While refinancings and prepayments are likely to pick up as a result of President Obama's housing plan, there is much uncertainty about by how much and whether it will reach previous refinance period levels.
Deutsche Bank Securities analysts noted that the recent up-in-coupon underperformance was rather muted given the possibility of a prepayment surge.
One possibility for the lack in response, Deutsche analysts said, is the increased odds of a steepening sell-off as a result of the possibility of substantial supply coming in Treasurys and mortgages.
In a discussion about mortgage supply, Deutsche analysts noted the potential for pipeline selling by mortgage originators, which could start in the next several months.
As the supply of long-duration mortgages come to market, it could cause a "violent steepening sell-off" as well as wider swap spreads, analysts said.
However, they said that, "there is sizeable uncertainty regarding the magnitude of this supply effect."
At this time, they said it is difficult to project what the future duration and prepayment behavior will be for the new low-coupon mortgages.
In addition, they pointed out that a sell-off leading to higher mortgage rates would cut refinance activity, and thus impact supply, while increasing unemployment would prevent homeowners from being able to refinance.
As the government is also involved in MBS purchases now, it could absorb the new duration supply which would reduce the need for private investors to push yields higher, analysts added.
Given this, analysts said, "the steepener exposures of the up in coupon trade, as well as the possibility of reduced prepayments in a sell-off is likely to have muted flows."
Another factor that possibly contributed to the market's reaction to a potential refinancing wave, Deutsche analysts said, is the concentration of servicing amongst the four largest banks.
They estimated that these four banks service around 60% of the mortgage debt outstanding. Unlike in previous refi events when it could be more difficult for servicers to replace the servicing income due to competition, this time around "due to the concentration of lending among key banks now, these banks are likely to acquire enough volume to make up the lost IO due to prepayment."
But the replacement of a higher coupon IO by a lower one could result in extension risk for these institutions, point out analysts, which could result in an up in coupon bias for banks.
Another factor analysts suggested for the relatively muted reaction is skepticism among investors about how effective the program will be given the experience of the government's previous programs throughout this crisis.
As the market seems more focused on one-month speeds for now, and March speeds are did not change much compared with February, carry remains too attractive to ignore. Analysts stated that, "the full pricing effect may be felt only on realization of initial high prepayments."
At this time and based on the current GSE guidelines, Deutsche estimated Gold 6s and 6.5s could prepay at about 60% CPR by May, with similar coupon FNMAs at about 50% CPR (due to its tighter standards at this time).
Analysts warned, however, that April and May prepayments (reported in May and June, respectively) are likely to vary considerably depending on the implementation of the refinancing plan.