With the back up in rates, questions are rising about convexity selling on a further sell-off that in turn would lead to even higher interest rates.

Deutsche Bank Securities analysts think it is unlikely in the current environment as they believe that many mortgage investors, including servicers, bank portfolios and the GSEs, took little action to buy duration when the market rallied.

They added these investors also didn't receive in swaps or go down in coupon in MBS in any significant size "with the rationale that MBS would trade with longer durations, since high LTV ratios and the related credit issues would tend to suppress prepayments."

With the government's housing plan that allows underwater GSE borrowers to refinance, durations might not be as long as expected which could result in MBS investors possibly being short their duration targets, suggested analysts.

As a result, they said that some of the recent mortgage related receiving of fixed in swaps in the recent sell-off could have been related to this redressing of the mortgage imbalance.

"Given this process, we would be surprised to see a large need to sell duration in a market sell-off," analysts concluded.

Meanwhile, Barclays Capital also believes that a duration-shedding episode is unlikely this year. Market participants might be getting flashbacks to the summer of 2003 when the 10-year note sold off sharply, but the current market environment (in housing and credit) is very different, including "very large buyers that do not hedge extension."

Also, even as 10-year Treasury yields have risen 63 basis points since the March Federal Open Market Committee meeting, mortgage rates have held below 5.0%, and Barclays analysts expect the Federal Reserve would be very aggressive in buying MBS if mortgage rates did start to increase.

Analysts don't believe that originators will spark convexity selling in 2009 like they did in 2003 as they don't foresee prepayments in any one month reaching 2003 levels, or falling off sharply after peaking. Instead, they like most analysts, anticipate a sustained rise in refinancing as the government holds mortgage rates low for some time to allow underwater borrowers to refinance into a more affordable payment.

Capacity constraints are also leading to a drawn out refinancing process. As a result, originators' pipelines and fall-out ratios are less exposed — unlike in the summer of 2003 when rates began to increase and borrowers quickly locked in their mortgage before rates moved even higher.

Back then, analysts said, originators were left with billions of dollars of unexpected loans in a rising rate environment which led them to quickly shed duration which in turn caused rates to move even higher. When all was said and done, the 10-year Treasury yield had surged 150 basis points in six weeks.

As noted above, other large MBS investors currently — the Fed, Treasury Department and Asian buyers — do not hedge which further reduces the risk of a heavy duration shedding event. GSEs have traditionally hedged, but there is less certainty this time around given their status of conservatorship and their role in helping the housing market get through this crisis.

"Nevertheless, GSE hedging (to the same extent as in 2003) remains a possibility," Barclays analysts warned.

Servicers are another source of hedging, but with the government and GSE programs promoting refinancing, analysts say it is likely that servicers will be able to recapture much of their prepaid servicing which reduces their need to hedge. Still, "servicers could be a driver of hedging at the margin," stated analysts.

All in all, analysts concluded that a repeat of 2003 is unlikely, and if mortgage rates do rise the Fed will likely respond to keep them lower. "Our recommendation: if 10y yields rise further, use it as an opportunity to leg into longs," they said.


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