A string of public events are goading private fears that the banks with the biggest holdings of CMO derivativesparticularly investment bankssoon could get burned badly.

Management is just figuring out that they are sitting on some losses, one banking industry analyst declared. Which banks will suffer most isnt certain, because the losses involved will depend on what CMOs the bank is holding and how skilled it is in selling the paper. But its a safe bet that the institutions most vulnerable are the 25 with the biggest CMO and Remic holdings. (See chart below).

Investment bankers selling these instruments may be facing the worst, industry analysts say. Its more difficult to find investors for the more risky, volatile CMO derivatives, Ryan OConnell, senior analyst with Moodys Investor Service, told Mortgage Marketplace. And if a broker wants to make a CMO deal, it must provide protection for planned amortization class investors. They do this by selling off more volatile derivatives to absorb the prepayment risk, usually companion bonds and related instruments such as inverse floaters, IOs [interest-only strips] and POs [principal-only strips].

OConnell said so far, the investors who have been hurt have been investing in the high-yielding, more risky instruments. Last fall, IOs hurt some investors, but more recently, it has been inverse floaters and POs.

Investors are demanding a much wider spread. If they are not getting them they are moving into safer PACs, said Jamie Newell, an analyst at CS First Boston. He says investment banks are forced to keep the more risky leftovers because they cannot sell them at a profit. This is what can potentially create the problems for the investment banks.

OConnell believes the sluggish CMO market is due to several factors. He cites the drop in new mortgages and the resulting 79% drop in CMO issuance since April as the primary factors for the struggling market. He also says that widely publicized corporate losses in these investments have also had a debilitating effect on the market.

Analysts say another problem is the vast mortgage portfolio held by Kidder Peabody & Co., the highly leveraged subsidiary of General Electric.

[Kidder] is clearly holding the CMO market in check, said one rating agency analyst. At some point, GE has to say start moving those goods. That could have a really depressing effect on the process and brokers wont be able to do as many new deals. It will reduce liquidity in the market, and investors are worried [that Kidder moving its inventory] would depress the market.

This constriction of the market is still considered by analysts as a threat to institutions highly leveraged in these instruments. According to several industry sources, many banks that have invested in CMOs generally have invested short and are not facing the same financial hits as investment bankers and other corporate entities that are more highly leveraged.

Typically, smaller institutions have been more conservative in their investing, said Jim Vogel, a senior vice president of First Tennessees bond division. They dont have as much extension risk as some bigger players, most mid-market banks are dealing with yield curve declines in value. These losses the mid-level institutions can easily absorb because their portfolios are widely diversified, Vogel said.

When asked about the condition of First Tennessees investment portfolio, he said his bank has concentrated on selling conservative instruments to their clients. We generally try to buy the product, then move it right out. He said his bank is not holding any risky instruments they cannot unload without a loss.

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