With a yield curve that steepened out dramatically since Sept. 11 and with heightened bank interest fuelling the CMO machine, October saw the highest level of single-month collateralized mortgage obligation (CMO) issuance ever.

Credit Suisse First Boston reported that the total number of Agency CMOs settling in October was approximately $44 billion.

Analysts said that the unprecedented amount of CMO issuance is caused by various factors. The biggest driver is the fact that with the steep yield curve and low Treasury rates, depository institutions are looking to CMOs to get some yield.

According to Art Frank, director of mortgage research at Nomura Securiites, short Treasurys, commercial paper, cash deposits (CDs), even short to medium-term Agencys currently do not offer very attractive yields.

"The higher yields that are available in the CMO market, specifically in the two-to-five year sector, have been attracting a lot of bank interest," said Frank.

Furthermore, since commercial loan demand has not been that strong given the weakness in the economy, banks are now looking to put their excess funds in the securities market.

Dealers are currently also willing to hold bigger CMO positions, said Frank. This is because aside from their ability to sell a considerable portion of new issue CMOs, dealers are also willing to hold some for themselves because in this steep-yield-curve environment the carry on a CMO position is quite attractive.

Some numbers

Analysts are comparing the current level of CMO issuance to that of 1993, which is considered the biggest CMO year ever in terms of market share. During this year, the CMO machine took out about 60% to 70% of all pass-throughs.

In 2001, the CMO share is only about 50% of the total number of pass-throughs. However, considering that the mortgage market is much larger now, the absolute dollar amount of CMO issuance is greater this year compared to that of 1993. Experts say that Agency CMO issuance this year is expected to be just under $300 billion.

To keep up with this hectic pace, CMO desks are very busy. For instance, CSFB said that last Monday alone its CMO desk traded $300 million in bonds and bid on double that amount on the same day.

The report also said that the bid lists came from a variety of accounts. Analysts from the bank noted that a list of particular interest was made up of 1993 production of busted planned amortization class bonds (PACs). There was another list on Tuesday that was made up of approximately $200 million of seasoned 1993 production bonds. CSFB said that seasoned CMOs from these lists traded well.

The analysts said, however, that prepayment characteristics of 1993 production collateral may not continue to be as well behaved as they have been this year.

Aside from this, CSFB emphasized that if mortgage rates were to continue to trend down, the convexity-short PACs that are backed by new production 6s would be far better compared to 1993 production 6.5s and 7s.

Meanwhile, in its Agency CMO commentary UBS Warburg said that 6% conventionals are the "most useable" for CMO deals. Analysts, however, noted that they have also seen deals backed by other types of collateral such as 30-year 5.5s, 6s, and 6.5s. They also said that the four-to-eight year sector of the PAC curve continues to remain attractive.

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