Collateralized mortgage obligations as investment instruments: what is the risk?
As interest rates move to 20-year lows, public investors and pension fund managers who assume certain yields on investments face the prospect of embarrassing results. The apparent high quality and attractive yields of collateralized mortgage obligations (CMOs) are appealing. Indeed, these exotic new derivative debt instruments backed by home mortgages can enhance returns in public fund portfolios for savvy managers who know what they are buying.
CMOs are among the most complex and intricate securities ever created. They were devised by Wall Street's brightest marketeers in an attempt to remove an uncertainty inherent in all mortgage debt: the impact that market conditions will have on mortgage prepayments. CMOs were engineered to deal with that uncertainty.
Billed as having AAA credit quality while offering yields exceeding U.S. Treasury instruments, CMOs constitute a huge market, accounting for about one-half of the $1.2 trillion of mortgage debt issued. Yet they have received their share of bad press. The following sample of headlines illustrates how the media have portrayed the CMO.
* "The CMO Return You See May Not Be What You Get," Wall Street Journal headline, August 3, 1992.
* "Choosing CMO Bond Fraught with Danger," Knight-Ridder News Service, April 1992.
* Of CMOs: ". . .precious few investors realize they have a tiger by the tail," Business Week, January 1992.
* "Insurance Regulators Express Concern Over Safety of Certain Types of CMOs," Wall Street Journal, June 6, 1992.
With this kind of press, it is no mystery that state and local governments are cautious about CMOs.
In a session on investing public funds at the Government Finance Officers Association's 1992 annual conference, attendees were warned against blindly using exotic securities to reach for yield. As an alternative, one speaker suggested CMOs with volatility ratings, or "V-ratings," which assess the safety of individual tranches. A tranche is a security created by dividing a CMO into pieces with different characteristics. Some have predictable price, cash flow and total return, and are stable, while others do not, and are volatile when market conditions vary.
V-ratings, launched by Fitch Investors Service in February 1992, measure volatility of individual tranches on a V1 through V5 scale to gauge market risk in the face of changing interest rates. Other means for measuring or containing the risk of CMOs exist as well. Banks and thrifts must comply with Federal Financial Institutions Examinations Council (FFIEC) codes for CMO safety, dubbed the "pass-fail" test. Separately, insurance regulators are studying various safety measures for CMO investments by that industry. California recently specified V-rated CMOs for its pooled investments as a way of quantifying the risk. Other states, such as South Carolina, are being asked by underwriters to examine the investment merits of rated tranches.
Thrifts and mortgage lenders sell mortgages to federal agencies such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Association (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae). Hundreds of mortgages are pooled to create mortgage obligations which are marketed to investors. Holders are paid from proceeds of homeowners paying their monthly mortgages.
Investors can only assume--based on "prepayment assumptions," as the Wall Streeters say--when mortgage debt will be paid, unlike general obligation bonds with their specified maturities. Although homes are bought with 30-year mortgages, the mortgages may be prepaid for any of a wide variety of reasons.
Interest rate variations compound the problem. When rates drop significantly, homeowners refinance in large numbers to lower monthly payments. Mortgages are paid off early leaving investors facing reinvestment risk or worse, loss of original investment. When rates rise, homeowners cling to their "cheap" mortgages, and prepayments extend beyond expectations. Investors could wait for years before getting their money back. How can a public investor or a public employee pension fund manager, with liabilities due on specific dates, justify mortgage debt?
Wall Street pondered the question. On agency-backed mortgage pools, government guarantees assure payment; that translates into predictable cash flows to investors come hell or high water. By pledging that cash to certain classes of securities, the uncertainty of timely payment is mitigated, and those securities become attractive to pension funds, life insurers and others requiring planned amortizations. Thus began mortgage debt splicing and dicing.
Safety vs. Risk
To erase some of the uncertainty associated with mortgage prepayments, CMOs are sliced into tranches. Certain tranches have a priority claim on cash flows, insulating them from the market risk faced by ordinary mortgage pass-throughs. Other tranches get paid later, and are more risky. Some tranches provide support to assure the stability of others. As interest rates fluctuate, the risk rises for tranches on the lower end of the payment scale or those engineered with special characteristics, and these are said to have high volatility.
CMOs come in dozens of structures requiring complex computer models which are not available for most investors to analyze. As a result, even the most sophisticated market players can fall into traps caused by unexpected rate gyrations, or by misjudging the length, depth or direction of interest rate changes.
How much risk can a money manager take? Investors have different objectives. Pension funds aimed at securing the retirement of employees have low risk tolerance. Growth mutual funds reaching for yield can be more aggressive. Sophisticated duration-matching strategists can turn winners out of the most risky CMOs. To select the right tranche, investors need to identify those with low, moderate and high volatility. Of 2,000 tranches tested in early 1992, nearly 80 percent fall into the V1 to V3 low to moderate risk range as shown in Exhibit 1.
The safety vs. risk relationships can be identified using the five volatility measures developed by Fitch after a year of testing and responding to market input. Tranches rated V1 and V2 are considered low volatility. V3 is moderate. V4 is volatile. V5 is highly volatile. The risk-reward ratio pertains to CMOs, just as it does with bonds. Lower CMO yields are associated with lowest volatility. Higher risk begets larger returns. Very sophisticated money managers can match certain of the most volatile V5s and get a total portfolio with relatively stable cash flow under stressful economic conditions. The Fitch ratings definitions appear below.
Low to Moderate Volatility. Securities rated V1, V2 or V3 perform predictably over a range of various interest rate scenarios. Generally, total return, price and cash flow indicators are less volatile than current coupon agency certificates.
V1--The security exhibits relatively small changes in total return, price and cash flow in all modeled interest rate scenarios.
V2--The security exhibits relatively small changes in total return, price and cash flow in most modeled interest rate scenarios. Under certain adverse interest rate scenarios, one or more of the indicators are more volatile than securities rated V1.
V3--The security exhibits relatively large changes in total return, price and cash flow in all modeled interest rate scenarios. Generally, however, total return, price and cash flow indicators are less volatile than current coupon agency certificates.
High Volatility. Securities rated V4 or V5 perform less predictably over a range of various interest rate scenarios. Generally, total return, price and cash flow indicators are more volatile than current coupon agency certificates.
V4--The security exhibits greater changes in total return, price and cash flow than current coupon agency certificates in all modeled interest rate scenarios. Most indicators, however, show less volatility than securities rated V5.
V5--The security exhibits substantial changes in total return, price and cash flow in all modeled interest rate scenarios compared to current coupon agency certificates. Under the most stressful interest rate scenario tests, negative total returns may result.
Market risk measurements of CMO tranches use as a benchmark current coupon mortgage pass-through certificates of Fannie Mae, Freddie Mac and Ginnie Mae. Tranches rated V1-V3 have volatility lower than or equal to these current coupon certificates. Tranches rated V4 and V5 have greater volatility over a range of interest rates. V-ratings differ from credit ratings in that the scale is not absolute. Credit ratings assume U.S. government bonds to be the highest quality and the benchmark of credit-worthiness and safety. When subjected to interest rate scenario testing for volatility, however, 30-year Treasuries appear as V3s, reflecting their decline in total return and price in rising interest rate environments.
Once assigned, V-ratings tend to remain constant, since they factor in a range of interest rate movements. In extreme rate shifts, however, certain tranche ratings may change because of cash flow prioritizations or the characteristics of the tranche structure. Ratings will improve as tranche life shortens and volatility potential decreases, since maturity is an important variable in market risk analysis.
In developing these ratings, six volatility measures are calculated based on the weighted average results from 12 different interest rate scenarios. The resulting V-rating describes the potential rate of change in price, total return or cash flows due to changes in interest rates or prepayments. Stress scenarios incorporate rate shifts of up or down 300 basis points within 18 months, then stable rates until maturity. The six measures are:
* change in total return;
* duration change relative to current collateral;
* change in effective duration;
* weighted average life variability;
* change in the Treasury hedge ratio; and
* percent change in price.
How does one respond to a salesman TABULAR DATA OMITTED who says, "Can I interest you in a PAC IO Z WAC?" Among the hundreds of CMOs issued are dozens of tranche types with names, symbols and features unfamiliar to most investors. A half-billion-dollar CMO offering can typically have 40 tranches. Exhibit 2 charts the more common types of tranches, ranking them according to their volume of issuance.
Some tranche classes, such as the Planned Amortization Class (PAC), are first in line for payments across a wide interest rate spectrum. These tend to be least volatile. Other tranches, such as the Z class, may receive no payments for 15 years or more while interest compounds. These are among the most volatile. There are dozens of tranches in between which receive payment in sequential order or from excess cash flows to PACs. Some tranches pay interest only (IOs). Others are entitled to principal only (POs). The impact of rising and falling rates can sharply alter a tranche's price, total return and cash flow causing swings in market value. A description of commonly seen classes and their volatility characteristics appears below.
Planned Amortization Class (PAC). Highly rated V1 and V2. PACs are the most frequently issued tranches, accounting for 40 percent of outstanding issues. They have predictable returns and low volatility, which appeals to risk-averse investors. Yields tend to be lower than those of more risky tranches. PACs receive principal payments according to a planned schedule and perform predictably across a wide range of interest rates. As such, their total return, price and cash flows are among the most stable. Average life on most PACS is two to 10 years, with shortest maturities tending toward least volatility. Advantages: cash flow stability, stable total return, price stability. Disadvantages: lower yield, protection varies with characteristics of companion bond.
Very Accurately Defined Maturity (VADM). The precise maturity targets of this tranche appeal to investors seeking predictable returns on their investments. Volatility is moderate, with 90 percent rated V1-V3. Holders tend to be banks, pension funds, insurance companies and individual retirement accounts seeking specific maturities. Advantages: cash flow stability, stable total return, predictable amortization schedule. Disadvantage: lower yields.
Companion Bonds (COMP). These securities support PACs and other tranches with defined amortization schedules. When rates fall, companions provide stability to the other classes by absorbing excess principal payments. When rates rise, a companion bond's claim to principal payments is subordinated to the tranche it supports. COMPs are moderate to high volatility, with those rated V4 or V5 providing substantial support to other debt classes. Advantages: higher yields than bonds which they support. Disadvantages: unpredictable cash flows and price when rates fluctuate.
Interest Only (IO). These tranches, primarily V4 rated, receive only the interest portion of the cash flow. Principal is directed to other tranches. Since interest only tranches have little or no principal, prepayments wipe out future cash flow. As prepayments accelerate when rates fall, investors could lose a portion of their initial investment. Conversely, investors benefit when rising rates extend interest payments beyond targeted maturity. IOs exhibit "negative convexity" and are considered a bearish investment. Advantage: typically a good hedge against rising interest rates. Disadvantages: potential loss of original investment, volatile total returns.
Principal Only (PO). These tranches, in the V3 to V5 range, receive cash flow from principal only and no interest. POs have more cash flow volatility than IOs, and they are sold at large discount from face value. Price volatility increases when rates rise since cash flows, normally received near maturity, are pushed further out as prepayments slow. POs perform best when rates fall. Advantage: typically a good hedge against falling rates. Disadvantage: total return fluctuates when rates rise, with longer maturities having highest price volatility.
Z Bonds. Like zero-coupon bonds, Z tranches pay no interest. Interest accrues and is added to principal and compounded through the accretion period, which can extend beyond 20 years. Zs stabilize other bonds by absorbing excess principal payments. Thus, their accretion period may be shortened substantially due to unpredictable cash flows. Average life, total return and cash flows are subject to wide swings as rates rise or fall. Advantages: high total return if held to maturity, interest compounds. Disadvantages: high cash flow volatility, uncertain total return and price as rates fluctuate.
V-ratings are the first of a series of analytical products to help investors gauge market risk. Since the rating system was launched last February, $204 billion, or 7,100 tranches, were rated covering virtually all outstanding CMOs issued in 1991 through second quarter 1992. In August, price and cash flow indicators were added in response to demand from the market for that underlying data. These appear as fields labeled VPR for price and VCF for cash flow. Ratings and data are available without charge on various electronic pricing services used by portfolio managers. Among them: Bloomberg Financial Markets, Telerate and Knight-Ridder News Service. Beyond tranche analysis is the ability assess the volatility of a total portfolio containing diverse tranches. This tool helps managers offered CMO fund investments a way to assess the fund's overall risk profile.
JAMES D. NADLER is managing director of Fitch Investors Service, Inc.'s CMO Volatility Group, which is responsible for ratings and market value assessments on individual tranches of agency-backed CMOs. BYRON D. KLAPPER is managing director and publisher of Fitch's Information Products Group with responsibility for research, technology and publications.
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|Author:||Nadler, James D.; Klapper, Byron D.|
|Publication:||Government Finance Review|
|Date:||Oct 1, 1992|
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