There are still attractive opportunities in call protection paper for investors who are concerned about a refinance wave happening as a result of a drop in mortgage rates, Barclays Capital analysts said.  

Loan balance paper is one sector that has been mentioned a lot lately by several firms and despite the attention, the sector remains historically cheap, analysts said.

The Barclays report noted that the current pay-up for FNMA LLB 6s is 12.5 ticks versus 29 ticks in February. Analysts further calculated, based on the firm's OAS model, that current pay-ups are only 12% to17% of their theoretical even-OAS value for FNMA 6s, and 12% to 17% for FNMA 5.5s.

Historically, loan balance paper prepays slower than generic collateral. They point out that at a rate incentive of 100 basis points back in 2003, TBAs prepaid at 75 CPR, while LLB prepaid at nearly 25 CPR. Loan balance paper also prepaid considerably slower in the most recent refi mini event - March 2008.

Analysts additionally pointed out that loan balance loans offer substantial carry advantage over TBA, and given their current pay-ups and estimated speed difference, the breakeven time is only about 3-4 months for 5.5s and 5-6 months for 6s.

"The market does not seem to have priced in the refinancing protection offered by the loan balance collateral correctly," Barclays analysts said. Given the excellent convexity and shorter breakeven period, they like LLB 5.5s the best.

Another sector analysts believe offers good refi protection is investor collateral based on analysis of the 2003 refi event and in March of this year. Investor collateral prepaid significantly slower than 2nd home and owner- occupied collateral.

For example, 12-24 WALA owner-occupied loans prepaid at about 80 CPR in 2003 (approximately 20 CPR in March 2008) compared to around 55 CPR for investor loans (approximately 10 CPR in March 2008). Looking at the prepayment behavior of loan balance and investor loans in March, analysts found that the investor collateral prepaid similarly to LLB.

Further inhibiting prepayments for this collateral are the higher up-front GSE guarantee fees for these loans. The government programs as well are targeted toward owner-occupied borrowers.

The third sector that analysts believe offers "tremendous" value is prepayment penalty hybrid ARMs. They note pay-ups on 5/1 hybrid ARMs with three-year penalties are flat currently compared to a theoretical even-OAS pay-ups of 14 to 23 ticks.

The lack of supply is also seen as a favorable technical. While there is risk that regulators could pressure servicers in removing the penalty, analysts don't believe they will be successful. But "as prepayment penalty hybrids are trading with no pay up, the worse case scenario is that you get a regular hybrid ARM, an asset that is already cheap," analysts said.

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