Regulators are concerned - though not in a panic - over the impact of prepayment losses on mortgage-backed derivative investments of banks and thrifts.
"The performance of [interest-only mortgage derivatives] has been pretty dismal since Jan. 1. 1990, through June 30 of this year," said William A. Stark, assistant director of the Office of Capital Markets at the Federal Deposit Insurance Corp. "Clearly you would have been better in Treasuries," he said.
Stark said his agency uses the data in the accompanying table to educate its supervision staff about prepayment and other risks inherent in different kinds of derivative products.
Because of the dramatic drop in interest rates that occurred in this period, prepayments hammered the return on derivative products, whereas regular Treasuries realized unexpected gains.
David Schmidt, vice president of Memphis, Tenn.-based Calibre Financial Group, confirmed that Treasury notes earned yields after many other derivative products.
"There's no question, from a total return standpoint, with bullet-maturity investments like Treasury notes, you would still have a year left," said Schmidt. "From a total rate of return perspective, Treasuries have done better than CMOs lover the past two years] I think nine times out of 10. you would have been better off with T notes."
Even though Treasury notes have done better than other derivative products, regulators say they are panicked by these risks, largely, they say, because they had fortuitously adopted protective policies.
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