FANNIE MAE INVESTMENT
Guaranteed REMIC (Real Estate mortgage investment conduit) - Pass thru certificates providing an undivided interest in underlying R/E mortgages. CMO recommendations:
1. A CMO is a "multi-class bond backed by a pool of pass-through securities or mortgage loans" and under NASD rules, the term may be used interchangeably with REMIC. Most CMO's are issued in REMIC form to create certain tax advantages for the issuer.
2. In order to prevent misleading communications regarding CMO's, certain factors should be considered:
a. Product identification. All CMO's should clearly describe the product as a "collateralized mortgage obligation". Firms should not use proprietary names for CMO's.
b. CMO's should not be compared to any other investment vehicle, including C.D.'s.
c. An offer to provide customers with educational material covering the following matters must be made.
1. A discussion of CMO characteristics as investments and their attendant risks.
2. An explanation of the structure of a CMO in including the various types of tranches.
3. A discussion of mortgage loans & mortgage securities.
4. Features of CMO's, including credit quality, prepayment rates and average lives, interest rates (including effect on values and prepayment rates), tax considerations, minimum investments, transaction costs and liquidity. .
Name: Fannie Mae* REMIC 1993-252 - $800,000,000
Client bought $80,000 2-10-94.
Client sold - $63,997 5-23-94 (Principal loss-$16,003)
Int. rate @ 6.50% - $433.33/mo. Maturity 2023 -30 years! *FNMA - A quasi Govt. agency.
Description: These mtge. certificates generally provide that the principal & interest on the underlying mortgages are passed through to the holder of the certificate. Pools reduce risk to individual investors because the risk of non payment on any underlying mortgage is divided among all participants in the pool. If an investor chooses to invest in an agency backed CMO (FNMA REMIC), the credit quality is unquestionably high. CMO - Collateralized mortgage obligation. A CMO consists of a series of traunches into which home loan cash flows are carved. Some traunches in the CMO represent early payments that come due on the home loans represented in the CMO's. Other traunches represent the later payments on the home loans. NOTE: THIS INVESTOR BOUGHT THE FOLLOWING TRAUNCH -"PAY INTEREST ONLY WITH PRINCIPAL BEGINNING AT LATER DATE. FANNIE MAE EST. PAYOUT OF PRINCIPAL 2-98 - 2-99.
Federal National Mortgage Assoc. (Fannie Mae) is a federally chartered & privately owned corporation organized under the Federal National Mortgage Assoc. Charter Act. Once Fannie Mae acquires the loan, It will issue a pass thru certificate. The pass thru certificate will represent Fannie Mae's obligation to make timely payment of amounts corresponding to scheduled payments of principal & interest on the loan, whether FNMA receives those payments from the developer or not. The pass thru certificate represents an undivided beneficial interest in the note and mortgage. However, the pass thru certificate WILL NOT GUARANTEE TIMELY PAYMENTS OF PRINCIPAL & INTEREST ON THE BONDS, BUT ONLY THAT FANNIE MAE WILL MAKE PAYMENTS CORRESPONDING TO PAYMENTS DUE ON THE LOAN.
THE PASS THRU CERTIFICATE DOES NOT CONSTITUTE A DIRECT GUARANTY OF PRINCIPAL & INTEREST ON THE BONDS, BUT ONLY SECURES FANNIE MAE'S OBLIGATION TO MAKE PAYMENTS CORRESPONDING TO PRINCIPAL & INTEREST ON THE DEVELOPERS LOAN.
CERTIFICATES TOGETHER WITH ANY INTEREST THEREON, ARE NOT GUARANTEED BY THE U.S. THE OBLIGATION OF FANNIE MAE UNDER ITS GUARANTY OF THE THE CERTIFICATES ARE OBLIGATIONS SOLELY OF FANNIE MAE & DO NOT CONSTITUTE AN OBLIGATION OF THE U.S. OR ANY AGENCY OR INSTRUMENTALITY THEROF OTHER THAN FANNIE MAE.
THESE SECURITIES, UNLIKE GNMA ASSETS, ARE NOT BACKED BY THE FULL FAITH & CREDIT OF THE U.S. GOVT., BUT CARRY AGENCY STATUS.
1. PREPAYMENT RISK - If an investor chooses to invest in an agency backed CMO (FNMA REMIC), one risk to be assessed by the investor is prepayment risk. Homeowners have the ability to pay off their mortgage loan at any time. As a result, investors whose bonds are collateralized by residential mortgages face the uncertainty as to how mortgageholders will react to changes in the economy. These changes in the economy include interest rate movement, home prices and local and national economic activity. Thus, an investors decision to buy a mortgage backed bond is predicated on a prepayment assumption. This prepayment assumption sets the stage for investors to outperform or underperform other fixed income alternatives.
2. INTEREST RATE RISK - The curious character of mortgage backed securities is that they become more interest rate sensitive as interest rates rise, and less so as rates fall. That's because more homeowners than expected refinance when rates fall. They stop refinancing when rates rise.
3. NO WIN SITUATION - When you add #`s 1 & 2 together,
you have a very strange investment. Like any bond, it loses value when interest rates rise. But when interest rates fall, instead of your getting an increase in value, people refinance and instead of a profit, you get your principal back. In other words, you get all of the downside of a bond but none of the upside!
4. MATURITIES ARE EXTENDED: These instruments usually carry 30 year maturities. Rising interest rates cause mortgages to "extend" in maturity, because prepayments grind to a halt. "The extension of duration is a continuos phenomenon", according to William Powers, who manages $24 billion of mortgage backed securities at Pacific Investment Management in Newport Beach. The risk in all CMO's is not "if" the principal will be returned, but "when" the principal will be returned.
5. RISK OF NON-PAYMENT OF PRINCIPAL & INTEREST.
6. LOANS TO DEVELOPERS INCLUDE HOME LOANS AND LOANS TO MODERATE INCOME PROP. LOANS ON MULTI-RESIDENTIAL PROPERTIES.
7. LACK OF APPROPRIATE DISCLOSURES - a FNMA REMIC is an exempted security. The certificates are exempt from the registration requirement of the Securities Act of 1933 & are "exempted securities" within the meaning of the Securities Act of 1934. Section 36-490 (A)(1) exempts any security including a revenue obligation issued or guaranteed by the U.S., any state, any political subdivision of a state, or any agency or corporate or other instrumentality of one or more of the foregoing; or any certificate of deposit for any of the foregoing.
Because of this exemption, there is the danger that these investments could be presented to customers without appropriate disclosures. IN THE CASE OF THIS CLIENT, NO PROSPECTUS WAS GIVEN! With an investment as confusing as this, adequate disclosure is essential for proper understanding by the client.
FNMA Certificates would not be an appropriate investment for any investor requiring a participation distribution of principal on a specific date or an OTHERWISE PREDICTABLE STREAM OF PRINCIPAL DISTRIBUTIONS!
CONCLUSION: This investment is not suitable for investors of advanced age! (maturities were too long). Further, interest rates were at historic lows in early 1994 and there were many signs predicting that the Fed would begin to raise rates. A loss of value due to interest rate increases was likely and in fact is exactly what happened. Further, the investor was forced to change a fully guaranteed and Govt. insured C.D. to a lesser guaranteed obligation with risk of principal and no appreciable increase in rate of return ( 6.50% vs. 6.29%).