Many fail to understand the risks of trendy CMOs Interest-rate changes could trap investors

February 09, 1992|By Glenn Burkins | Glenn Burkins,Knight-Ridder News Service

Despite all the warnings, many people still invest in things they don't understand.

Consider the case of collateralized mortgage obligations, better known as CMOs.

They are among the most complex financial tools ever created, and most people who buy them don't really understand how they work, experts say. But that hasn't stopped CMOs from selling like peanuts at a baseball game.

As interest rates have fallen, CMOs have become one of the top-selling, fixed-rate investments on the market today.

It's not uncommon to see CMOs promising yields close to 9 percent, even in today's environment. Compare that with CDs yielding 4 percent to 6 percent.

But unless you understand how CMOs work, you may be better off with a simpler and safer product that pays less.

"People need to understand that these things embody a significant amount of interest-rate risk," said Suzanne Greenberg, a partner at Cumberland Advisers, a money-management firm in Vineland, N.J.

Ms. Greenberg said her firm manages about $300 million in assets, of which only about $40 million is invested in stocks. The rest is in fixed-rate investments, including CMOs.

As interest rates have fallen in recent years, more retail brokers have been pushing CMOs. And in many cases, Ms. Greenberg said, the people selling them do a poor job of explaining them to buyers.

"The question is: How well does your broker understand them himself?" Ms. Greenberg said. "In the case of most retail brokers, the answer is very little."

As the name suggests, CMOs are mortgage-backed securities. The underlying mortgages are guaranteed by the Government National Mortgage Association, the Federal Home Loan Mortgage Association and Federal National Mortgage Association -- Ginnie Mae, Freddie Mac and Fannie Mae.

Because the mortgages are backed by the three agencies, there is very little credit risk to investors. In other words, CMO buyers need not worry about homeowners defaulting on their loans. Nearly all CMOs are rated AAA.

CMOs are created, in effect, when mortgages are taken from each of the three agencies, mixed together and baked into a loaf. The loaf is then sliced, and each slice is sold to investors for a minimum of $10,000.

As homeowners pay their mortgages, the money trickles down to CMO holders, who get payments once a month. Part of each payment is a return of principal; the other part is interest.

Each slice of a CMO is different. Each has different lengths of estimated maturity, for example.

Maturity is calculated based on the amount of time it usually takes for homeowners to pay off the mortgages in a given CMO slice.

But here's where things get tricky: When interest rates fall, homeowners often prepay their mortgages faster than usual. And when that happens, CMO investors may get their money back much sooner than expected.

For example: A CMO with an estimated maturity of 10 years may actually mature in five years if enough mortgages are prepaid.

The opposite would happen when interest rates were rising. That happens when prepayments are slower than usual. In that case, a five-year CMO may be stretched into 10 years.

The inability to pinpoint when a CMO will mature is the investor's biggest risk.

For example, if you get your money back sooner than expected when interest rates are falling, you'll be forced to reinvest that cash at a lower rate.

But if interest rates are rising and your CMO maturity is extended, you won't be able to take advantage of those rising rates because your money is tied up.

In addition, not all slices of the CMO loaf are created equal. Some are structured to be more predictable than others. And if one slice is structured for safety, another slice must absorb that risk.

The safest slices are served to big institutional investors -- banks, insurance companies and mutual funds. The more risky slices are sold to individuals.

For people who understand the products, CMOs can be a great investment, Ms. Greenberg said. But for those who don't, it's best to look elsewhere.

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