anyone have an opinion about CMOs - Collateralized Mortgage Obligations

[DrDan]

I have had a CD mature and need to reinvest the $$$. CD rates are very low - 4.4 or so for a year.

One advisor suggested I look at CMOs. Triple-A rated, government-backed. Paying about 5.7.

I know very little about them except the basics about how they work.

Any advice or warnings?

[A HERETIC I AM]

1. CMO's are issued by almost every major mortgage lender. There are several different types.

Some basic info for those not familiar with them;

"A collateralized mortgage obligation (CMO) is a security whose foundation is made from mortgage-backed securities (MBS), such as pass-throughs or pooled whole-loan mortgages. The CMO issue is divided into multiple classes, or "tranches", which possess defined characteristics that are unique to the underlying MBS. The classes are purchased by investors who receive monthly principal and interest cashflows according to their defined schedule. The variety of classes is large. The three most common types are sequential pay, planned amortization (PAC) and targeted amortization (TAC) classes. Many more extravagant classes exist but investors should be wary of them due to their complexity and average life volatility. The original and most basic CMO is the sequential pay CMO.

A sequential pay CMO is structured with numerous classes which are retired consecutively. For example, consider a sequential CMO with four classes, A, B, C, and D. Class A would have the shortest maturity, then B, C, and finally D. Each class receives periodic interest payments. Initially, all principal, scheduled and prepayments, are applied to class A till it is retired. The following principal payments are then applied to class B till it is retired, then class C and so forth. A typical sequential pay CMO may have up to ten tranches ranging from one to 20 years.

The cashflows and hence the average lives, are estimated based on assumed prepayments rates. The prepayment rates are sensitive to interest rate movements, the coupons of the underlying mortgages, and other factors. If rates fall, prepayments typically rise, shortening the average life of the classes. If rates rise, the opposite may be true. A 200 bps rise in rates could extend a 10-year average life investment to 14 years. A decline of 200 bps could result in a 10-year investment shortening to a seven year investment. However, due to their structure, sequential CMOs offer greater insulation to prepayment fluctuations than a comparable pass-through security. Class C in that example does not receive any prepayments till classes A and B are retired, and experiences less volatility in price and prepayment performance."

Keeping the above in mind, it is important to consider the quality of the mortgages underlying these securities. The difference between the mortgages (and the ability of the homeowner to make timely payments) issued by any of the so-called "Sub-Prime" lenders, for instance and those guaranteed by Ginnie Mae can be rather dramatic.

There are certain CMO's that differ substantially from traditional debt securities in that the principal is typically paid back along with interest over time as opposed to receiving the entire principal back at maturity. In other words, if you bought a triple-A rated, 5.5% coupon 10 year corporate bond at Par ($1,000) you would receive annual payments of $55.00 in interest and at the end of the ten year period, would get your $1,000 back. These CMO's are structured in such a way as to provide a steady stream of income during the expected life of the bond but the final payment will have brought the principal to zero.

If an investor is considering these securities in the current environment, security & a viable guarantee of repayment is, in my opinion at least, certainly something that should be given the highest priority. For that reason alone, it would behoove the individual investor to carefully consider the risks involved in purchasing any CMO that was NOT a Ginnie Mae backed security.

Here is the page from the Ginnie Mae website that describes exactly what they do and how they do it.

Disclaimer; I did not write the first 3 paragraphs above. Those portions were taken from several sources I am unable to link to publicly. However, I can share privately an informative article with any reader interested in learning more about these securities, I am simply prohibited from posting that article on a public message board. PM me with an Email address and I will be happy to pass it on. There is also a plethora of articles available on the internet as well. Here are the Google results for Collateralized Mortgage Obligation Bonds