Win: An ancient Chinese curse says, “May you live in interesting times.” A number of factors make these times especially interesting for you who are responsible for your companies' pension funds.

High returns over the past five years or so in both the stock and bond markets lowered the effective costs of funding pension liabilities. In many cases these high returns generated cash surpluses in pension funds.

Many companies tapped their surpluses and plowed the cash back into operations.

But, just as some of your CEO's were getting used to funding pension liabilities cheaply and even finding the pension fund to be a source of cash, high prices in the stock and bond markets have lowered yields and expected returns. The lower yields and expected returns have eroded surpluses. Some companies are worried that their surpluses may disappear.

The discounted-cash-flow calculations that determine pension liabilities generate higher liabilities in times of low interest rates.

Meanwhile, while you're trying to explain these interrelationships and their implications to your company's CEO and investment committee, more and more of the assets that you can invest in are derivative products— products that owe their existence to complex mathematical computations.

But what, you may ask, has all this got to do with mortgage-backed securities?

The factors that make your professional lives interesting— in the Chinese sense— are risks, yields, interest rates, and mathematical complexity. This too happens to be what mortgage-backed securities are about: risks, yields, interest rates and mathematical complexity.

"So what?" you may say, "That's what all investments are about."

True enough, but for mortgage-backed securities, the interactions among these factors are different than they are for stocks and for other bonds.

To decide if there's a place in your pension portfolio for these unusual instruments, you might want to know how risks, yields, and interest rates interact for mortgage-backed securities. You might want to know some of the simple principles that lie behind the complex mathematics.

To plunge into the risk-reward interactions for mortgage-backed securities, let us pose the fundamental question: what are the risk characteristics of mortgage-backed securities and how much are you, the investor, compensated for bearing them? How do these risks and your compensation relate to fluctuations in interest rates? How do you manage the mathematical complexity that links risks, yields and interest rates?

To answer these and other questions that people in corporate treasury departments most often ask about mortgage-backed securities, I turn to my colleague Donna Blair. (Light up on Donna at her podium.)

Donna, Let's start with risk. What is the risk profile of mortgage-backed securities?

Donna: Thanks, Win. I admire your ability to talk for ten minutes about mortgage- backed securities without ever saying what they are, who issues them, or how they're structured.

I guess that's how you get to be a managing director.

In discussing the risk profiles of mortgage-backed securities, I may have to reveal what these instruments are and how they work.

Let's start with credit or default risk— the risk that the borrower will not repay principal and interest. Credit risk need not be a concern with mortgage-backed securities.

Underlying every issue of mortgage- backed securities is a pool of mortgages.

Homeowners make monthly payments on their mortgages. These payments flow through a servicing entity to the holders of the securities.

For mortgages that qualify under their programs; Ginnie Mae, Freddie Mac, and Fannie Mae guarantee repayment of interest and principal. Ginnie Mae is part of the Department of Housing and Urban Development and wields the full faith and credit of the United States government. Freddie Mac and Fannie Mae are private, government-sponsored corporations.

Credit risk is not where the action is with mortgage-backed securities. Securities with government guarantees of repayment constitute the bulk of the market. There are instruments out there for which credit risk is a factor, but they are not our focus today.

Win: Where is the action, Donna? That's what we want to know.

Donna: The action in mortgage-backed securities is not whether or not investors will get their money back, but when they will get it.

To understand the “when” issue from the investor’s side, all you have to do is look at it from the point-of-view of the typical homeowner.

Understanding the timing issue from the homeowner’s point-of-view lets us understand it from the investor’s because the investor’s cash flow mirrors the homeowner’s cash flow.

How many of you have home mortgages?

Most of you.

Let's suppose your bank sold your mortgages and they're being used to provide a cash flow to investors in a mortgage-backed security.

	Scheduled monthly payments of principal,
	Monthly interest payments on the principal outstanding, and
	Prepayments of principal.

When are you planning to repay your mortgage?

Well, you know...

It kinda depends.

Have any of you just recently refinanced your mortgage? Or are any of you considering refinancing your mortgage?

When you refinance a mortgage, you take out a new one and pay off the old one.

What's that going to do to the cash flow of an investor on the other side?

It's going to speed up repayments. You're contracting the maturity of the investor's security. Buried in the contract between the homeowner and the mortgage originator is the option for the homeowner to call the loan at par value.

The investor in a mortgage-backed security has invested in a callable bond. The investor has to be paid a premium for granting the homeowner a call option.

Why are you refinancing?

Interest rates are down. When is the investor getting his money sooner than he or she planned?

When interest rates are down. When he or she has a poor opportunity to reinvest the money. The investor has to be paid a premium for accepting this reinvestment risk.

If you take out a mortgage and rates go up, are you going to refinance?

No. You may hold onto that mortgage until the bitter end. Will the investor get any prepayments?

Not many. You're extending the maturity of his security.

When won't the investor get any prepayments?

When interest rates are high. When it would be a good time to reinvest them.

The investor has to be paid a premium for accepting this exposure.

So you see, there's a high degree of uncertainty not in whether or not mortgage-backed securities will be repaid, but when they will be repaid.

To accept this uncertainty, the investor in the mortgage-backed security is paid a premium rate.

Win: Sounds good to some of you. You're assured of getting your money back with interest and you get paid premium rates for accepting uncertainty of timing.

Maybe you want

to rush right out and buy a mortgage- backed security or two?

Great! Well, how much should you pay for one?

Donna: Like any security, the fair price of a mortgage-backed security depends upon the size and timing of its future cash flow. But we just said that, for mortgage-backed securities, the timing is uncertain. It's related to rises and falls in interest rates— which, if you could predict with certainty, you would be the richer than Ross Perot.

How do you figure out a fair price for a mortgage-backed security?

I'll give you a hint. If you're going to do it with pencil and paper, I'll see you in about three hundred years.

To figure out a fair price in the face of interest-rate uncertainty, we're thrown into the realm of the mathematics of probability.

To price mortgage-backed securities, issuers and investment managers use sophisticated, computer-based models.

First, an interest-rate-simulation model projects a probability distribution of several thousand interest-rate paths over the life of the security.

Then, these several thousand interest- rate paths are fed into a prepayment model.

Out comes a probability distribution of cash flows, a fair price for the security, and a calculation of how sensitive the security is to changes in interest rates. A security’s sensitivity to interest rate changes is called its duration.

Win: I have a simple device that helps me understand Donna when she starts talking this way.

(Win reaches under podium, pulls out Albert Einstein wig and puts it on.)

(Win turns to screen.)What do you think Al?

He's a tough guy to impress.

I'm sure Donna did a better job of it with that "probability-distribution-of-several- thousand-interest-rate-paths" stuff.

All right, Donna. Let's say

I'm an investor. I like the certainty of getting my money back. I like the idea of getting a premium to accept the uncertainty of timing. My investment manager has all these computer models to find me a security that is a real value. But, you know what?

Donna: What?

Win: Something still bugs me.

Donna: Is it something you can articulate?

Is it something you'd like to share with us? After all, we are in California.

Win: If I invest in a mortgage-backed security, does that mean I'll be getting small bananas— I mean drips and drabs of payments every month for fifteen to thirty years?

Donna: You can. Securities that simply pass along homeowners' payments are called pass-throughs.

Win: Surely somebody's figured out how to make tidier packages out of these things? Something that looks more like the bonds that I'm used to investing in. Maybe something that lets me have a little more say in how much prepayment risk I take.

Has anyone given any thought to this?

Donna: Yes. In fact, the financial engineers have gotten kind of carried away with mortgage-backed securities. Today you can buy mortgage-backed securities with almost any cash-flow and risk characteristics you want.

The financially-engineered securities are referred to collectively as CMO's— collateralized mortgage obligations. Today collateralized-mortgage obligations include: Planned Amortization Class Bonds, Very-Accurately-Defined- Maturity Bonds, Planned-Amortization- Class-Principal-Only Bonds, Planned Amortization Class Z Bonds, Vanilla Bonds, Planned Amortization Class II Bonds, Planned-Amortization-Class- Interest-Only Bonds,

Companion Bonds, Inverse Floating Rate Bonds, Interest-Only Bonds, Principal- Only Bonds, and Targeted Amortization Class Bonds.

As if these names weren't unintelligible enough, people who work in mortgage- backed securities refer to them as PAC's, VADM's, PAC PO's, PAC Z's, Vanillas, PAC II's, PAC IO's, Companions, Inverse Floaters, IO's, and PO's.

I have a theory that, as children, financial engineers had too much alphabet soup in their diets.

Win : Donna, we'd love to have you explain each instrument to us in detail, but that might be too much excitement for one evening.

Maybe you could give us a few executive- level concepts.

Donna: Okay. The ideas that underlie the engineering of CMO's are pretty straightforward.

To create a CMO, an investment bank or other entity establishes a sole-purpose trust. The trust receives monthly payments of principal and interest from a pool of mortgages.

Instead of disbursing funds equally to all investors, a CMO establishes different classes of bonds.

A set of rules governs how the trust distributes payments to each class.

For example, a simple or Vanilla CMO might establish four investment classes A, B, C, and Z. The trust issues A bonds, B bonds, C bonds and Z bonds.

The rules might state that the trust distributes payments of interest to investors in A, B, and C bonds on the outstanding par values of their bonds.

The trust distributes all payments of principal from the mortgage pool to investors in A bonds until the A bonds' par value has been paid in full.

Next the trust sequentially pays off the B bonds

and C bonds.

The Z bond accrues interest like a zero- coupon bond. Only after the trust has retired all the other bonds, it uses the cash flow from the mortgage pool to satisfy the obligations on the Z bond.

The class structure restricts the maturity ranges of the securities. It buffers the exposure of investors to uncertainties in the cash flow.

Win: Sounds like a Vanilla CMO cuts down the uncertainty around the timing of my cash flows, but doesn't really lock it in. What if I need to match some maturing liabilities pretty tightly? Are there CMO's that let me do that?

Donna: Sure. What you want is a Planned Amortization Class or PAC bond. PAC bonds can be created with very little cash-flow uncertainty.

To create a PAC, the issuer examines what the cash flow from the underlying mortgage pool will look like over time if interest rates fall. Let's say the cash flow will look like this.

If interest rates rise, the cash flow will look like this.

The falling-interest-rate scenario and the rising-interest-rate scenario have a considerable amount of cash flow in common. That is, there exists a pattern of cash flow that will occur whether interest rates fall or rise.

The issuer carves up this highly certain cash flow into classes of bonds. These low-risk bonds are the PAC bonds.

Win: So the issuer has just engineered away the risk.

Donna: Not exactly. A universal principle that governs the creation of CMO's is this: Financial engineers cannot get rid of any of the total risk inherent in the underlying mortgage pool.

Win: Or as Einstein might say, “Risk is like matter. It can be neither created nor destroyed.”

Donna: That’s correct. What the financial engineers can do is create investment classes and write rules that partition the risks into different bonds.

To absorb the uncertainties locked out of the PAC bonds, the issuer creates other bonds that absorb all the uncertainty. The risk-absorbing bonds are called companion bonds. After the cash flow satisfies obligations to the PAC bonds, the excess payments service the companion bonds.

Win: Companion bonds, then, have highly uncertain cash flows?

Donna: Correct. A small change in interest rates, down or up, can cause a big change in their cash flow.

Companion bonds pay investors a premium to accept this degree of uncertainty.

Win: What if I have some liabilities that track changes in interest rates pretty closely?

Is there a CMO that will let me match those?

Donna: How about a floating rate bond? You can buy a floater that pays an interest rate tied to LIBOR. To be able to offer floaters, issuers also create bonds called inverse floaters— bonds that pay an interest rate that floats in the opposite direction of LIBOR.

With the floaters and the inverse floaters offsetting one another, the CMO always pays the same overall coupon rate regardless of changes in LIBOR.

Win: These sound very similar to many of the bonds found in the corporate market.

Donna: They are. Except that very often CMO's have a higher credit rating than comparable bonds in the corporate market.

Win: What if you really want to roll the dice, Donna? The companion bonds sounded pretty exciting. Does the CMO market have anything else with a big kick?

Donna: Sounds like you're ready to put some money in PO's or IO's.

Another approach issuers take to carving up cash flows is to distribute homeowner payments of principal to one bond class and payments of interest to another. These bonds are called Principal-Only and Interest-Only bonds, or PO's and IO's.

The investor in PO's benefits from a fast repayment rate while the investor in IO's benefits from a slow repayment rate. PO's and IO's both exhibit substantial price volatility when interest rates change.

Win: If any of you are already invested in mortgage-backed securities, I suggest you ask your investment manager if he or she has you in any companion bonds, IO's, or PO's. These are great investments if interest rates move your way. But if rates move against you, you can be in for a bit of a shock.

Donna: Those are the major ways that issuers carve up cash flows from mortgage pools. As we speak, financial engineers are dreaming up new designs for CMO's. But the basics remain the same.

For the investor, what the financial engineering of CMO's means is this: Within mortgage-backed securities, you can choose your degree of risk. The investor can walk the high wire of high- risk, high-yield bonds; climb the stairs of moderate-risk and good returns; or stay on solid ground with low-risk bonds that still pay a premium above Treasuries.

Win: Donna, Suppose that I'm a treasurer with pension-management responsibilities. I've been to a conference where I've learned that more and more pension funds are investing in mortgage-backed securities.

Being trained in analytical decision making, I say to myself, "What the heck? We might as well go with the flow here."

What are the most important things for me to communicate to my investment committee?

Donna: Take it from one who knows, investment committees are only interested in four things:

	Credit Quality
	Bond Yield
	Liquidity and
	Portfolio Performance

The credit quality of mortgage-backed securities is extremely high. Pass- throughs are fully collateralized by pools of mortgages. CMO's are typically over- collateralized.

The vast majority of mortgage-backed securities are rated triple A, or— better yet— have government guarantees. A mortgage-backed security with a triple A rating is generally considered to be of higher credit quality than a corporate bond with the same rating.

Yields. On new issues, the yields of mortgage-backed securities are usually above those of comparable Treasuries. Mortgage-backed securities offer as good as or better yields than corporate bonds without the investor taking the risk of a downgrade. It is almost impossible for a government- or agency-backed security to be downgraded. Corporate bonds are downgraded with the ebb and flow of a company's success.

Portfolio performance. Portfolios of mortgage-backed securities show an excellent performance track record. Shearson Lehman and Salomon Brothers both report performance indices for mortgage-backed securities. Over the past ten years, these indices have out performed Treasuries by 150 basis points and matched the returns of higher-risk corporate bonds. During this period, the annual return of the Lehman index for mortgage-backed securities has averaged 13.4%.

Liquidity. Mortgage-backed securities are highly liquid. Today more than $4 trillion in mortgage-backed securities are outstanding. This is a very liquid market.

Win: Okay. So I give this knockout presentation to my investment committee. The chairman says, "Do it." What criteria should we use to select an investment manager for mortgage- backed securities?

Donna: The most important criteria are mortgage expertise, technological sophistication, and experience.

Mortgage expertise and technological sophistication are closely linked. You need an investment manager with the ability to spot discrepancies between Market Prices and cash-flow values. You need an investment manager with the ability to identify bonds that offer superior tradeoffs between risk and yield.

Projecting yields means having the interest-rate-simulation software to project several thousand interest-rate paths over the life of a bond. It means having the prepayment models to project the probable cash flow for each of those several thousand interest-rate paths.

Assessing the tradeoff between risk and yield means having software that can calculate the present value of several thousand cash flows, find the average, and calculate the uncertainty of achieving that value.

To maintain these capabilities, a firm easily can spend several million dollars a year on analytical systems and other technological support.

Identifying mortgage-backed securities that are good values is a difficult business for a boutique to go into.

You need an investment manager who possesses the expertise to assess future cash flows of new mortgage structures.

Quite a few factors besides changes in interest rates affect speed of prepayment. Every time you walk past a bank window, you see a new mortgage variation. To evaluate the cash-flow implications of those variations, an investment manager has to understand the individual mortgages in the pool.

For CMO's, analyzing a new issue— or a bond in the secondary market— means having the expertise to translate cash- flow-distribution rules into probability distributions of future cash flows (Win grabs his wig hair with both hands.) for each bond class. If you're new at this, you can pull out all the hair in your Einstein wig.

Experience. To be an effective player in the mortgage-backed-securities market, a firm needs technological prowess and in-depth expertise. Developing the prowess and expertise is not an over- night undertaking. Find an investment manager who has been in mortgage- backed securities long enough to have a solid track record.

Win: Well, just how much of its pension assets should a company put in mortgage-backed securities?

Donna: That's an area of some debate.

The Solomon and Shearson Lehman indices allocate about 30% of fund assets to mortgage-backed securities.

Personally, considering the risk-yield attractiveness of mortgage-backed securities, I think a fund normally should have 40% of its fixed-income assets in mortgage-backed securities.

Win: Thanks Donna.

That pretty much concludes our prepared remarks for today. In a moment Donna and I would like to hear your observations on allocating pension assets. We would be happy to offer our thoughts on how you might respond to specific concerns of your investment committees about mortgage-backed securities.

But before we turn the meeting over to you, I'd like to tell you what I personally find most noteworthy about investing in mortgage-backed securities.

That is, that this arena is evolving quickly. The market for pass-throughs and CMO's is still in its adolescence.

The combination of low credit risk and good yields is drawing in many new investors.

Most importantly for you, this market is drawing in many unsophisticated investors.

The presence of unsophisticated investors in a market creates its own dynamics. Sometimes unsophisticated investors get in your way. If they or their investment managers do not have the technology to analyze the pricing of a new issue, they allow the issue to clear the market above its cash-flow value.

But most of the trading in mortgage- backed securities is not in new issues. It's from actively-traded portfolios.

If you or your investment manager has the expertise and sophisticated analytics; you will spot opportunities to buy bonds below their cash-flow value. You will spot opportunities to sell bonds above their cash-flow value to unsophisticated investors.

Donna and I started our presentation today with an ancient Chinese curse: "May you live in interesting times."

In closing, we offer you a blessing:

In interesting times, may you buy low and sell high.