MORTGAGE DERIVATIVES

The Journal Sentinel staff

The Wisconsin Housing and Economic Development Authority had unrealized derivatives losses of $32 million on its books at the end of February, according to the agency's executive director.

February is the last full month for which figures are available. The paper losses represented just under 7% of the authority's $463.8 million investment portfolio. They were the result of investments in collateralized mortgage obligations, or CMOs, which are volatile bond-type investments that derive their value from groups of home loans.

"We have every intention of holding these to maturity or selling when the market will give us a gain," said Richard J. Longabaugh, the authority's executive director. The authority has about $121 million worth of CMOs that are part of the investment portfolio it manages, he said.

"The CMOs are all AAA government-backed investments," Longabaugh said.

He believes the authority will suffer no principal loss if they are held to maturity, and the instruments will continue to pay interest until then. Less Flexibility

"Right now it doesn't appear to be a major problem," said John Fargnoli, an analyst at Standard & Poor's bond rating service in New York. S&P has been reviewing the derivative investments and has not downgraded the authority's bond rating, he said.

However, Fargnoli believes the unrealized loss will give the authority less flexibility with its financing in the future.

WHEDA is a state-chartered authority that was started with a $250,000 loan 22 years ago. The private, non-profit organization paid back the loan from the state and now sells mortgage revenue bonds to raise money that it lends to low-income, single-family home buyers. The authority also finances multifamily developments for low-income, elderly and family apartments.

The authority has been using CMOs since 1990, Longabaugh said.

"CMOs were absolutely instrumental in our being able to stay in business in 1993," he said.

The authority had a high interest rate on its mortgage loans in 1993 relative to rates in the marketplace, Longabaugh said. It couldn't lower its interest rates because it had sold bonds based on those rates, Longabaugh said. Most of the time, the authority has lower rates because of its ability to sell tax-exempt bonds.

The CMOs were being used to hedge the cost of paying interest on the authority's bonds, Longabaugh said.

One CMO contributed to about 25% of the $32 million paper loss. It was a principal-only type of CMO that has lost about $8 million, Longabaugh said. He expects the authority to recover its full principal on this investment in 10 years. No Crystal Ball

"The real genius would have been able to sell that before the market turned against us," Longabaugh said.

In a perfect world, the authority would have foreseen the CMO problems, but "the crystal ball was fuzzy," Longabaugh said.

"Interest rates moved up so quickly, it precluded many investors from orderly liquidation of their portfolios," he said. S&P's Fargnoli said the authority's derivatives experience is "a little less troubling" than the State of Wisconsin Investment Board's $95 million derivatives losses that will cost the board $130 million over the next five to 10 years.

"These aren't really funds they need immediately, and that makes a big difference," Fargnoli said.

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