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Risks In A CMO Portfolio – How Government-Sponsored Refinancing Increases Extension Risk

On June 1st, the Federal Housing Finance Agency (FHFA) issued a press release noting that Home Affordable Refinance Program (HARP) refinances have nearly doubled to 180,000 from 93,000 when comparing 1st quarter 2012 to 4th quarter 2011. While this is good news for struggling and underwater borrowers that can take advantage of the program, this is most definitely not good news for many CMO investment portfolios on credit union books today.

A “typical” CMO is derived from a pool of mortgages and is engineered to assign priorities to the cash flows received from payments, both scheduled payments and unscheduled payoffs. The same pool of mortgages typically results in multiple CMOs which are divided into Planned Amortization Class (PAC) or Companion (Support) tranches. Although other types of CMO tranches do exist, this brief analysis will focus on the relationship between PACs and their companion tranches.

A PAC (sometimes divided into multiple levels, e.g., PAC I, PAC II, etc.) is designed to establish a fixed principal payment schedule that is relatively stable in a range of environments. These tranches have first priority to cash flows from the underlying mortgages. Once the portion of scheduled cash flows has been satisfied, any remaining cash flows from principal payments flow to lower-priority PAC tranches and then to their support tranches.

If these PAC tranches, especially PAC I or II with the highest priority, are engineered to have the most stable cash flows out of any CMO investment, where does the risk come in? The risk comes from the reduced principal balances in the support tranches. As the underlying mortgages either prepay or extend, the cash flows for the support tranches either speed up or slow down. As the economy has been in such a historically low interest rate environment, those borrowers that have been able to refinance probably already have, sending more principal to the support tranche of the respective pool of mortgages that make up the CMO investments. This reduces the ability of the support tranches to continue to support prepayment activity and, more importantly, help absorb the extension risk of the underlying mortgages.

Increasing the refinance activity of all FNMA or FHLMC guaranteed mortgages can have the unintended consequence of extending the principal cash flows on PAC tranches, especially if rates were to go up, by continuing the reduction of the support tranches. Any mortgages left in the pool that are not eligible for the refinance program may continue to pay as agreed, resulting in the extension in the CMOs that are left—which will undoubtedly include some PAC I and II tranches.

Credit unions should be continually monitoring the extension risk in their CMO portfolios. Minimally, credit unions should be looking in the current rate environment and in a +300bps rate shock scenario though going beyond a +300 is ideal. For clients of c. myers that elect to have their CMO cash flows analyzed, the cash flows are analyzed in at least 13 different long-term rate environments. This level of analysis goes well beyond industry standard and can help credit union management teams realize when investment strategies may need to change to accommodate the presence of extension risk in CMO portfolios.

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Evaluating Investments

This post is a continuation of Investing At “Record” Low Rates… published February 10, 2012.

Investments with complex optionality are increasingly being added to credit union investment portfolios.  As such, it is critical that credit unions have a solid understanding of what they may be purchasing, before the transaction is executed.

First, make sure your broker is providing you with a complete picture of the characteristics of the investment in question.  In general, most brokers provide market value, and cash flow information for the current environment and a +300 basis point (bp) rate change.  However, some investments (in particular some CMOs) may look “okay” if rates go up 300bp, but have the potential for extreme extension risk if market rates go up 400 or 500bp.  Credit unions should ask their broker for cash flow and market value shock data for the +400 and/or +500bp rate change, particularly for investments with optionality.  Remember that short-term market rates were 500bp higher than they are today as recently as 2007.

In addition to cash flows, other optionality features can be very important as well.  For example, if the investment is variable rate, make sure that all of the repricing parameters are clearly understood: repricing frequency, margin, caps, floors, etc.  When the first repricing can occur is particularly important, especially with rates being so low.  For callables and step ups, consider call dates and potential repricing dates.  For step up investments consider if the future step protection warrants the lower starting coupon rate compared to a bullet or callable with the same final maturity.

Working with a trustworthy broker certainly helps in this process, but that does not absolve decision-makers of completing their own due diligence and ensuring an investment fits within their overall strategic objectives.  Keep asking questions until there is clarity on the investment and its structure, consider the other pertinent decision drivers (for example, policy, impacts to aggregate risk position, etc.) and consider the unexpected in the decision-making process.