The Money In Mortgages

A few months ago, I got a cold call from a stock-broker, pitching me on a "high-rate, triple-A mortgage investment, government guaranteed." When I asked what's the catch, he said no catch. "You're only risk," he joked, "is that you'll get your money back too soon.

He was touting a collateralized mortgage obligation (CMO), although those inscrutable words never crossed his lips. Current yields on CMOs run from 8 to 8.5 percent, backed by mortgages with stated or implicit federal guarantees. So they sound sweet to starry-eyed savers who want something richer than certificates of deposit.

I have already dumped on CMOs in this space (NEWSWEEK, Sept. 9, 1991), an opinion that brought me a pile of rancorous letters from stockbrokers ("irresponsible journalism"; "a disservice to readers"). With more than $40 billion now cuddling up to these investments, however, they and their relations rate a further look. So, dear brokers, ready your pens. I'm about to dump again.

First, a general word about mortgage-backed investments. They include Ginnie Maes (loans guaranteed by the Government National Mortgage Association), whose new issues now pay 8.3 percent--0.8 points more than comparable Treasury securities. And the new adjustable-rate mortgage (ARM) funds, whose January yield averaged 6.4 percent, compared with 3.9 percent for money-market funds.

But mortgages don't behave like fixed-term bonds or CDs. With bonds you earn interest; on a known date, your principal comes back. But when you buy a mortgage-backed security, you finance hundreds of homeowners who repay both interest and principal simultaneously.

You don't know how fast they are going to repay, and that s the catch. If mortgage rates rise, homeowners won't move as often, so you won't get your money back nearly as fast as you hoped. Your cash will be stuck in what will have become a low-rate investment. By contrast, if mortgage rates fall--as they did last year--homeowners will rush to refinance. You'll get your capital back much sooner, forcing you to reinvest at a lower rate.

The stockbroker who called me made it sound jolly to get money back ahead of time. But tell that to an investor who bought 14 percent tax-exempts 10 years ago that were recently paid off before maturity. The best he or she can get today in comparable bonds is around 6.25 percent. Getting money back early is usually the pits. Prepayments also lower the yields on mortgage-buying mutual funds.

So what's the bottom line on these hot investments?

Steer clear of retail CMOs, also known as companion CMOs. Supposedly, you sign up for a specified time period. But few brokers explain that "maturity" dates depend on what happens to interest rates. You could easily get your money back much too early or much too late (chart). Always ask what will happen to the CMO's pay-back rate and yield if rates rise--or fall--by 1 and 2 percentage points (Warning: the answer may be fudged.)

In the view of Mark Donohue, bond analyst at the New York brokerage firm Gabriele, Hueglin & Cashman, the only CMOs you and I should consider are the PAC-1s (for "planned amortization class"). They're yielding more than half a point less than retail CMOs but should remain stable over 2- or 3-point changes in interest rates. PAC-2s and 3s are slightly more volatile. The minimum investment: usually $25,000, although some brokers break them into $1,000 or $5,000 pieces, sold at higher prices.

You buy a small CMO for keeps. They're tough to unload if you find that you suddenly need some cash.

These invest your ready cash in adjustable-rate mortgages. Share prices rise and fall, so they're not stable like money funds. But the risks appear small. So far, the changes in price have amounted to only a few cents either way. Last year, ARM funds outdid the money funds; now they're barely keeping up. Investment adviser Don Nichols, author of "The Income Investor," says he's withholding judgment on whether ARM funds are better until they've been bloodied by a period of rising rates. Of 22 funds, only five have been around for more than a year.

Unfortunately, the majority of ARM funds levy sales charges, which chop your return. For example, Franklin's ARM fund yielded 8.67 percent last year, but only 4.28 percent after adjusting for the 3 percent load. If you want to experiment with ARM funds, use pure no-loads, like the Benham Adjustable Rate Government Securities Fund in Mountain View, Calif., and the T. Rowe Price Adjustable Rate U.S. Government Fund in Baltimore.

They're being hit by both mortgage prepayments and the upturn in interest rates. Donohue prefers PAC-1 CMOs, whose payback is more predictable. Still, Ginnie Mae mutual funds are outdoing Treasury funds, and you can leave it to the experts to pick the securities. The Income & Safety newsletter likes the Ginnie Mae funds from Benham, Vanguard in Valley Forge, Pa., and Fidelity and Scudder, both in Boston.

Yield shoppers love high-rate collateralized mortgage obligations (CMOs). But there are hidden risks. If rates rise just 1 percentage point, this seven-year CMO may not repay you for almost 24 years.

Direction of              Average wait for         Annual

interest rates            your money back*          yield


Flat                        7.4 years              8.32%

Up 1 percent               23.7 years              8.66%

Down 1 percent              1.8 years              6.88%