CMO residuals: the last can be first.

In the world of collateralized mortgage obligations identifying the real source of high yield means learning to separate principal and interest in the most profitable way.

The rubble of today's thrift crisis is hatching new investment opportunities. One such opportunity is the current buyer's market in collaterized mortgage obligation (CMO) residuals being liquidated by thrifts. Even in today's low-interest-rate environment, an investment in a CMO residual can provide exceptional yields--internal rates of return as high as 20-30 percent. As Ben Weberman, long-time Forbes financial columnist has written recently, fixed-income investors "looking for a little more yield" are thinking a lot about CMOs. It should be noted that the liquidation of residuals by the thrift industry, one of the factors that has created the buyer's market, is being driven primarily by regulatory, not economic, considerations. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) mandates that all thrifts divest themselves of their investments in CMO residuals, as well as certain other direct real estate investments, by 1994. Concurrently, the Resolution Trust Corporation (RTC) is selling off portfolios of CMO residuals of thrifts in conservatorship or receivership to raise capital in their effort to recover the liquidation costs of these failed thrifts. The resulting supply imbalance presents an opportunity to invest in CMO residuals at very attractive levels, and demand for new CMO bonds remains strong as evidenced by the more than $83 billion of new CMO bonds sold by Wall Street in the first five months of 1991.

THE RESIDUAL RESULT

The first CMO bonds were issued, and the first CMO residual was created, in 1983. These bonds were collateralized by a group of fixed-rate home mortgages that had been pooled into mortgage certificates issued and guaranteed by the Federal Home Loan Mortgage Corporation (FHLMC). This first sale established a model for CMOs. The cash flow from the agency-guaranteed mortgage certificates--i.e., principal and interest--is separated into short, medium, and long-term CMO bond classes, or tranches, that are sold in the open market. Each bond tranche has a different maturity with a corresponding yield, and it should be noted that it takes a good deal of professional expertise to distinguish and discriminate between these tranches as Randall W. Forsyth, Barron's capital markets editor, reported recently in a commentary called "Tranche Warfare."

The CMO bonds are rated "AAA" because they are structured so that the principal and interest payments generated by the mortgage certificates are more than sufficient to fund principal and interest payments to the bondholders. The resulting positive differential between the cash flow from the assets collateralizing the CMO bonds (the GNMA, FNMA, or FHLMC mortgage certificates) and the principal and interest payments on the collateralized bonds became known as a CMO residual or CMO excess cash flow. Today, Wall Street has progressed to such a degree of sophistication that CMO residuals are available with myriad performance characteristics. They can be bullish or bearish, and accommodate an investor's own economic scenario based on yield curves and anticipated changes in interest rates--both long and short-term.

REITS AND RESIDUALS

Individual investors can utilize CMO residuals by purchasing shares of stock in real estate investment trusts (REITs) and other publicly traded entities that own CMO residuals. By pooling investors' funds, these entities are able to purchase numerous residuals that act together to produce attractive returns in a wide range of interest rate environments-- rather than investing substantial funds in the characteristics of only a few CMO residuals. Asset Investor's Corporation increased its dividends 33 percent in the first half of 1991, to $1.20 per share, up from $.90 during the first half of 1990. In addition, the purchase of shares in a publicly-traded CMO REIT enables investors to take advantage of the highly advantageous tax treatment provided to REITs by the Internal Revenue Code, A REIT's earnings are not taxed prior to their distribution as cash dividends to stockholders.

THE RISK WITH RESIDUALS

As an investment, CMO residuals primarily are subject to fluctuation in key interest rates, accelerated prepayments of principal on the underlying mortgage collateral, and defaults on the mortgages that underlie the mortgage certificates. Of these, interest rate fluctuations are the most significant factor associated with CMO residual income. Because the variety of CMO structures is endless, as each residual generates its own distinct excess cash flow return pattern, therefore hedging is possible. When it comes to prepayment risk, early mortgage principal repayments narrow the spread between the interest earned on the mortgage certificate collateral and the interest paid on the bonds reducing the future cash flow to the CMO residual. If prepayments are faster than projected, the return will be lower than anticipated. Those concerned about the plight of real estate and principal risk, can still participate solely in CMO residuals where the mortgage certificate collateral is guaranteed by government or government-sponsored agencies (GNMA, FNMA, or FHLMC) reducing this variable to its lowest possible level.

AND REWARD

The current outlook for CMO residual performance is quite good. The temporary imbalance in supply offers the opportunity for acquisitions at attractive yields, and even with lower inflation and the White House's desire to see the Federal Reserve reduce interest rates, it is unlikely that long-term rates will drop appreciably. Current prepayment trends are relatively flat and will probably remain stable as the traditional fall-winter slowdown in home sales begins. Performance and yields on CMO residuals likely will continue at near record levels in 1991, and may well extend into next year if the modest expectations anticipated for the next economic cycle become a self-fulfilling prophecy.

Spencer I. Browne is president and Chief Executive of Asset Investors Corporation a Real Estate Investment Trust with interests in more than $750 million of CMO variable-rate bond classes, and estimated 1991 taxable income of $35 million.