Putting Together Pieces of the CMO Investment Puzzle

CMO tranches, floaters, companions, residuals, IOs, POs, Jump Z bonds, PACs, and TACs all sound more like abbreviations for military operations than investment strategy for an institution's portfolio.

The purchase of CMOs -- collateralized mortgage obligations -- and their maintenance require careful analysis and an understanding of the prepayment risks, tranche type, and overall structure.

It is important to incorporate this information into the balance-sheet analysis in order to determine whether the investment is appropriate for a given institution's interest rate risk and asset/liability needs.

Growing Complexity

During the mid-1980s CMOs were a popular investment alternative to short-term and intermediate-term Treasury and agency securities.

As technology has become more advanced, the simple CMO has changed from an easy-to-understand structure to a unique investment tool -- better suited to sophisticated investors.

Attracted by relatively higher yields and better-defined maturities, banks and thrifts have committed significant funds to the CMO market. Their goal has been to increase net interest margins and do a better job of managing interest rate risk.

In the recent past, however, many purchased the more complex instruments -- such as companion bonds, TACs, residuals, and stripped securities -- without fully understanding or evaluating prepayment-risk scenarios.

One problem is the inability to predict if or when a home mortgagor will prepay or refinance a given loan. The cash-flow risk, for this reason, is that certain CMOs may not maintain the structure initially desired.

Each investment officer will approach this risk differently. But the basics of a proper evaluation are to understand thoroughly the structure being presented, run different prepayment scenarios to gauge stress points, and compare potential performance to other alternatives.

Finding Tools to Match the Job

Certain CMOs can be very effective tools in managing interest rate risk. But, finding the CMO with the right characteristics can be a very difficult, time consuming, and complicated analytical process. For instance, CMO price performance should be reviewed.

It is important to go beyond looking at projected price performance, given certain assumptions. It is also necessary to see how similar issues have actually performed under changing interest rate environments.

This is not easy to do, since a readily available historical CMO price data base does not exist. You may have to talk with several people before finding the information you want.

What Exactly Is a CMO?

CMOs are bonds collateralized by mortgage pass-through securities such as GNMAs, FNMAs, FHLMCs and high-quality whole loan mortgages. As a mortgage-backed security (MBS) derivative, CMOs offer attractive yields and sound credit quality.

In some structures they reduce -- while exacerbating, in others -- the cash flow and average life uncertainty that is driven by prepayments (PSA).

The simplest or "plain vanilla" CMO transforms the collateral into four separate classes, or tranches as they are commonly called. Each tranche has its own coupon, yield, average life, prepayment assumption, and price.

If it's so simple, what is the issue? Plain vanilla CMOs are the minority. A significant portion of newer CMOs are complicated variations built upon this initial structure.

Risks for the Investor

Because of the unpredictability of prepayments and the complexity of each issue, there are three major risks in purchasing a CMO tranche:

* Risk No. 1. The ongoing prepayment assumption (PSA) may become different than originally stated. As a result, once the issue is seasoned, the yield and weighted average life varies from that anticipated at purchase.

This potential risk must be evaluated for every issue an investor may now own and it should be part of the evaluation process for each purchase.

* Risk No. 2. Price volatility of a CMO is principally driven by interest rate movements and the actual and perceived prepayment expectations of the underlying collateral. This volatility can be compounded by the issue's complexity.

The unlimited potential for alternative structures makes every tranche unique. By some estimates, there are over 11,000 CMO tranches currently outstanding -- meaning 11,000 different securities.

We understand that, beginning this quarter, First Boston Corp. will supply a daily price on some CMOs that will be available as a subscription on the Bloomberg Financial Markets system. This could help the portfolio manager.

* Risk No. 3. The internal structure of the CMO varies with each issue. The tranche purchased will most likely be affected by the other tranches in the structure. The purchased tranche may not maintain the expected cash flows due to other priority traches in the issue.

Thus, it is not sufficient to evaluate just the one tranche being considered. The entire structure must be understood.

Evaluation Guidelines

How should investors evaluate a CMO portfolio to determine their risk level? To begin, they should determine the exact instrument(s) owned. Investors should have a deal prospectus for each CMO on file.

They must then analyze how the tranche they hold is affected by the others in the CMO issue. It is essential to compare the current PSA rate with the projected rate to ensure that the investor is still receiving the yield and weighted average life expected upon purchase.

Investors must make sure that the CMO portfolio fits within their overall asset/liability objectives. Some CMO structures, due to their inherent cash-flow risk profile, could move the portfolio outside of acceptable tolerances.

The pending Federal Financial Institutions Examination Council guidelines consider certain CMOs and their derivative products to be high-risk investments for banks and thrifts. The guidelines do not recommend including stripped MBS, certain CMO tranches, and residuals in an investment portfolio unless the institution can prove the viability of such an instrument through detailed internal analysis.

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