In a recent report, Citigroup Global Markets said that the mortgage market is still undervaluing the "cheap" convexity provided by low loan balance (LLB) pools.

LLB 5.5s are pools with balances averaging roughly $65,000. Compare this to an average loan balance of $175,000 for 2003 production 30-year FNMA 5.5s, as well as $169,000 for 2002 production 30-year FNMA 5.5s.

Lower loan balance pools usually prepay more slowly versus. higher loan balance pools. Citigroup attributed this to lower dollar savings from refinancing for those with smaller loan balances. Recent prepayment speeds have emphasized the considerable difference in LLB paper vs. its corresponding cohort average.

Analysts said that though price transparency for specified paper continues to improve, recent pay-ups for LLB pools show the market prizes carry more than convexity. While analysts don’t disagree with the market’s willingness to sell convexity, they can’t dismiss the cheap insurance that LLB pools provide. If the market rallies considerably, LLB paper can offer significant protection. When analysts incorporated LLB pools into their scenario analysis and extended the time horizon to six months, the convexity benefit is compelling, they said.

Many investors are concerned that pricing services often price these securities at TBA levels. This is a problem for those forced to use these pricing services, but Citigroup’s analysis demonstrates that, even if buysiders mark these pools at a zero pay-up, they still provide an attractive return profile.

Citigroup believes the upside in a low interest rate environment counters the downside in a market selloff. This relative payoff profile is similar to that of a call option and reflects that the purchaser of LLB paper has "bought back" some callability. Analysts stated that the market has yet to realize the "cheapness" of these call options and is not willing to pay even modest premiums for these slightly out-of-the-money benefits.

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