The CMBS market is holding onto impressive spread levels from top to bottom. With new-issue triple-A 10-year paper around 32 basis points over swaps, and triple-Bs at 105 basis points over swaps, the market is wondering how long these levels are sustainable. The new-issue calendar is cooperating, with a slow cadence of conduit paper since the flurry seen at the end of the first quarter, and investors are getting more used to top-heavy deals that are a cross between a fusion, a large-loan and a traditional conduit.

That said, there are other forces at work. The market is suffering from a lack of supply everywhere, especially in Agency paper. The residential mortgage market has actually experienced shrinkage since mid-2002, and most recently is expected to post a record negative $30 billion for 30-year fixed paper outstanding, down from the April record of negative $28 billion.

The lack of MBS paper has that sector trading at significant premiums, all while refinancing activity is at an all-time high. The prospect for even better performance from mortgages once the refi machine slows down boggles the mind, especially when considering that the convexity trade already has the 10-year Treasury trading at 102 22/23 to yield 3.3%, as of last Wednesday's close.

Shrinking duration has the MBS sector down to around a half of a year, much to the pain of Fannie Mae's and Freddie Mac's respective portfolios. The discrepancy between the assets (MBS) and liabilities (debentures) causes a stir each month when, more notably in FNMAs case, the duration exposure is released. Much of the strategy to combat this showed up in increased mortgage buying, hedging in Treasuries, and through derivative products. Most recently, however, the GSEs are bringing the liability side of their balance sheet into the spotlight.

Issuance in both callable and non-callable debt has been on the slide during the first half of the year. In May, Fannie, Freddie and The Federal Home Loan Banks System called nearly $90 billion in callable debt versus a preliminary estimate of $56 billion in new-issue supply. Those new issues in themselves were down 22% from April's totals. This month, Freddie engaged in the biggest buyback ever, $2.5 billion in 10-year callables. Reading between the lines, the GSEs are trying to increase their duration picture by issuing less paper.

To take this tale a bit further, equity investors are starting to add the term "duration gap" to their vocabulary. Concerns that the GSEs are overexposed to mismatched cash flows have become a concern. On top of ongoing political pressure for more Congressional oversight, investing in the GSEs is not the slam-dunk it once was. Investors will take a second look at their credit worthiness, while the GSEs themselves will long for the day when the market offered more incentive to borrow.

The long-and-short of this is that the CMBS market is the Big Market On Campus right now. Talk of crossover buying and basis purchasing versus debentures and MBS has been well advertised, but the pitfalls are just starting to crystallize in the mind of the larger market. This can only serve to help what is an already impressive spread run, as some are talking about spreads reaching the high 20 basis point area over swaps this year. Until the prepayments, large-scale delinquencies and credit concerns become an everyday risk for the sector, it's hard to argue with those projections at this point.

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