Mortgage-backed securities investors were carefully eyeing an inventive first-of-its-kind residential MBS deal launched last week by Bear, Stearns & Co., which securitizes Countrywide Home Loans' excess servicing portfolio, made up of Fannie Mae collateral.

The transaction, entitled FNSTRI 305, is a derivative-style interest-only (IO) strip deal backed by 242,000 loans, representing $30 billion in collateral. It has been garnering significant attention from investors both because of its potential to limit investors' prepayment risk and because it is the first time such an IO deal has been done in the agency sector.

Moreover, the deal gives mortgage market observers better insights into weighted average coupon (WAC) dispersion data for Fannie Mae pools - information that is typically very difficult to get from the GSE. These types of collateral information and loan statistics give investors a clearer picture of what a Fannie Mae pool actually looks like.

"This is a very interesting transaction, and if it goes well, we will see more of these to come," said Michael Hoeh, head portfolio manager at Dreyfus Corp. "I was under the impression that WAC dispersion on a Fannie Mae pool is pretty close [in basis-point range], but the reality is that it is a wider breadth than that."

"This deal is unique because we have access to loan-level data from Countrywide," added Dale Westhoff, managing director of MBS at Bear Stearns. "We're securitizing the excess servicing strips from each of these Countrywide-Fannie Mae conforming loans, creating a series of fixed IO tranches from the excess servicing."

It's A WACky Concept

WAC dispersion data is key to defining prepayment risk. In the current deal, each group of loans - broken up into 26 tranches - is given an extremely narrow WAC range; for instance, one of the groups in the transaction is backed by loans with WACs between 6.5% and 7%, and no individual loan is above or below that range. With such little WAC dispersion, the prepayment performance is much easier to predict. Therefore, such a bond should outperform comparable trust IO's, a feature which certainly would catch an investor's eye.

"They broke up the deal into what I call mini trusts,' and in this way, it becomes easier to handle the upside and downside risk," said Kathleen Foody-Malus, head MBS portfolio manager at Pittsburgh-based Federated Investors. "Each group is devoted to a specific coupon, so it's easier to model."

The WAC dispersion behind a typical trust IO is, on average, around 190 basis points. The Countrywide portfolio in this deal is broken up into five segments, and each group is backed by loans in a range of just 50 basis points.

"If you compare historical prepayments on these individual fixed IO's that we are creating versus the comparable trust IO, in every case the FNSTRI 305 is paying slower than the comparable trust, all due to the very narrow WAC dispersion," Westhoff added. "The theoretical value of limited WAC dispersion is between 35 and 60 basis points in option-adjusted spread, and in terms of price...these bonds should trade one-half a point to three-quarters of a point higher than the trust IO, because there is less prepayment volatility."

Overall, the structure of this excess servicing securitization will reduce prepayment risk at a discounted price, market participants say. The bonds are being priced at a discount to a regular trust IO, so investors are viewing this as an attractive bond.

Within a portfolio context, the main concern right now for investors is extension risk and higher interest rates, so many investors see this as an opportunity to shorten durations and add very attractive yield to existing portfolios.

"Prepayments are getting slower, so this is a compelling carry-trade, and that is why we are looking at it," said an MBS money manager. "Mortgage bankers will be lining up to follow suit if this thing goes well. I'm sure Norwest - probably even Freddie Mac - are looking at this one real close."

While officials at Countrywide declined to comment on the transaction, Westhoff pointed out that Countrywide will be retaining the primary servicing on the transaction, and securitizing the small strip of excess servicing.

"Most of these are backed by discount loans, and our view is that prepayments will slow an additional 30% to 40% due to seasonal and higher interest rates, so these bonds will look better four or five months from now," added Bear Stearn's Westhoff. "The IO market is at a lower dollar price because of the recent rally, so these will look better than a comparable trust."

Investors Make A Pitch

Some investors, however, have no interest in derivative securities, and are therefore ignoring the deal; others are considering pairing up the paper with another derivative structure in their portfolio, such as a PO strip, because this would produce a cheaper piece of collateral than buying the collateral outright by itself.

"This is only going to appeal to a limited audience, by virtue of the fact that it is a derivative security," said Lisa Brown Premo, an MBS portfolio manager at First Union. "For instance, I did not look at it, but I do think that this is something noteworthy that we will be seeing again in the near future."

According to market sources, some investors have already "put in a level" to Bear Stearns, trying to offer a certain percentage at which they would be interested in buying the security. For instance, one investor reportedly asked to buy at "X%" of where regular IO trusts are trading, but were turned down by Bear Stearns.

"Lots of clients are looking at this one," said the source.

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