The efforts of regulators to control the amount and type of collateralized mortgage obligations that can be held by insurance companies has not diminished their popularity.
Increased investments by the insurance companies have been a significant factor in the phenomenal growth of the CMO market.
The shift of insurers' investments from commercial real estate lending to securities is resulting in more money being pumped into an industry weakened by the decline in the country's real estate market.
CMO investments may carry higher risks, particularly prepayment risk. but the higher yields are continuing to support insurers' cost structures and credit strategies, says Larry Mayewski, vice president of A.M. Best Co.'s life and health division.
"The additional yields provided by CMO investments enable companies to maintain their dividends while, at the same time, allowing them to be more competitive or at least maintain their rates from a crediting stand-point." Mayewski said.
The insurance regulators have their doubts, however, and the National Association of Insurance Commissioners is crafting a model investment law that will place some limits on the type and amount of MBS derivatives companies can hold. The limits, though, may not affect many insurers. (See The Mortgage Marketplace, May 25, page 1.)
There were barely $10 billion of CMOS issued in 1983, according to Thomas Morano, senior managing director at Bear Stearns & Co. By the end of 1991, nearly $250 billion of CMOS have been issued in one year. The current projection for 1992 is approximately $350 billion, he added.
Life insurance companies, for example. increased their holdings of CMOS and securities issued through real estate mortgage investment conduits to $42.8 billion (book value) at the end of 1991 compared with $8.4 billion at the end of 1986.
No comparable figures are available for property and casualty companies, though the NAIC is conducting a comprehensive survey of the size and type of all mortgage-backed securities holdings maintained by an insurance companies.
There are certain reasons why the CMO spread has been so big. said Morano. First is the REMIC legislation, which provides better financing arrangements than those that existed for CMOS before the enactment of the 1986 Tax Reform Act.
The law provided that CMOs may continue to be used from Jan. 1. 1987, until Jan. 1, 1992, after which only REMICs may be used.
Issuers have to meet certain requirements related to the type of mortgages that qualified for REMICs and the trust status. The requirements all set guidance on how the cash not yet distributed to security holders could be invested.
The law created a great amount of flexibility for issuers of multiclass CMOs, enabling them to maximize the cash flows on the underlying collateral." Morano explained. "Also, traders were able to create new and unique bonds to help satisfy the demands of investors on the market."
Instead of the choices being limited to a seven-year or a 10-year average life bond, traders were able to create a variety of bonds ranging from one-year to 20-year average life, and floating rate securities off fixed-rate collaterals.
Crosscollateralization with different collateral coupons was also introduced into the market.
"All of the collateral that is in the market today is going into CMO deals," said Morano. "That is a reflection of a demand for tailored cash flows against simply accepting a single class pass-through."
The second reason is phenomenal growth of the facsimile, or fax. market. The fax machine gtves dealers a speedy medium for communicating with clients.
"You need the fax machines to facilitate the CMO deals," Morano said. "We usually wipe out a quarter of the world's rain forest in a week. judging by the volume of fax paper we use in such transactions."
The emergence of CMOS opened up the secondary mortgage market to nontraditional mortgage investors that included insurance companies. CMOs provided insurers call protection while avoiding "active management." which would trigger taxation. Can protection assured investors, to some degree, that their investment will earn the stated yield and not be "called" before maturity.
As long as interest rates remain stable, the CMO market will remain attractive to insurers, said A.M. Best's Mayewski. Even with prepayment risk. insurers feel comfortable with the marketplace and in their ability to manage such risk. he said.
"Those companies that have significant positions in the marketplace are very sophisticated in their asset-liability management disciplines and are doing a fine job," he added.
