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Last updated: February 7, 2012 8:07 pm
Banks have been responding to low interest rates by snapping up billions of dollars of bundled mortgage products that resemble the sliced-and-diced debt some blame for the financial crisis.
The products, known as “collateralised mortgage obligations,” or CMOs, group together securities backed by mortgage loans. These securities are then sliced into various tranches, with each portion being paid out to investors at a different time.
Banks find the CMOs attractive, because they can yield more than US Treasuries or plain vanilla securities backed by government-guaranteed mortgages. CMOs also can be customised to suit banks’ balance sheet needs, allowing them to match their assets with their liabilities better and preserve precious regulatory capital.
With the Federal Reserve forecasting record low interest rates until at least 2014, such balance sheet management has become even more important for US lenders. Low rates typically make it harder for banks to earn a profit on their lending and investments.
Analysts say that, because of the customisation offered by CMOs, the structured products are more attractive for banks than normal mortgage-backed securities, or MBS.
““The CMO business involves buying mortgage-backed securities, dividing them into pieces and then selling the sum total of the pieces at a higher price,” said Deutsche Bank’s Steven Abrahams. For under-pressure banks, he added, that premium may be worth paying.
Banks increased their holdings of CMOs by $82bn in the first nine months of last year to $479bn, according to data compiled by the Federal Deposit Insurance Corporation.
The proportion of CMOs on banks’ balance sheets rose almost half a percentage point to 3.47 per cent over the period. By contrast, the share of US Treasuries on banks’ balance sheets decreased by 0.17 percentage points between the end of 2010 and the third quarter of 2011 to 1.25 per cent or $173bn.
While the dollar amount of CMOs sitting on banks’ balance sheets remains far below traditional securities issued by US government agencies such as Freddie Mac, analysts say the CMO build-up has accelerated in recent months.
“We’re seeing banks deploy cash to some short-term markets including CMOs,” said Brian Foran, a New York-based banking analyst at Nomura.
Unlike the subprime collateralised debt obligations that helped inflame the financial crisis, the majority of the CMOs being bought today by banks are made up of mortgages backed by the US government, which are generally considered safe. CMOs backed by non-guaranteed mortgage-backed securities are less attractive, since banks have to hold more capital against them.
“Assuming the guarantee of the government is good, then it’s really all interest-rate risk,” said Mr Foran, meaning banks holding CMOs could suffer if official rates changed unexpectedly.
Increased demand from banks for CMOs could also help lower rates charged on home mortgages by driving up demand for loans and the underlying mortgage-backed securities, analysts say. But, for banks, buying the CMOs is still more expensive than just picking up plain-vanilla mortgage securities.
With additional reporting by Nicole Bullock in New York.
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