Recently, the finance industry witnessed the bailout of two Bears Sterns hedge funds and the collapse of Brookstreet Securities. Both had portfolio holdings of collateralized mortgage obligations (CMOs) and suffered huge losses thereof. We have seen such CMO losses before, when in 1994 interest rates rose, CMOs fell in value and bond mutual funds suffered unexpected losses.
In this paper, Dr. Craig McCann provides a selective history and description of CMOs to help investors understand their risks. Dr McCann finds that CMO losses cannot simply be explained by credit losses in subprime mortgages, the increase in interest rates and the slow appreciation of home prices, and that CMOs can be misrepresented as having little interest rate risk when they in fact have substantial interest rate risk. Unsophisticated investors should have a clear understanding of CMOs and know the concentration of CMOs in their funds.
