The recent dramatic selloff that moved the 10-year Treasury above 5% has improved the outlook on MBS, Street analysts said.

For instance, Lehman Brothers analysts noted several reasons to be optimistic on the sector as convexity risk is reduced, fixed-rate supply is likely to be lower and current valuations should be attractive for yield-based investors.

Much of the extension risk in the MBS sector has been eliminated, said analysts in a recent report. For example, they pointed out that at the start of May, a 50-basis-point selloff would have resulted in an MBS Index OAD extension of 0.67 years and an additional $277 billion of 10-year equivalents.

Today, however, a 50-basis-point selloff would cause only a 0.38-year extension in OAD and add just $99 billion in 10-year equivalents. Lehman analysts said this translates to about $15 billion of 10-year equivalents for active hedgers, not counting servicers. Servicer needs have declined to about $38 billion from $54 billion, assuming a selloff of 50 basis points.

There is also anticipation that fixed-rate supply will come off its high levels due to the increase in interest rates as well as the steepening of the yield curve. The steeper curve also plays a part

in increasing the attractiveness of adjustable-rate loans.

Buying has started to pick up, but it is still too early to know whether it will be sustained, Lehman said. On an encouraging note, however, the recent backup in rates has increased the difference between the current coupon yield and banks' average COF to 247 basis points, compared with 193 basis points at the end of March and this year's average of 207 basis points. Still, the current level is below the five-year average of 267 basis points.

Another positive factor is the strong deposit growth of 8% to 9% year over year. This suggests that banks do have money available to put to work, analysts said. GSEs, on the other hand, are expected to remain limited players in fixed-rate MBS, because they're more interested in hybrids and short subprime floaters.

In their review on the recent selloff's impact on MBS, analysts stated that 6.5s are now the new 6s. With supply expected to increase in 6.5s, the deliverable is likely to cheapen, they said. Also, over the past several months, 6.5s were deemed to have more favorable convexity characteristics with borrowers previously likely to be of worse credit quality. This will no longer be the case, Lehman said.

On the other hand, supply in 5.5s should decline, which will make the 5.5 deliverable much more seasoned and increase the value of the coupon. At the same time, it will also cheapen the payup for seasoned 5.5s.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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