As slowing economic numbers and favorable remarks from Alan Greenspan point to Fed tightening to begin early next year, and mortgage rates plummet 23 basis points since the beginning of December, the likelihood that mortgage rates will reach important MBS prepay triggers in 2001 has increased substantially, according to Bear, Stearns & Co.

Even more notable, in a research report released last week, researchers from Bear said that mortgage rates do not have to reach 1998 levels to match the supply volumes observed in 1998.

"You would only have to have a rally of 40 more basis points in mortgage rates in order to reach the peak levels of 1998," said Dale Westhoff, managing director at Bear Stearns and co-author of the report, entitled MBS Prepayment Thresholds 2001. "We do not have to rally down to a 6.80% mortgage rate to trigger the same level of supply seen in 1998."

And many investors were taken aback by this. Westhoff noted that he received several phone calls last week when his research report was published.

"Some people were a bit surprised that this was the case," Westhoff said. "The reason we match 1998 levels is that since 1998 the overall mortgage market has grown by 43%, so it is a much bigger market to start with. Then, we are rallying to a level that's triggering these 1999/2000 issues and getting significant prepayments - so we are able to match those levels."

Not everybody agreed completely with Bear. One investor noted that the average coupon is much lower than it was in 1998, and 6.5s will have to become refinancible before the peak levels of 1998 are attained. "To get to peak refinancing you'll need another 75 basis points in rates. We will see a pick-up in refis but we're a long way from 1998 levels."

But according to the report, as a result of the 1998 Refi wave, 65% of the MBS universe is concentrated in 6s, 6.5s and 7s; however, on a dollar balance basis, today's market has much more exposure to 7s and 7.5s than it did in 1998, and only slightly less exposure in 8s and 8.5s.

Therefore, a smaller percentage of today's fixed-rate universe entering the refi window will match total dollar volume of supply observed in 1998, which hit a low mortgage rate of 6.8%. The break-even point to 1998 supply is at an effective mortgage level of 7.10%, which exposes 82% of the 99/00 universe and 52% of the total universe. Obviously, the potential increase in supply increases the risk of pricing pressure.

"You'll start to see short-term prepayments reflect this, certainly in the December reports" Westhoff said. "We are expecting a nice upsurge in the 7.5% and 8% coupons next year, but primarily the 8% will be hit in the next report."

The sector of loans most vulnerable to even modest refi pressures are 99/00 7.5s and 8s. According to their threshold table, at a 7.5% mortgage rate, 64% of the 99/00 universe is exposed to refi risk and 34% of the total fixed-rate MBS market. At an effective rate of 7.25%, 2000 7s become exposed, raising the 99/00 universe at 68% and the total universe just slightly to 35%.

According to Bear, sectors that offer the best convexity plays is the low-loan balance sector, 2028 WAM conventional 6.5s, 7s and 7.5s, and certain Alt-A issuers.

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