By Agnes Crane

Investors in U.S. collateralized mortgage obligations were badly burnt by interest rate hikes in 1994. Some of the contributory factors are again in place. Banks and other investors in the little-known trillion-dollar market for CMOs could be set for a spill.

CMOs sound and look a lot like CDOs, the structured products that helped bring the financial market to its knees in 2008. But there’s one big difference. CMOs are built out of mortgage bonds guaranteed by government-run agencies Fannie Mae, Freddie Mac  and Ginnie Mae. Should defaults on the underlying securities mount, these agencies — and ultimately the government — will keep investors whole.

Thanks partly to this backing, $176 billion of CMOs were issued in the second half of 2009, well above the $44 billion in the same period the prior year, according to Thomson Reuters. There are around $1 trillion of the instruments outstanding, according to Barclays Capital. Some banks and other investors have been buying them partly — and somewhat ironically — because they can’t find what they need in the mortgage-backed securities market, thanks to a Federal Reserve MBS buying program.

Despite their creditworthiness, CMOs can lose value sharply when interest rates rise — or when short and long-term borrowing costs converge, known as a flattening of the yield curve. In 1994, both those things happened when the Fed started raising rates aggressively. With today’s short-term rates near zero and the yield curve near a record steep incline, those circumstances could conspire against investors again.

CMOs have the effect of slicing up the underlying mortgage bonds by different maturities. They are often used to help manage mortgage investment risks such as prepayment by borrowers. Banks commonly buy short-dated CMOs, and if they’ve stuck with that strategy, rising rates won’t hurt them much. But if they’ve bought longer-term CMOs in search of more yield — as pension funds do, for instance — a spike in rates could generate big paper losses, even though the eventual repayment of the bonds is assured.

It’s another reason U.S. bank regulators have been trumpeting their concerns about banks being exposed to interest rate increases, a danger that increases the longer the Fed keeps rates near zero. Regulators had better hope banks listen — and remember the lessons from 15 years ago.