What Are CMO’s?
Collateralized mortgage obligations (“CMOs”) are securities issued by the Government National Mortgage Association (“Ginnie Mae”), the Federal Home Loan Mortgage Corp. (“Freddie Mac”), or the Federal National Mortgage Association (“Fannie Mae”). Inverse floaters are a type of CMO, which are structured in such a way so that interest payments are inversely related to a floating rate index, such as the London Interbank Offered Rate. They tend to be highly leveraged and vulnerable to a high degree of price volatility as interest rates move. The expected maturity date of an inverse floater may be prolonged by positive shifts in the interest rates.
Inverse floaters are traded in the over-the-counter market, and are among the most thinly traded and volatile types of CMOs. Generally, Inverse floaters are considered to be volatile, risky, and complex securities.
FINRA has advised its members that inverse floaters “are only suitable for sophisticated investors with a high-risk profile and the investor must be made aware of the risks and characteristics” of the inverse floater being purchased.
Market and Liquidity Considerations
There are many aspects of market and liquidity considerations which must be taken into account with inverse floaters. Firstly, you may be unable to sell the desired amount of certificates, regardless of whether it is a small or a large amount, at prices comparable to those available to other investors. Furthermore, the sale price of this product may not be comparable to similar investments that have a more developed market. These products probably have a limited market for resale, leading to little or no liquidity and more price volatility than other similar mortgage-backed securities. The limited liquidity can lead to a profound negative effect on the market value of these types of certificates.
As it has been previously stated, inverse floaters have rates which change contrary to the trend of the floating rate index being used. This leads to prices which are more volatile than those of other similar floating rate mortgage-backed securities based on the same index with otherwise comparable terms. The increase volatility is a result of the fact that an increase in the floating rate index not only decreases the interest rate (and thus the value) of the certificate, but also reflects an increase in prevailing interest rates, thus further decreasing the value of this type of a certificate.
When purchasing this type of investment, one has to understand that there is a high risk attached to them, that they may not be easily sold, that the value of certificates will fluctuate over time, and that the fluctuation can result in large losses. The risk is exasperated if one is unable to hold these products until they mature.
Inverse floaters are not suitable investments for retail customers with conservative to moderate investment objectives due to the volatile and highly risky nature of inverse floaters.
There are other considerations, but these are some typical examples of why CMO’s (eg. Inverse Floaters) may not be suitable for you, and may give you the right to sue your broker. The law firm of Sonn | Erez represents investors nationwide in claims against investment firms. To learn more about whether we can assist you or inquire about us, contact us to arrange a free confidential consultation with one of our attorneys at 844-689-5754.
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