With the recent selloff, the catch phrase in the mortgage market last week was extension risk as Street research devoted many pages to the topic.

For instance, in a report released Monday, Lehman Brothers said that considering the cuspy nature of the mortgage market, the risks toward the extension side are "staggering." The report said that for a 100 basis points increase in rates, analysts are actually projecting the duration of the MBS Index to extend by $650 billion in 10-year equivalents.

Furthermore, the fact that a large proportion of these portfolios are now being hedged with passthroughs adds to the overall extension risk. Lehman said that the impact of mortgage hedging flows would probably become pronounced in a selloff. This should manifest in the form of secular spread widening as well as a spread curve steepening. Aside from this, implied volatility is expected to increase further in a market downtrade and hedgers would likely rush to buy extension protection via the options market.

Mortgages should end up as the worst performers in this scenario, Lehman said. Aside from having to manage the duration of the asset, the mortgage market would have to contend with a steep drop in bank demand and servicer selling of mortgage hedges. The other noteworthy aspect about extension risk is that a market selloff is not needed for the effects to materialize. For each month that premiums are replaced by the lower coupons, the impact is close to an orderly

increase in rates.

"The process of Index restriking results in an overall increase in the duration of the mortgage market, a more symmetric risk profile as well as an increase in the vega exposure of the MBS Index," Lehman noted.

Andrew Davidson, president of Andrew Davidson & Co., Inc., said that the bulk of the mortgage market is still at a premium; this is why there is no significant extension yet. However, the market is now at the brink where further upticks in rates could start to lead to extension risk and the creation of a discount market.

"We are closer to where people may need to take action if they are not protected against extension risk," said Davidson. "Investors need to look at their portfolios and conduct scenario analysis for up 50, up 100 or up 200 basis-points scenarios and determine whether or not they have appropriate protection for those environments. To the extent that they are not protected, they should determine what the trigger points are for adding hedges or altering their strategies."

Davidson said that his firm has been advocating over the last couple of months that investors should look to some higher coupon product that actually benefit from rates backing up. Investors who have applied this strategy are in better shape, he said, while those who have rolled to the lower coupons should face extension risk sooner.

Furthermore, he said investors should consider either purchasing instruments that have shorter final maturities or that have limited extension risk in one form or another or should have liabilities and hedges that would protect them against rising rate scenarios.

In terms of Davidson's model, the firm has generally tried not to recalibrate in the middle of market moves because it only makes it more difficult for their clients' portfolio management decisions. "While our model has been performing very well, we will continue to evaluate the performance of our model over the next few months to see how well it does with the rate increases," Davidson stated.

However, he said that pool-specific trading and the use of additional disclosures provided by Freddie Mac and Fannie Mae would be more of a factor in their prepayment modeling and analysis going forward. "Any recalibration that we do over the next few months would probably be more directed toward that rather than toward the movement of rates," he said.

But don't forget contraction

With the rates having the potential to either go up or down at this point, investors are well advised to look at their portfolio in both directions, sources said. In a recent report, Citigroup argues that despite the increased risks of mortgage extension, given the continued economic instability and interest rate uncertainty, it is too early to write off contraction risks. The report showed that the increasing production of lower-coupon passthroughs and the continuing bias toward high refinancing speeds imply increased call risk in mortgages.

Citigroup analyst Victoria Averbukh stated that in the last few months the production of cuspy 5s and 5.5s has gone up, and could rise even further. These cuspy coupons now represent 35% of the conventional mortgage universe, which is a big jump from only making up 10% of this universe six months ago.

"If you look at premium coupons like 6.5s, they are so short right now that their extension risk is quite significant while their contraction risk is minimal," said Averbukh. "But if you look at 5s and 5.5s, they could go either way depending on interest rates. Mortgages are very rate directional right now." She added that considering last week's selloff, 5s or 5.5s have as much extension risk as high premium 6.5s. However, 5s and 5.5s have much more contraction risk at this point.

Averbukh also noted the average price is currently at 2003 lows, while index duration is at its peak for this year. In addition, even as rates were higher at the start of the year, the number of fast prepaying premium coupons was higher while the index duration was shorter. She added that even if interest rates rise back to March levels, it is possible that the index will not extend as much as currently expected, which is contingent on continuing high speeds on cuspy coupons as well as subdued burnout on premiums.

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