The CMO machine is riding slower this year versus 2003, as CMO production plummeted to a monthly average of $20 billion so far compared with $40 billion last year. However, analysts remain optimistic that CMO production will pick up going forward.

The drop in CMO production is not unexpected, said analysts from Deutsche Bank in a recent report. "An overwhelming consensus for higher rates, significantly lower refinancing needs, and persistent richness of mortgages all contribute to investors' recent discontent with the CMO market," they wrote.

Moreover, so far this year, the commercial banks that drove agency 2003 CMO production have been less active. One telling indicator: at the height of bank CMO participation in 2003, agency CMO issuance averaged 35% of total MBS production per month. Meanwhile, year-to-date, this number is merely 25%.

Deutsche points to the overall richness of mortgages and smaller reinvestment needs as factors driving banks away from short CMO collateral, which they had favored just a year ago. Furthermore, the strength of the dollar roll market also serves as a negative technical for the sector. The attractive financing terms that passthroughs currently provide also make comparable-duration CMOs less attractive, said analysts.

Aside from all of these factors, the expected rise in rates may be dampening these banks' portfolio growth, said Deutsche. In addition, when the Fed eventually raises rates, banks may be motivated to sell mortgage-backeds.

Banks are not quite at a point where they will totally withdraw support away from CMOs, as they still don't have other sources of income, analysts said. However, investors should be cautious as the time will come when banks are likely to withdraw from the mortgage market - which is closer to happening now than it was a year ago. This is why analysts are cautiously optimistic only for the near term.

There are some positive signs for CMOs, however. For one, even though issuance has dropped from the recent past, it remains well over lows seen previously, specifically in light of inventory buildup from 2003.

"Going forward, we expect to see CMO production pick up from February's level, unless the interest rate environment changes dramatically," wrote Deutsche, adding that the non-agency sector should remain robust. After all, CMOs still provide appealing carry as well as desirable flexibility for managing risks in prepayments.

Deutsche also mentioned current production trends in the sector. The number of new CMOs backed by Freddie Mac collateral is now surpassing those from rival Fannie Mae. Freddie's efforts to diversify origination and to slow prepayments have drawn dealers to its product. Even recent aggregate speeds on Freddie collateral have been lower compared to their Fannie Mae counterparts. Popular coupons of choice for new CMO transactions remain the 30-year 5s and 15-year 4.5s, Deutsche also noted.

In terms of current risks in the sector, extension protection "remains the main theme," said analysts. Aside from well-structured PACs backed by 30-year 5s or 15-year 4.5s, buysiders should look into other ways of mitigating this type of risk. For instance, investors should focus on VADMs that provide desirable weighted-average life profiles in rising rate scenarios as well as offer whipsaw protection. Deutsche also mentioned new sequentials backed by low-coupon collateral and last-cash-flow sequentials off of 15-year 5s.

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