Secondary Mortgages Popular but Risky : Investments: While institutional investors are main purchasers, individuals can participate in REMICs and CMOs.
Imagine owning your own home mortgage.
As far-fetched as this prospect may seem, it’s very much a reality thanks to two increasingly popular, yet controversial investment vehicles: real estate mortgage investment conduits (REMICs) and collateralized mortgage obligations (CMOs).
These mortgage securities form the backbone of what’s known in industry parlance as the secondary mortgage market. Lenders are often unwilling to wait the full term of a mortgage to get their money back. While they can’t force borrowers to pay off their mortgages early, the lenders can sell off several hundred mortgages at a time to outside investors.
These loans usually continue to be serviced by the original lender, but payments of principal and interest (less a moderate service fee) get passed on to REMIC and/or CMO investors.
For the most part, other banks and institutional investors are the buyers for these so-called mortgage pools. Individual investors can buy into the pools too, however.
And theoretically, these investors can “buy” a part of their own mortgage--along with a piece of several hundred other mortgages. CMOs and REMICs are usually bought in $1,000 denominations, although a minimum purchase of $25,000 is usually advised.
As long as investors are willing to put their money into CMOs and REMICs, lenders can continue to make mortgage loans--often without soliciting bank deposits.
These real estate-linked securities also allow lenders to spread some of their interest rate and loan default risks among a broad pool of investors.
Be advised: For individuals, assessing these risks is a difficult--and some say impossible--task.
Today, most REMICs are also CMOs and most CMOs are REMICs. Basically, the investment sponsor elects to form a mortgage pool as a REMIC for tax purposes. The interest income from REMICs is taxable only for the individual investor.
Pure CMOs (in non-REMIC form) are taxed as a corporation and the interest income is treated as a dividend for which investors must once again pay income tax.
Since the early 1980s, about 1,300 CMOs have been issued with an original value of about $380 billion, according to Salomon Bros Inc.
These instruments can be issued by lenders directly, or more often through the Federal National Mortgage Assn. (Fannie Mae) or the Federal Home Loan Mortgage Corp. (Freddie Mac).
The Government National Mortgage Assn. (Ginnie Mae) does not directly issue CMOs, but dealers do package CMOs based on Ginnie Mae collateral.
Most CMOs are backed at least indirectly by the federal government, and such issues are generally rated as AAA bonds. These securities pay anywhere between 30 and 100 basis points over Treasury securities--currently yielding about 8.5%. (That translates into an extra one-third to one full percentage point for investors--or about 8.8% to 9.5%)
This year, it should be noted, Fannie Mae alone has issued 98 CMOs. Freddie Mac has sponsored about 185 CMOs since its first such issue in June 1983, according to Lehman Bros. of New York.
While CMOs and REMICs may seem relatively straightforward, nothing could be further from the truth.
For CMOs aren’t just sold to investors as a pool of whole mortgages. Rather, these loans are broken up into three to five other pools--known as tranches.
Investors who don’t fully understand which tranch they are buying can be hurt by either getting their money back too soon or having to wait longer than they had expected to recover interest and principal.
Each tranch also has its own interest rate yield.
“CMOs are the real estate equivalent of a nuclear reactor,” warned Burl East, a vice president at investment adviser Bateman Eichler, Hill Richards in downtown Los Angeles. “They’re the black hole of finance.”
“You need a supercomputer to figure these things out,” East said. His advice to the individual investor: “You’re probably in over your head.”
Individuals interested in mortgage securities are better off opting for less complicated and more direct investments in Fannie Mae, Ginnie Mae and Freddie Mac securities, East said.
Understanding CMOs is no easy task even for the experts, said Fred Price, a principal at New York-based Sandler, O’Neill & Partners, a brokerage firm specializing in mortgage securities for institutional investors.
“It’s very difficult for us in the business to distinguish how certain tranches will pay out,” Price said. “I don’t think the (individual) investor has any place being in this stuff.”
Not every broker agrees with East and Price, however.
Some brokerage houses have been marketing CMOs as something of an investor panacea--especially with uncertainty in the real estate and stock markets. Some CMOs are even paying as much as 14% annual interest.
If this sounds to good to be true, consider that these CMOs are bundles of second vs. first mortgages, and that the risk of default is greater for these hybrid CMOs than for more traditional first trust deed mortgage pools. Also, these mortgage pools and their tranches are unaffiliated with Fannie Maes, Ginnie Maes or Freddie Macs.
How does a tranch work?
CMOs are usually structured to include three to five different bundles of cash flows--or tranches. By breaking mortgage pools into these different tranches, investors have more of a choice in how they would like to be repaid.
Some investors may choose a tranch that accommodates a two-year investment. Others may opt for a longer-term tranch. CMOs are also often divided into Planned Amortization Classes (PACs) and Targeted Amortization Classes (TACs).
PACs--also known as Planned Redemption Obligations (PROs)--first appeared in 1986 and function similarly to corporate sinking fund bonds.
PAC bonds are retired according to a planned amortization schedule. The schedule of other tranches (such as a TAC, which is in essence a narrow PAC) are either accelerated or slowed to complement these PACs.
Investors also have a choice of long-dated Z bonds that accrue interest and pay the investor nothing until all other tranches are paid out. These Z bonds are also known in some circles as accrual bonds. Investment advisers can’t agree, though, on whether these Z bonds are in fact coupon bonds or not.
They also can’t agree on the wisdom of investing in what are known as IO and PO tranches. These interest-only and principal-only schedules provide yet another option for investors. Just about every broker/adviser urges that only the most sophisticated of securities mavens should indulge in these complex creations.
Finally, there are CMO residuals for investors with a desire to gamble or a need to hedge a fixed-income portfolio against the risk or rising interest rates. Residuals are created when a CMO’s actual cash flow exceeds the cash flow required to pay off bond holders.
This may occur as a result of a small number of prepaid mortgages or because of very conservative predictions about the income from a mortgage pool. Investors can dabble in residuals through the direct issuance of a CMO, buying into a CMO-issuing entity or investing in a CMO owner’s trust.
Prepayment risk, it should be noted, is the biggest risk associated with CMOs. When interest rates go down, many homeowners refinance their mortgages at lower rates and pay off their old mortgages. When this happens, the CMO backer gets its money back earlier than expected, while the investor now is faced with reinvesting his/her/its money in lower-yielding instruments.
If you’re not yet confused, CMOs (REMIC or non-REMIC) may be for you.
“You really have to understand which maturity you’re buying,” said Stan Ross, partner at accounting firm Kenneth Leventhal & Co. in Century City. Still, he added, “you can get some really excellent yields.”
“It’s a good time to play with real estate yields,” Ross concluded. But, “the minute someone says you can make lots of money,” he warned, “beware!”
For a detailed primer on real estate securities, what options are currently on the market and an analysis of their investment returns send $2.50 and a stamped, self-addressed envelope to Ron Galperin, c/o Real Estate News Group, 1505 E. 17th St., Suite 211, Santa Ana 92701. Make checks payable to Real Estate News Group. Please do not send cash. Your primer--including glossary of real estate security terms--will be sent within three weeks.
DEVELOPMENT
Great Western Builds New Headquarters Great Western Financial Corp. broke ground late last month on a new headquarters complex totaling 78,000 square feet on 20 acres in Chatsworth. The site is adjacent to nine buildings at Corbin Avenue and Plummer Street that currently serve as a company service center.
A new 10-story executive office building is set for occupancy in 1992. Great Western’s current headquarters--a 10-story, 227,000-square-foot tower at Wilshire and La Cienega boulevards in Beverly Hills is for sale.
The Lakes at West Covina--a 16-acre office project set to eventually include 614,000 square feet of office space--officially opened its doors last Thursday with the completion of two four-story buildings totaling 180,000 square feet. The $130-million business park is located near the San Bernardino Freeway at Vincent Avenue. Watt Investment Properties Inc. is the developer.
Galperin is a Los Angeles-based free-lance writer who has covered the commercial real estate scene for several years. News releases and column inquiries should be mailed to 8306 Wilshire Blvd., No. 7078, Beverly Hills, Calif. 90211.
