then price the bonds based on how fast they assume the mortgages will pay off--in brokerese, these are prepayment assumptions, or “PSAs.”

Consequently, some CMOs, which usually sell in minimum denominations ranging between $1,000 and $25,000, sell for less than their face value, while others sell for more.

CMOs backed by Ginnies, Fannies and Freddies bear virtually no principal risk. But investment bankers still don’t know exactly what the Does are going to do. So investors have to realize that the life and yield of this investment may be different than what’s been projected.

Investors should also realize that some CMOs are not backed by Ginnies, Freddies and Fannies. Those that aren’t do carry some risk to investors’ principal.

What can investors do to limit their risk? First make sure the CMO they’re buying is backed by one of these quasi-governmental agencies. Secondly, find out what category is being sold and what risks are associated with it.

Then find out what sort of prepayment assumptions the broker is making to estimate the annual interest rate and find out what would happen to your yield if the assumptions were higher or lower. And consider what yields you could get on a Treasury and a corporate bond. (The Treasury yield will usually be lower, since there are fewer risks to investing in Treasuries. The corporate bond yield should be higher.)

Finally, choose your broker carefully. If the broker can explain the risks, lead you through the prepayment assumptions and yields on similar investments, you’ll probably do fine. But brokers who can’t provide these explanations are not in a position to help you evaluate this investment, so stay clear.