With the NCUA’s recent approval of exchangeable CMOs for credit unions,
could you tell me more about them and whether or not they are a good choice?
ALM First Financial Advisors has been following this issue for some time, and
we were pleased that the NCUA has approved exchangeable CMOs as legal investments.
We have been a strong supporter of the rule change because the exchange features
provide investors with more flexibility and, as a result, better trade execution.
I wrote a column about exchangeable CMOs last year, and the issue is even more
relevant now (June 2003). This investment represents a type of structured mortgage-backed
security, which can be “exchanged” into another CMO that has different
principal and/or interest characteristics. Exchangeables are relatively new
– first created in the mid-1990s, but they have become well-accepted in
the market and most deals contain them. With rates moving up, the built-in flexibility
that exchangeable CMOs offer makes them especially desirable.
To understand the advantages for investors, it’s helpful to look at the
features from the issuer’s side: When issuing a two-year PAC CMO with
a coupon of 3.5 percent against 5.5 percent collateral, the issuer must create
an interest only (IO) strip. This derivative is the interest-only payments of
the coupon difference of 5.5 percent, less 3.5 percent. Although an issuer may
not be able to sell a bond with a 3.5 percent coupon and 2 percent yield because
the premium will be too high, a 3.0 percent coupon would be more appealing to
investors. Because of its exchangeable feature, the issuer can cut an additional
0.50 percent from the IO strip without going to the secondary mortgage market
to re-REMIC the bond. Thus, it is more cost-effective for the issuer to alter
the bond’s characteristics because the option is “free” to
the investor; that is, purchase yields are comparable to non-exchangeable securities.
Now, look at the example from an investor’s side: For an exchange fee
(typically 1/32), an investor can exchange a CMO with a coupon of 3.5 percent
for a CMO with a coupon of 3.0 percent that has comparable traits and an IO
strip of 0.50 percent. Regulations prohibit credit unions from holding IO strips,
so the dealer will retain or sell the strip to a separate account and exchange
the CMO back to the original investor. As a result, the investor has a security
with a new coupon, but the CUSIP doesn’t change. (Note that the original
PAC CMO with the 3.5 percent coupon is the combination of the newly created
PAC CMO with a 3.0 percent coupon and the IO strip. But separately, the IO strip
would be an illegal investment for credit unions.)
Exchangeable securities are becoming more popular. By modifying NCUA’s
rules, parts 703 and 704, the Agency allowing credit unions to enjoy the flexibility
of exchangeables without adding risk to their balance sheets. If the embedded
option is not executed, the make up of the exchangeable tranche and its risk
characteristics are the same as non-exchangeable CMOs.